Asset allocation model boosts projections for private debt returns

With interest rates and inflation on the rise, consultant Cliffwater raises return expectations across most asset classes.

Private debt is expected to have among the best performance across major asset classes – both traditional and alternative – in LP portfolios, according to a new study from consultant Cliffwater.

The Los Angeles-based advisor recently released its Third Quarter 2018 Market Outlook and Asset Allocation Report, which boosted expected returns across most major investment categories. The long-term expected return for private debt investments received the highest quarter-over-quarter boost in the allocation model, rising 50 basis points.

“While there is a give-up in liquidity, private debt looks pretty good in total return delivery,” Stephen Nesbitt, Cliffwater’s chief executive, told Private Debt Investor.

Robust returns predicted for private debt

The 10-year expected return for unlevered private debt rose from 6.85 percent to 7.35 percent per annum, the highest quarter-over-quarter change in the report.  For its part, levered private debt expectations climbed 25 basis points, from 9.30 percent to 9.55 percent.

Compared to 31 asset class categories, the expected returns for levered and unlevered private debt ranked better than 90 percent and 70 percent of the other categories in the model, respectively.

Historically, private debt has yielded 8.43 percent in the four quarters ending on 31 March, according to the Cliffwater’s Direct Lending Index (CDLI) indicates. The index tracks data on more than 6,000 direct middle market loans worth $93 billion.

“We expect private credit to beat public credit by at least 300 basis points,” Nesbitt said.  “Our research shows that institutional funds have achieved that return premium across the last 15 years.”

Sitting in between the unlevered and levered sleeves of private debt is the public BDCs, which are now expected to produce 7.55 percent annually across the long term, down 35 basis points from last quarter’s estimate of 7.90 percent.

The BDC category is currently yielding 9.11 percent, based on data from 42 BDCs with a $32 billion market capitalisation within the Cliffwater BDC Index. The BDC yield spread over high yield bonds stood at 247 basis points, as of June 2018, offering an “attractive alternative” according to the report.

A backdrop of lower volatility, minimal losses and floating-rate coupons accentuate the high returns for private debt, resulting in accretion for a diversified portfolio.

“The major takeaway is that return expectations for traditional 60/40 stock/bond portfolios remain low and unlikely to meet investor return objectives.” Nesbitt emphasized. “Private debt can be accretive by increasing return and lowering risk.”

The annualised volatility of private debt assets measure between and three and four percent going back to 2004, according to CDLI metrics. Also, the report identified private debt as “attractive relative to realised loss rates that average 1-2 percent over long time periods.”

Private equity leads other asset classes

Private equity is the best performing asset class in Cliffwater model, with expected long-term returns ranging from 9.20 percent for buyout funds up to 10.70 percent for venture capital. “The good news for private equity is that the sector keeps doing well relative to public equities,” Nesbitt pointed out.

Real estate is the only asset class where Cliffwater reduced its long-term return expectations across all subcategories. “Cap rates are getting squeezed as a lot of money is rolling in the sector. The price of real estate is getting bid up on the coasts,” Nesbitt explained. “Also real estate investors are migrating out of retail and into senior, student, and industrial properties.”