Private credit, a relatively new asset class, offers investors a large, multi-asset class that encompasses a variety of niche strategies. While the term “private debt” is not well defined by the industry, “We estimate the size of the U.S. middle market at around $400 billion, and adding distressed would bring that number much higher,” said Stephen Nesbitt, chief investment officer at the investment consultant firm Cliffwater. Yet, that lack of definition has left many institutional investors and consultants grappling with an important question: how does one benchmark private debt, especially when trying to measure performance for an opportunity set that is so diverse, both by collateral type and geographically? The answer to that question is just as diverse as the asset class, according to investment consultants and advisors. IA spoke with several of them to get their take on the benchmarking question and to find out how they are resolving it.
“From our perspective and the clients we work with, benchmarking the private credit asset class is difficult for multiple reasons: one of the biggest is the valuations, and how to think about the role the asset class serves in the portfolio,” said Rose Dean, a managing director at Wilshire Consulting, an investment consulting firm.
“While private credit shares some common characteristics with private equity or fixed income, investors are starting to recognize that it deserves specialized attention, due to its unique set of risks and implementation considerations, said Sylvia Owens, senior portfolio advisor, Aksia, an investment consulting firm.
“There are a couple of reasons why there is no generally accepted benchmark: it’s a relatively new asset class, most private credit funds were launched post-financial crisis, and so many are only resolving themselves now, explained Chris Acito, a partner at Gapstow Capital Partners, an asset advisor specializing in credit investing. “It’s challenging, because the asset class is not all that developed, but it’s really exploded since the crisis and more so over last five years,” he said.
The other problem is that investors definition of “private debt can lump together several fairly disparate strategies, including esoteric forms of private debt, distressed debt, CLOs (collateralized loan obligations), middle-market direct lending, which all are very different return profiles. So, to say there is a singular benchmark is somewhat of a flawed concept as well for those categories,” Acito said.
At consultancy Aon, “we look at benchmarks in a couple different ways. We try not to benchmark individual funds within our client report, when looking at the public market equivalent or benchmark,” said Eric Denneny, senior consultant, global private equity research at Aon. “We tend to benchmark it at the asset class level for our client reports or at the vintage-year level, so every deal done on a specific vintage year on an IR (internal rate of return) basis, he said. “We tend to show benchmarking to a peer universe quartile ranking, so we use Burgiss, a database of private capital funds, including private equity, private debt and real assets,” he said.
Different schools of thought
Owens contends that while there are no easy answers, there seem to be two main schools of thought for how to benchmark the asset class. “One is to use an ‘opportunity cost’ benchmark, taking into account where the capital may have been deployed otherwise. So, if the money is coming from fixed income, they might use a benchmark of leveraged loans plus a modest premium for illiquidity. The “alpha” will often come from taking on structural and/or strategy complexity,” she said.
Another approach “is to match current or intended strategies by using a blended benchmark composed of public market equivalents and/or available private credit benchmarks. However, public benchmarks are often a mismatch and private credit benchmarks tend to be limited to distressed, mezzanine and direct lending, which may or may not reflect the actual portfolio or its risk/return objectives,” Owens said.“The other drawback with this approach can be that private credit is meant to be opportunistic, so predetermining a strategy mix could end up influencing future investments,” she added.
Acito has found that: “In general, for private credit benchmarks, many investors borrow a ‘public markets plus’ approach used in benchmarking private equity. Over the long term, private equity investments are usually expected to produce 300 to 400 basis points more than a relevant public equity index, such as the Russell 2000 Index. For private credit, a relevant metric might be 200 to 300 basis points above a 50-50 blend of high yield bonds and leveraged loans,” he said.
Different benchmarks for different debt
Still, the sheer diversity of the asset class continues to present a problem for investors. “Senior secured direct lending is different in terms of returns from mezzanine debt or distressed debt or opportunistic credit. Because the components that make up private credit are so different, it’s difficult for clients to get their hands around an all-encompassing benchmark,” Denneny said. “So what we have seen from working with our clients on direct lending is that clients will use a bank loan public-market proxy for their senior secured direct lending strategies, whether that is the S&P / LSTA Leveraged Loans Index or Credit Suisse Leveraged Loan Index plus some premium, which could be 150 to 300 basis points,” he said.
Many of Aon’s clients ask about how to benchmark debt that is tied to direct lending strategies. “We direct people to use, from a public perspective, a bank-loan-like benchmark,” Denneny said. Investment consultant Cliffwater also has a series on direct lending that collects data on the underlying data and creates an index of direct loans, based on data held by BDCs ( business development companies), he said.
Cliffwater looks through the BDCs to the yield on underlying holdings, and they report on it on a quarterly basis. “But ILPA (Institutional Limited Partners Association) and those groups have not officially sanctioned or signed off on a benchmark that they think should be considered for these type of things, so what makes the most sense to investors is all over the place right now,” Denneny said. “From our perspective, we try to be as broad as possible and try not to benchmark at each individual investment, but more think about the asset class when benchmarking to public indices,” he said.
Acito agreed that for direct lending products, the industry still hasn’t yet settled on what the go-to benchmark should be. “If you go to consultant studies, they will give you a very sober view, which is that direct lending should provide a premia over public markets, and their benchmarks might be 50-50 high-yield loans, plus 300 basis points, or a flat 7 percent to 7.5 percent, so clinically that is not too far off,” Acito explained. “But there is dissonance in the marketplace, because managers are usually setting expectations in the low double digits. Or, there is no manager presentation that says our expected return is 7 percent, everyone says it’s 10 to 12 percent, so what is right? On one hand, when pushed to it, a consultant will say ‘7 percent is what can I expect,’ but would you choose a manager who says 7 percent? Probably not,” Acito surmised.
“For mezzanine, what we have seen used there is reference to a high-yield benchmark,” Acito continued. “Really the idea there is that high-yield benchmarks tend to have a higher correlation to equities from time to time. Mezzanine debt has an equities portion to it as well, so that tends to be where clients go.”
In times when equity markets are booming, high-yield debt will return pretty strongly, noted Denneny. “So there is a little bit of simpler correlation with mezzanine debt, because there is a decent equity component to mezzanine debt from 20 to 30 percent of return, which tends to be tied to the equity that they are holding alongside that debt. So, it can boost returns in up-market time periods,” he said.
The most difficult type of private debt to benchmark is opportunistic credit, consultants agree. “We see things across the board in opportunistic credit,” Denneny noted. “Some people, if they have a shorter life strategy or more liquid component to it, will use the HFRI hedge fund benchmarks, but usually some kind of splice of a return series is used,” he said. “A lot of times you will hear a manger say that they don’t track to a specific benchmark, or that they track to the S&P 500 Index, if they think of it as asset class level-opportunity cost. A lot of times, it’s an alternative bucket, and the money being allocated to those investments is coming out of equities. So, we’ll just say, we have to beat our public market equity benchmark, otherwise it doesn’t make sense to do the investment.”
The allocation from which it comes
A lot of Wilshire’s clients use private debt as a fixed-income diversifier in their portfolio. “If the money comes from their core fixed-income or bank loan allocation, they can be benchmarked to the leveraged loan index plus whatever they think the liquidity premium should be. That has ranged from 2 to 3 percent or so,” Dean said. “If the allocation is from private assets, where it’s part of the private equity and private credit portfolio, then you have to decide where you want to be in terms of the credit and equity risk that you are taking,” she added.
“When it is benchmarked to an absolute-return target, then you have to think about where the private credit investments are in the capital structure, it’s more like an absolute-return target, looking at it versus similar credit or equity-risk returns and setting the expectations as to whether these should earn similar levels of return,” Dean said.
The Bottom Line
As the private credit market matures, investors and consultants are, clearly, still working out their best solutions and strategies for the asset class. But investors are beginning to differentiate between private credit funds. “For example, within middle market corporate lending, investors are asking how much leverage is being provided, what industries are being targeted, how large are average loans, what should be the assumed loss rate, will the fund get all of your capital to work, what are the expenses going to be, and what is net of net-of-everything return we should expect, ” Acito delineated.
For now, investors may have to be satisfied with leaving some of these questions unanswered. “The bottom line is that benchmarking continues to be a topic that is very much in discussion, and we have observed investors over time recalibrate their benchmarks as programs become more mature,” said Owens. In addition, we have seen that as people start to recognize private credit as its own asset class, with its own risks, there is more of a push to making sure there are specialized resources to support the asset class, including risk management,” she said.