The Growth of Direct Lending – An investor Q&A

On the investor side, demand for direct lending has reflected a favorable return profile, loss rates comparable with (or better than) the public markets, and diversification from a traditional investment portfolio. On the borrower side, companies have valued the ease and simplicity of the transactions, the certainty of execution and the value of having a strategic partner. Structural market shifts have also allowed the private credit market to grow, as seen in the higher “barriers to entry” in the public markets.

What is private credit, and how is it related to direct lending?

Within the US$11.7 trillion alternative asset universe lies the US$1.3 trillion private credit market (see chart on page 2). Direct lending represents the largest category in private credit, at 44% of AUM, and refers to financing that is directly negotiated between a lender (often an alternative asset manager) and a borrower (usually a small-to-mid-sized company).

How does its size compare to public markets?

Private credit’s strong growth since the global financial crisis has established it as a sizable and scalable asset class for a variety of buy-and-hold investors. It’s now on par (in terms of size) with the Bloomberg U.S. HY Corporate Bond Index (US$1.3 trillion) and the S&P/LSTA U.S. Leveraged Loan Index (US$1.3 trillion). Growth is expected to continue -- Preqin estimates that the global private credit market will reach US$2.3 trillion by 2027, with the strongest growth expected in North America.

What have been the most significant growth drivers of private credit?

There have been many drivers. On the investor side, demand for private credit – and the resulting inflows – have reflected favorable return profiles, loss rates comparable with the public markets, and diversification from a traditional investment portfolio. On the borrower side, companies value the ease and simplicity of the transactions, as well as the certainty of execution.

Structural market shifts have also allowed the private credit market to grow. Beyond the enhanced bank regulations in the wake of the financial crisis, the “barriers to entry” in the public markets have increased, as seen in the growth in the average deal sizes in the U.S. HY corporate bond and leveraged loan markets.

How have returns of direct lending compared to publicly traded investments?

To track the performance of the direct lending asset class, we use the Cliffwater Direct Lending Index (CDLI) as a proxy. The CDLI is an asset-weighted index of 12,000 directly originated middle market loans totaling US$260 billion as of Sept. 30, 2022. Since its inception, the CDLI has outperformed the U.S. HY bond and U.S. leveraged loan indices for 12 of the last 17 years, as well as through the first three quarters of 2022 (most recent data available). On a global basis, private credit returns also compare favorably to the global HY and leveraged loan indices, as measured by the Preqin Global Private Debt Index (which includes all private credit strategies).

How does direct lending perform in a recession?

Historical loss rates for direct lending compare favorably to the public HY and leveraged loan markets. In periods of market stress such as the global financial crisis, the energy sector disruption of 2014-2015, and the COVID-19 pandemic in early 2020, net realized losses in direct lending were either similar to or lower than our estimate of loss-given-default in the U.S. HY bond and leveraged loan markets.