From time to time, we will feature investment topics we are researching in our quarterly memo. For this quarter, the topic is Private Debt, which we consider to be an attractive investment opportunity with current distribution yields of 10%. We like the combination of high current yield distributions, historically low default rates, consistent performance across market cycles and low volatility.
Summary
Private debt or loans made to private businesses is a form of lending that has produced nearly 10% returns over the past 20 years with low volatility and despite a near zero interest rate period from 2008-2022. These returns reflect the entire category as opposed to one particular investment firm.
Private loans are the result of a shift towards private markets vs. public debt or bank originated loans. The loans typically have floating interest rates and are “first-lien,” which indicates they are the first loans to be paid back in the case of default. Private lending funds are diversified and provide higher income options compared to traditional investments such as stocks and government bonds. The funds are oftentimes managed by large money management firms who oversee $100’s of billions in total assets, including private debt/lending strategies. The individual loan size varies but could range from $20 million to $2+ billion.
High Income Distributions
Private debt is attractive because it offers high and steady income, yet the risk is relatively low. The average expected return is around 9-12% per year, which is far higher than what you would generate from other income-oriented investments such as government bonds or savings accounts. For context, short-term U.S. government bonds have yielded approximately 3.5% over the past 100 years.
Sources of Return / Income
The 9-12% return/income over the long-term from private debt/loans comes from four main sources:
- Base Interest Rates: 2-4% return long term, which is similar to the interest rate from short-term government bonds over the past 100 years vs. the current base interest rate of 5.25%
- Credit Spread & Illiquidity Premium: 6-8% incremental return for the risk of possible loan defaults; oftentimes credit spreads will widen when the base interest rate declines; additional compensation for the fund being willing to issue the loan yet not be able to sell that loan in the public markets; but, as an investor in the fund, we do have substantial liquidity if we want to sell (fund by fund detail important); the estimated breakdown between the Credit Spread and Illiquidity Premium can be difficult to decompose
- Underwriting Fees: 1% incremental return earned by the fund/investors for setting up the loan; this fee is earned by the fund for the benefit of fund investors, such as our clients
Low Risk of Defaults
Historically, private loans or direct lending have very low default rates, averaging about 1% per year. Funds we are actively analyzing for our client partners have far lower default rates of around 0.1% or even lower. This means that the companies borrowing the money nearly always pay it back. Even if some loans do default, the average net loss is minimal, resulting in a net yield of approximately 10% over the past 20 years for the entire category. The value of these loans is set quarterly, with the value typically consistent with the original value of the loan unless a default is likely.
Performance During Cycles
Direct lending has exhibited resilient performance during economic downturns. The worst annual return in nearly 20 years was a mid-single-digit loss (around -7%), and recovery from such losses typically happens within a year. The lowest rolling 10-year return was 9%. The performance of direct lending has been relatively stable over time. Currently, the returns are slightly higher than the long-term average due to higher interest rates, with a current yield of over 11%. If interest rates decline, the other income components are likely to increase, keeping overall returns attractive.
Leverage
Many direct lending funds use a bit of leverage, or borrowed money, to boost returns. Typical leverage levels are about 1.25x the net assets, which increases returns without undue risk. If you compare the leverage of 1.25x to a traditional bank at 8-10x+, it appears conservative. The maximum leverage is typically around 2x.
Market Dynamics and Transparency
While financial press pundits sometimes argue that too much money is flowing into private debt/loans, the market demand aligns with the financing needs of businesses. Transparency is strong, with regulatory oversight ensuring that a significant portion of the market is well-monitored and disclosed, unlike traditional banks which are less transparent. Individual funds oftentimes disclose the individual company loans.
Conclusion
Private debt in the form of loans made to private businesses is an interesting investment opportunity, particularly for client partners seeking income solutions. We like the combination of high current yield distributions, historically low default rates, consistent performance across market cycles and low volatility. We will be investing in these types of strategies over the coming months as appropriate.
Brief Market Review
Large company stocks in the U.S. have continued their strong performance in 2024 as noted by the S&P 500 up 15% and led by the mega-cap technology companies. Outside of stocks in Japan with the Yen-hedged being up 29%, diversification continues to not be rewarded on the surface. Gold has zigged when stocks zagged and is up 14% while India is also up 14%. However, U.S. small company stocks are up only 1%, International stocks up 4% and Emerging Markets up 8%. Further, after a late-2023 rally, broad bond indices are flat and high yield bonds are up 3%.
The ratio of large stocks vs. small stocks and growth vs. value stocks are at their largest disparity since the dotcom bubble of 2000. This is an observation of the extremes present today but not a bubble call as extremes can become more stretched.
The economy in the U.S. is now slowing yet inflation remains well above the Fed’s target of 2%. The data coming out suggests a stagflationary environment where economic growth disappoints to the downside and inflation is higher than expectations. In this version of our Core Four Economic Environments, stocks typically do not fare well yet those that do are typically high quality and high growth companies. Thus, it would not surprise me to see the large-company technology dominance continue for at least a few more quarters.
I appreciate your continued trust and support.
Nick
Investment advisory services offered through Essential Partners, LLC, an SEC registered investment adviser.
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