Under pressure, but bearing up

Returns for direct lending are predicted to come down slightly over the next 10 years, but the asset class still looks attractive on a relative basis, writes Andrew Hedlund

Direct lending’s forecasted return over the next decade will decrease slightly from last year, according to an annual report from Cliffwater.

The Los Angeles-based investment advisor’s expectations for a future 10-year return are 6.95 percent on an unlevered basis and 9.45 percent on a levered basis. That’s slightly down from last year’s forecast of 7.05 percent and 9.65 percent, respectively. The index used for the asset class is the Cliffwater Direct Lending Index.

The one-year return for 2017 was 9.3 percent for unlevered direct lending and 11.3 percent for levered direct lending. Private debt should perform well in the rising rate environment due to floating-rate structures, the report said.

“Our view has been that direct lending continues to be a relatively attractive asset class even though absolute levels of return [across all asset classes] are coming down,” says Steve Nesbitt, chief executive of Cliffwater.

Public business development companies are expected to post a 7.55 percent return over the next 10 years, compared with last year’s forecasted 7.25 percent. The one-year return for the strategy in 2017 was 0.9 percent.

Institutional investors will likely continue to favour private direct lending funds over public BDCs, Nesbitt says. For public BDCs to gain traction, the space needs more “high-quality entrants”, as well as a regulatory change to a rule that makes BDCs more expensive for some institutional investors like mutual funds.

Private equity’s forecasted 10-year return also decreased slightly. A diversified portfolio is projected to return 9.5 percent, down from 9.7 percent last year. For the asset class’s subcategories, buyout vehicles are expected to return 8.75 percent, venture capital 10.25 percent and energy 9.5 percent. All those groups’ 10-year returns decreased 0.2 percent from last year.

“Our view has been that direct lending continues to be a relatively attractive asset class even though absolute levels of return [across all asset classes] are coming down.”

Steve Nesbitt

Cliffwater calculated their return projections by adding anticipated cash yield and cash growth. A manager alpha component was also factored in for the alternative asset classes, which the firm re-examines annually based on past alpha generation and adjusts the data accordingly.

Tactical return components may also factor in, but those returns from valuation changes trend toward zero, so Cliffwater did not include the tactical return components into the projected 10-year returns.

Nesbitt doesn’t expect any large departure from last year for 2018 in private credit.

“Most institutional investors are a little bit stuck,” Nesbitt says. “Their required returns lead them to need at least a 7-plus percent return. While there’s tremendous concern about assets being overvalued, there are no good low-risk alternatives.”