By Stephen L. Nesbitt – Chief Executive Officer, Chief Investment Officer of Cliffwater.
It’s not complicated. Allocators are formulating return and risk assumptions for private debt that compare favorably to other asset classes, in turn recommending new or higher private debt allocations using traditional asset allocation models.
Allocators universally direct monies to asset classes based upon long-term expected returns, risk, and correlations, collectively known as capital market assumptions, or CMAs. CMAs have ruled institutional asset allocation for the past 40 years. The recent emergence of private debt in asset allocation discussions was made possible by indexes like the Cliffwater Direct Lending Index that provide an historical record of private debt return and risk, which in turn assist allocators in developing CMAs for that asset class. Allocators evidently like what they see, both historically and prospectively. Exhibit 1 displays consensus (average) expected return and risk for 11 asset classes based upon individual forecasts from 12 of the largest allocators.
Higher allocations to private debt are fully explained by Exhibit 1. Private debt plots well above the average return/risk spectrum shown by the dotted line and its 8.9% consensus 10-year return is second only to private equity, which has roughly double the risk. Unquestionably, individual allocator assumptions reflected in consensus forecasts are driving new or higher private debt allocations from optimization models.
Also noteworthy:
Private debt’s 8.9% expected return is highly accretive to the average institutional portfolio with a consensus 6.9% expected return.3
Individual allocators’ private debt expected returns range from a 7.0% low to an 11.5% high with 8 of 12 allocators posting expected returns in the 8-9% range.
Real estate allocations will likely decline judging from their low 5.8% consensus expected returns, a full 3.2% below private debt with roughly the same risk level.
Allocators continue to see non-US stocks as a value opportunity relative to US stocks, rather than a value trap, with consensus non-US stock expected returns at least one percentage point above US stocks.
Hedge funds will continue to struggle to gain allocations as investment grade fixed income expected returns have returned to pre-2008 levels.
About the Author:
Steve Nesbitt is Chief Executive Officer and Chief Investment Officer of Cliffwater, and is primarily responsible for the day-to-day management of Cliffwater Corporate Lending Fund (CCLFX) and the Cliffwater Enhanced Lending Fund (CELFX), an SEC registered credit interval fund focused on the US corporate middle market.
Steve is recognized for a broad range of investment research. His papers have appeared in the Financial Analysts Journal, The Journal of Portfolio Management, The Journal of Applied Corporate Finance, and The Journal of Alternative Investments. His private debt research led to the creation of the Cliffwater BDC Index, measuring historical BDC performance, and the Cliffwater Direct Lending Index, measuring historical performance for direct middle market loans. Steve authored the book, Private Debt: Opportunities in Corporate Direct Lending, Wiley Finance (2019) which provides the analytical and empirical underpinnings of the private debt market.