A new study takes what is called a “first look” at the aggregate performance of private credit funds. Using data going back to 2004, the authors (two of whom are affiliated with Adams Street Partners) determine that private credit funds “have performed about as well, or better than, leveraged-loan, high-yield, and [business development company] indices.” Such funds also display a low correlation with benchmark indices, which suggests that they provide diversification vis-a-vis other credit strategies. The paper, by Shawn Munday, Wendy Hu, Tobias True, and Jian Zhang, begins with the observation that this asset class has of late been flying underneath the usual scholarly radar. There are commercial data providers who collect material on these funds, but “each has a unique approach to doing so, incorporates different potential biases, and captures only a subset of the private credit fund universe,” making life difficult for those who would study results. The Database For their study, Munday et al. use the Burgiss database. This takes in the performance of 476 funds. Among them are 155 direct lending funds. This allows Munday et al. to “develop a preliminary view of performance and risk across various private credit strategies.” The Burgiss database is superior to others because due to its cash-flow level data sourced from limited partners, which is more informative than self-reported IRRs. Also, Burgiss has a high level of data integrity allowing precise analysis of fund and strategy performance. This fund space took on a new role after the global financial crisis, and after two important regulatory responses to that, the Basel III accord setting capital requirements for banks, and the Dodd-Frank Act in the US. In reaction, banks cut back on their corporate lending operations. But growing companies still needed capital, so somebody was bound to step in and fill the void the retreating banks had left. Where are the asset managers who constitute that “somebody” getting the funds they lend? Largely from institutional investors, which find themselves “faced with a historically low-interest rate environment,”—another consequence of the GFC, looking for new vehicles with attractive risk-reward characteristics. The Private Debt Strategies The paper distinguishes among five strategies, then adds a catch-all “other” category. The five are:

  1. Business Development Companies. The BDCs operate under specific regulations mandating their “significant managerial assistance” to their debtor companies. The majority of BDCs are treated as RICs for tax purposes, which involves additional regulatory oversight.
  2. Senior Loan Funds. These are closed-end vehicles that make first or second lien loans to small- and mid-sized companies. They use floating rate spreads composed of a risk premium and the benchmark rate, and typically target gross returns in the neighborhood of 10%.
  3. Mezzanine Funds. These are also closed-end vehicles. Typically, they make junior capital investments (often a hybrid between debt and equity) in small- and medium sized companies funding acquisitions, growth, recapitalizations, or buyouts. They typically target return in the mid- to upper teens, given their position subordinate to the senior liens.
  4. Distressed Debt Funds. These can be either closed- or open-end vehicles. They invest in the debt securities of mid- to large-sized companies that are experiencing financial distress, seeking deeply discounted purchases. There are a variety of strategies involved under this broad heading, including loan-to-own or turnaround lending.
  5. Special Situation Funds. These are typically closed-end vehicles. They, too, target mid- to large-sized companies in tight circumstances. They have a much broader mandate than the distressed debt funds, investing across the capital structure.

Beyond these strategies, as noted, there are “other funds,” a basket that includes structured credit vehicles, multi-credit strategy funds, and specialty finance strategies. Direct lending funds, that is, funds that generally initiate investment opportunities bilaterally, might be treated as another category alongside the above. But these authors note that the direct lenders are divided up, especially among categories 1 through 3, on the above list. Investors often believe that the direct lending funds have an attractive value proposition, by virtue of cutting other intermediaries out of the picture, thus direct lending funds have attracted a disproportionate share of the new commitments to private debt in the period since 2009. On the other hand, the authors caution, direct lending can involve a loss of liquidity and greater uncertainty in comparison to the alternatives that do make use of those pesky intermediaries. The pooled IRR for all strategies for all vintages 2006-2016 is 8.1%, “which is roughly on par with return expectations for equity over this period through perhaps below expectations set by fund managers.” The direct lenders did better than the intermediated lenders for the majority of the study. And among the strategies listed above, the most stable performance comes from the Mezzanine.