December 2023
Cliffwater’s goal is to provide solidcompounding returns in even tumultuous environments. Fran explains how directlending can be considered an alternative to traditional bonds and may offerpredictability, lower interest rate risk, and yield premium over publicmarkets. Cliffwater is intentional and selective about the managers they chooseand tend to lend to defensive sectors. Fran and Bruce note that rising interestrates are both a challenge and an opportunity in the direct lending market,which is growing rapidly and gaining market share from traditional bonds.
Watch previous episodes here:
Ep. 64 Generating Attractive Returns Through Creative Private Lending
Ep. 63 Artificial Intelligence: Possibilities and Pitfalls
I'm Bruce Tyson. I'm a partner at Morton Wealth. And with me today is Fran Beyers. You've flown in from Chicago, New York, New York. Fran is head of the Cliffwater Capital Markets Group and she's the portfolio manager for the Cliffwater Corporate Lending Fund as an integral part of our portfolios.
So you've been good to get to know what she's got to say. Their investment philosophy dovetails really well with ours, you know, a constant companion. In all my years as an advisor is the parade of stories about investors who who swing for the fences and miss. And either through buying stocks that crater high flying stocks or crater, or somehow get involved in investment scams and it’s a source of psychic pain for advisors like like those at Morton, where we know that we wish that investors could know what we know, that continuous compounding of returns and minimizing losses is the surest path to success.
And so that's why we put on events like this symposium and a chance to offer a continuing education to our clients. Now, when I was a freshman in college, we had an aptitude test, and my results came back that I should either be a part of the clergy or an educator. So this is I guess and this is partly preaching and teaching.
My destiny is fulfilled. And so anyway, we have Fran here. The aim of Cliffwater is to provide solid compounding returns in any environment. So let's talk about how Cliffwater is a go anywhere, all weather investment.
Thank you, Bruce. And sometimes I feel like a nun too, so I can relate. And I have to say, this is the first conference I've ever been to where there's alcohol throughout the day. And so I fully support drinking it makes direct lending way more fun to talk about. So I support it. But thank you guys for for having me today.
A little background on Cliff water. We have been advising on asset allocation for nearly two decades and our DNA has historically been alternatives for our large pension fund clients. But over the last I'd say five years, we saw a real need to bring a private credit solution to the high net worth channel who really didn't have great access to the asset class.
And we felt it's all whether it has really low volatility and these high net worth investors weren't getting the same level of opportunities and that a scaled institutional investor was getting. And so in 2019 we launched Cliffwater Corporate Lending Fund and today it is the largest private credit interval fund out there at 17 and a half billion.
And we designed it for folks in this room. I spend a lot of my time talking to investors and I have to say it is really stressful trying to invest your money responsibly In the last couple of years, whether it's been massive macro uncertainty, crazy interest rate movements, there's been a ton of market volatility and it really has not been kind to 6040 portfolio folios or equities and bonds.
And I'm going to give you a perfect example coming into 2023, if you are reading the headlines in The Wall Street Journal or Bloomberg, they were saying 2023 is going to be the year of the investment grade bond. The assets are generating the highest returns we've seen in 15 years at 7% yields. And these are investment grade borrowers.
They're riskless. They're not going to go bad. We'll fast forward to today if you put your money in investment grade bonds at the beginning of the year, your year to date returns would have been negative three and a half percent as of Monday. And so it's reasons like this that we believe if you're willing to give up a modest amount of liquidity on a modest portion of your portfolio and put it into direct lending, you can do one of three things.
First and foremost, you can increase the predictability of your return stream. Direct lending returns tend to be in a very narrow band in that high single digit area year after year. Regardless of what's going on in the markets and the economy. Secondly, you can eliminate your interest rate or your duration risk because these are floating rate assets. And then thirdly, direct lending in private markets generates a really nice 2 to 300 basis point yield premium over public markets.
And I know what you're thinking, like, my God, Fran, this sounds amazing, but I don't believe you. We actually have data and the numbers to back it up. So coming out of the great financial crisis about ten years ago, we were starting to see institutional investors begin allocating to direct lending. And our CEO, Steve Nesbitt at Clif Water said We really can't expect investors to invest in this asset class in any meaningful way without a benchmark.
And so ten years ago, we went out, we bought we built the Cliffwater direct lending index. It is now the gold standard in the industry. It was just quoted in the Wall Street Journal this week and it showed some really compelling data on the return stream of direct lending. It goes back 20 years. And what it shows is that over the last 20 years, every single year, the returns were positive except for one which was going into 2008 during the great financial crisis.
But the returns were only negative by like 6% versus equities, which was down 30, 40%, and bonds which were down 20%. It outperformed liquid loan markets 19 of 20 years, it outperformed high yield bonds 16 of 20 years, and it only had one year of negative returns versus even investment grade bonds that had at least 3 to 4 negative return years in the last couple of years.
And so when we launched Special Effects, we wanted to mirror this index and offer broad access to the direct lending asset class and an index like fund. But we built in a couple of extra protections to make it low volatility. We only do first lending, so it's 95% of our portfolio is first lien, which means we have a first claim on the assets if a borrower to default as opposed to the index, which has about 20% junior, this creates less volatility in the fund.
Secondly, we skew to the best managers in this space. We cherry picked them to make sure we're getting the best deals. And then thirdly, we did what every other direct lending direct lending manager in place doesn't want to do. We offered low fees and so we had the lowest fees in the space. And we believe that over time, as the space grows, fees should come down.
And this is the best way to offer the most consistent return to your investors, and that's keeping your costs low.
So this is really an institutional product and you normally have a $10 Million minimum, but because more than clients are all grouped as one, everybody qualifies and can can invest in this that usually only larger institutions can can take advantage.
You can put a dollar in it if you really want to.
And what you have, you select the best managers. Can you go through the selection process like how many managers are arguing? I mean, as you because you are keeping the index, you can see everything. You get a great overview. How do you pick the managers in which what's the what's the size of the universe of managers?
So our research on direct lending goes back ten years. As I was saying, coming out of the GFC, people started to allocating to it and the entire universe of private credit managers globally is about 330. And of that data set we chose 25 lending partners to work with in our fund. So how did we get to 25 is about seven and a half percent of the market.
So what we did is we went out and we ranked all the managers A, B and C, We don't tell them what their rating is because you wouldn't like that, but A, B, and C, the sees is about two thirds of the universe that's out there. And our view is they're not institutional grade. We would never recommend them to a client.
Of the remaining 100, about 50 are ranked A, B and 50 are ranked and A with a, of course, being the best. So the question is this what makes you an A? And the answer is it comes down to your ability to not lose money because in direct lending, your upside is limited to just the coupon that the borrowers are paying.
But your downside is massive. And so the best lenders in the space have a proven track record of lower losses through time. And just to give you a perspective of what's the average loss rate in a direct lending portfolio, on average, our index shows about a 1% loss rate per year or 100 basis points. But if you can lend and work with just the A-rated managers, that loss rate falls to only 20 basis points or 25 basis points.
So you're really minimizing that downside risk. So what is it that they're doing that's keeping their losses low? We dig through their portfolios. The first thing is they are lending to defensive sectors. They are not plowing their dollars into leisure companies, casinos. We all have casinos. But in a recession, we're not going to casinos, restaurants, consumer companies. They're putting them into software companies, health care companies, business services.
And these sectors tend to show consistent performance through macro cycles. The second thing we notice from the A's is they have real experienced workout teams. When a loan goes bad, they are showing that they can really extract high recovery dollars on those loans and minimizing losses. They tend to work with the best quality private equity shops. The private equity shops raise a ton of money you want to be lending to borrowers and that are backed by private equity that have tons of money, because if something goes bad, they put the money in to support the company.
And then the other thing we notice is the A's have scale. They have brand value, they have the ability to fundraise and they have different industry expertise. They can raise different pockets of money. Why is this important? Because if you have scale and you can raise a lot of money, you can move up market, you could do bigger deals.
And so those tend to be more resilient. And then the last point is they have all encompassing sophisticated asset management platforms. These are not just five guys with a dog in a Bloomberg terminal in the middle of the city, just like doing their thing. Like these are big, reputable asset managers that have deep bench of talent on their legal teams, their operation teams.
They have financing folks. So the point is, is we are an evergreen fund. We're in this for the long run. We're looking for partners that we can grow with through time. Is recognized, can consistently make hundreds and hundreds of loans well through time.
Right. So these are mostly middle market loans, right? So do you want to define middle market and then talk about maybe how this is different from traditional from from like when when a company gets too big, they can go into the public markets, but then they don't have to have the covenants or they get lower interest rates, Right?
Yeah. So it's funny, we don't even really say middle market lending anymore because it almost implies this is a cottage industry and this is now a big sophisticated asset class. And my view is, I mean, I follow markets all day long. It is a matter of a year to two years where the direct lending market has surpassed the size of the high yield bond market and the institutional loan market.
It's coming and there's nothing stopping it. But typically a middle market borrowers 10 million of up to 50 million of duh. But what you're seeing now is these direct lenders are getting so large and so skilled that they're able to lend to companies that are 100, 200, 300 million of EBIT that are even bigger.
What does that translate to in terms of size of capitalization of a company?
Some of these deals we're doing are two $3 billion deal size. As a matter of fact, the average EBIT in our portfolio is 140 million. These are not small borrowers. These are very skilled borrowers that have showed a positive success story through their growth. That being said, we do still lend to 10 to $20 million EVA companies, but in the direct lending market they're very high growers and fast growers because private equity shops are buying the high growth companies because they want to make a return.
And so what we find is the quality of the borrowers are far greater than what you're seeing in the public. Bond markets. In the liquid loan markets.
People are familiar with traditional bonds and, you know, traditional bond is typically brought to market by an investment bank. And they have there instead of incentives. And then those are different from from the private, from the direct lending. There's where the direct lenders are sticking with with the loan. Right. Talk about.
That. Yeah. So interesting Couple of things on the higher bond versus direct lending market, because the direct lending markets taking meaningful market share away from the higher bond market, it shrunk, high yield bond market shrunk about $200 billion in just the last 12 months and we've benefited from it. And so you're starting to see a lot of headlines where people are saying, you should be in the higher bond market.
It's the highest quality it's ever been. It's got them. Half the portfolios are double B rated by double B rated issuers, and it's the highest of secured debt it's ever been. And the coupons on the low on the bonds are 7 to 8% versus direct lending, which is 11 12%. So folks are saying we think bonds are going to outperform direct lending.
But the truth is, is that never happens. And if you look at bonds right now, their default rate is around two and a half percent versus in direct lending. It's around one and a half percent. And again, it comes back to the high yield bond markets lending to more cyclical companies, and we're lending to more through the cycle companies.
But the bigger issue right now is the higher bond market. Seeing the highest loss rate, the lowest recovery rates we've ever seen. And this comes to your question on alignment. Why are people why are these bonds when they go bad? Is everyone losing so much money? And it's because as an investor, no one has your back when a bond deal goes bad.
So how is your bond get done? You've got the investment bank who holds none of the paper, who's structuring the deal and trying to win the deal from the private equity shop? How do they win the deal? They offer the most aggressive terms. They can undock limitation in terms because they want to win the deal, but they don't hold any of the.
Defensive, meaning there are no cuts.
Loose, very loose stocks, no covenants. The private equity shop or the or the middle market, the borrower that's taking the bond doesn't really have any loyalty to you, the investor, because if you use hot money, you're trading in and out of their bond deal every day. So whoever comes to their bond yield close ain't there next week. So they don't have your back either.
And then the mutual fund manager is really managing their inflows and outflows and they're the guy you pay the fee to, so they should have your back the most. But at the end of the day, they're managing their redemptions. But at the end of the day, when one of these deals goes poorly, it's all about the borrower. They have such a loose stock, they have no covenants and they've got all these gotcha loopholes about.
The bond market.
The bond market? yeah, We didn't get to direct lending yet, but all these gotcha loopholes so they can extract whatever value they need and then it turns out the bond recovers like $0.10 on the dollar, $0.20 on the dollar. The direct lending market is nothing like that. As a matter of fact, the investor is very much the priority.
You don't have the investment bank, you have just the private credit manager who's underwriting and structuring the deal and they're raising money from you, the investor who you're paying fees to. You're not going to just write a check to any private credit manager. You're going to do deep diligence and you're going to hold them accountable. And so they want to structure the deal appropriately because they can't exit the deal.
There's no trading out of a direct lending deal. It's illiquid. When I make that loan, I better really love that loan because I'm living with that loan for the next 5 to 7 years. The private equity shop really cares about the manager because no one's trading in and out of his deals. And so he's going to be very selective about who's in his bank group.
He has to live with that bank group for the next 5 to 7 years. And so we're all kind of rowing in the same direction and then just to add to a little bit more alignment in this market, when a private equity shop buys a borrower or buys a company, they're writing a massive equity check. Okay? Like if it's $1,000,000,000 deal, they're putting a $500 million equity check in.
They offer that deal to their co-investors, their LPs. So those LPs are investing alongside the private equity shop. The direct lender may give them a $500 million loan and they offer that to their investors. That's actually sale effects. We partner with these managers and so we're all in this together. We have alignment. And this is why no matter what the media is going to say, All right, that alignment always results in a better outcome in terms of lower losses.
So let's say something goes wrong and the company needs to maybe put up some more cash. You talk about how you re underwrite a deal when things are going a little. Yeah.
So in the direct lending market, we have covenants on these deals. A covenant is basically a financial test that a borrower has to meet every quarter and it acts as an early warning sign. If we start to see deterioration on these borrowers and we're getting monthly financials. So every time the financials come in, I'm opening them up, I'm going through the MD and I'm reading them through.
And if I'm not happy, I'm emailing the deal team, I'm emailing the management team and we're getting responses quite quickly. But we have covenants on these deals and if we're going into some sort of market dislocation or softening in the economy or the company is not doing well, they hit that covenant before anything really bad happens. It brings us back to the negotiating table with the private equity shop and the borrower to two things happen.
Number one, we reprice the loan higher so we get a higher rate of return because we're in a riskier investment. Now. It's not the same thesis we underwrote a year ago or two years ago. The second thing is for us to negotiate anything and agree to anything. The sponsor has to put money in to basically help that borrower along.
And just to give you an example, even in our portfolio, special effects, we looked at all the amendments we've had through the life of our fund and two thirds of the time in our amendments, the sponsor put equity in. So this is a real way to right size balance sheets and get these borrowers through.
So I've got time for one more sort of a double question. But given the rising interest rate environment, you're probably seeing challenges and opportunities. On the challenge side, higher interest rates might impinge the borrowers ability to renew with an interest payment. But on the other side, there are opportunities for because the banks are stepping aside.
Yeah, so this is probably the most common question we're getting right now because direct lending returns are the highest on record. Okay, Interest rates have gone up, our asset class has benefited the most and it's been at the expense of private equity. It's been great for investors, but it's a double edged sword because what's great for you guys hasn't been great for the borrower.
There's cash flows are constrained because all their cash flows are now going to paying interest. And so it's really removing value from the private equity shop who was doing CapEx with the borrower. Maybe they were doing M&A and they kind of have to stop doing a lot of that. They have to conserve their costs, so they're paying their interest expense.
But we're first lean and we have a claim on those assets if anything goes wrong. So we're in a really good position where the borrowers cutting costs and we're the beneficiary and the investors are the beneficiary. If something goes awry with the economy, the best thing we have right now is private equity is the most flush with capital it's been in our entire history.
There's about 1.4 trillion in dry powder in the private equity landscape right now. And so we are seeing them put money into de-lever the balance sheets. Or we can have one other tool in our toolkit, which is we can pick some of the loan. So like 8% is cash pay and a little bit is non-cash pay. But today we really haven't had to use that tool.
And then in terms of opportunities, we're seeing a massive tailwind right now with banks stepping away from the market because of all the onerous regulations of Dodd-Frank and and whatnot. And so direct lenders are basically taking huge market share away from the banks, and I don't see that ending anytime soon.
It feels like we're at the Academy Awards and the music is coming.
I feel like I'm at the Golden Globes They're like, Fran, you've been speaking way too much. We want to go to the bar. Yeah, I get it. So thanks, guys. Thank you.
Disclosures: Information presented is for illustrative purposes only and is subject to change without notice. It is not intended as investment advice and should not be construed as an offer or solicitation with respect to the purchase of any security. This investment opportunity may only be available to eligible clients and involves ahigher degree of risk. Opportunities for withdrawal and transferability of shares in such investment will be limited, so investors may not have access tocapital when it is needed. Additionally, the fees and expenses charged in connection with this investment may be higher than the fees and expenses ofother investment alternatives and may offset profits. Fund fees charged are approximately 1.63% on NAV (excludes fees and interest payments on borrowedfunds of 1.90%). Each investment opportunity is unique, and it is notknown whether the same or similar type of opportunity will be available. Mortonmakes no representations as to the actual composition or performance of anysecurity. All investments involve risk, including the loss of principal. Pastperformance is no guarantee of future results.
Althoughthe information contained in this report is from sources deemed to be reliable,Morton makes no representation as to the adequacy, accuracy or completeness ofsuch information and it has accepted the information without furtherverification. It should not be assumed that Morton will make investment recommendations in the future that are consistent with the views expressedherein.
Target returns or other forecasts contained hereinare based upon subjective estimates and assumptions about circumstances and events that may not yet have taken place and may never take place. Targets areobjectives, are shown for information purposes and should not be construed as providing any assurance as to the results that may be realized in the futurefrom investments. There is no guarantee that the investment objective will be achieved. Morton Wealth makes no representation that the strategies describedare suitable or appropriate for any person. You should consult with your financial advisor to thoroughly review all information before implementing any transactions and/or strategies concerning your finances.
Index Disclosures:
References to market or indices, benchmarks or other measures of relative market performance over a specified period of time (each,an “index”) are provided for information only. Reference to an index does not imply that a portfolio will achieve returns, volatility or other resultssimilar to the index. The composition of an index may not reflect the manner inwhich a portfolio is constructed in relation to expected or achieved returns,portfolio guidelines, restrictions, sectors, correlations, concentrations,volatility or tracking error targets, all of which are subject to change overtime. An index is unmanaged and investors cannot invest directly in indices.Index returns reflect the reinvestment of dividends but do not reflect thededuction of any fees or expenses, which would reduce returns.
The Bloomberg US Aggregate Total Return ValueUnhedged USD Index(Bloomberg US Aggregate Index) represents securities that are SEC registered,taxable, and dollar denominated. The index covers the U.S. investment gradefixed rate bond market, with index components for government and corporatesecurities, mortgage pass-through securities, and asset-backed securities.
The Cliffwater Direct Lending Index (the “CDLI”) andthe Cliffwater Direct Lending Index – Senior (“CDLI-S”) seek to measure the unlevered, gross of feesperformance of U.S. middle market corporate loans, as represented by theunderlying assets of Business Development Companies (“BDCs”), including bothexchange-traded and unlisted BDCs, subject to certain eligibility requirements.The CDLI and CDLI-S are asset-weighted indexes that are calculated on aquarterly basis using financial statements and other information contained inthe U.S. Securities and Exchange Commission (“SEC”) filings of all eligibleBDCs. Any CDLI and CDLI-S returns or other information shown are not based onactual advisory client returns and do not reflect the actual trading of investibleassets.
