Many consultants and investors face a conundrum when trying to formulate a performance benchmark for private credit. There are a variety of product types within the asset class, making it hard to evaluate them all under one roof. Researchers also point to the evolving nature of the asset class, which includes a relatively small number of funds and many different strategies, as part of the benchmarking challenges for the class. According to a new paper titled Performance of Private Credit Funds: A First Look from the Institute For Private Capital, a multi-university effort to promote academic research on private investments,“On an adjusted basis, we find that there is no single benchmark that is clearly preferred for calculating relative performance,” for private credit. However, if one must choose a benchmark from the existing indexes, the researchers say, in many instances, the leveraged loan index (LLI) could be the best bet. The report is slated to be released in this fall’s issue of The Journal of Alternative Investments.
Rose Dean, a managing director at Wilshire Consulting, however, cautions against coming up with a singular approach. “The implications of this benchmarking deficiency are that allocation decisions can be made based on inaccurate return/risk premium expectations,” said Dean. “It may seem that an allocation to a private-credit strategy has generated stellar performance against a leveraged loan index, but that performance could have been the result of incorporating meaningful equity-related risk in the strategy to generate high returns. Inappropriate benchmarks will fail to reflect the risk premium associated with the particular type of private credit strategy, leading to a flawed asset class and/or manager performance assessment,” she said.
“This is an important asset class to institutional investors, and shockingly little benchmarking is done around it today, so maybe we need to codify, by definition, the different buckets of private credit,” said one of the report’s lead author, Shawn Munday, professor of the practice at UNC Chapel Hill, Kenan Flagler Business School, in Chapel Hill, NC. “LP’s [limited partners] are constantly making choices about where to invest their capital. Without the ability to evaluate risk/ return on a relative basis, their job is made more difficult,” he said.
Could the leveraged loan index be the best bet?
With just one full cycle and a limited number of funds—most private credit funds were formed after 2009, resulting in a small volume of data to be evaluated—it is empirically difficult to identify the precise risk characteristics of different private credit strategies. “That said, it appears that the leveraged loan index provides the best fit among benchmarks we examined for most private credit strategies,” Munday stated.
The authors surmised that a more definitive analysis would likely rely on observing an additional credit cycle, where the performance of a large number of more recent funds can be observed.
One type of private credit fund that has gained in popularity of late is the direct-lending fund. “There are credit funds that have formed in the post-crisis period that are targeting opportunities that in the past a traditional bank might have financed on the private side, but today they don’t or can’t or won’t,” Munday noted. “They have origination platforms tied to them, and they have professionals that go out and source credit opportunities. They work directly with the underlying companies to structure a solution that is flexible enough to meet borrowers needs, while providing incremental risk protections for the lender,” he explained. The Burgiss database (a database of institutional-quality private-credit funds) did not have a categorization of direct-lending funds, so we worked with them to develop one, and then did all the same analysis around those direct-lending funds,” Munday said.
So what did they find? “Direct-lending funds demonstrate relatively low beta and positive alpha, when compared to leveraged loans and high-yield, and that is pretty important. What’s probably the most impactful is that direct lending funds have very low correlations with all the benchmark indices we evaluated, suggesting they could provide important diversification benefits for investor portfolios,” Munday said.
Private credit strategies collectively
The team’s analysis concluded that “When the underlying private-credit strategies were compared, collectively, to each benchmark, the leveraged loan index also did the best job collectively, but if you invest in mezzanine funds, it would be a misrepresentation to say that the leveraged-loan index would be your best benchmark,” Munday stated. “What we found was more subtle than ‘the leverage loan index is the right answer.’” he said.
Munday continued: “We found that credit funds, on average, provide mid-to-high-single-digit returns with the top three quartiles of funds providing consistently positive returns across a range of strategies and vintage years. This performance is noteworthy given that the sample period included the global financial crisis. Additionally, while we found that no single benchmark was preferred for evaluating relative performance, the leveraged-loan index provided the best fit among benchmarks for most private credit strategies with the exception of mezzanine funds and direct lending funds. In the case of Mezz and DL, the Cliffwater Direct Lending Index provided the best fit among benchmarks,” he said.
Munday added that for direct lending, excluding mezzanine, the high-yield index provided the best fit from a benchmarking perspective. In conclusion, “Choosing the appropriate index has significant implications for investor perceptions of relative risk and return inherent in their investment portfolios,” he said.
How the research was compiled
The researchers used the Burgiss database of institutional quality private credit funds to evaluate the performance of 476 different funds dating back to 2004. Various private credit strategies evaluated included direct lending, mezzanine and generalist and distressed funds, among others. The authors also compared these funds to several benchmark indices, including a high-yield index, leveraged-loan index, the S&P Net Total Return BDC Index, and the Cliffwater Direct Lending Index, in order to develop an early view of both performance and risk across the asset class.
“Burgiss [a portfolio management, software, data and analytics provider] maintains a research quality database that includes the complete transactional history for thousands of private capital funds with a total capitalization representing trillions of dollars across the full spectrum of private capital strategies. It is representative of actual investor experience because the data are sourced exclusively from limited partners (LPs), which avoids the natural biases introduced by sourcing data from general partners. The data includes the date of cash flows and are further supplemented with fund profiles,” Munday said. “As a result, the Burgiss data includes the exact size and timing of cash flows as well as precise to-date fund valuations, which allows for much more robust analysis of both performance, risk and benchmarking,” he added.
The paper’s other authors are Wendy Hu, senior researcher at Burgiss; Tobias True, partner, investment strategy and risk management, Adams Street Partners, a provider of global private markets investment management services; and Jian Zhang, principal, investment strategy and risk management, Adams Street Partners.