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While nonbank loan channels have always coexisted with traditional banking, those channels were historically small niches in the overall economy. That changed after the Great Recession when new regulations limited the ability of banks to make traditional loans to U.S. middle-market businesses (generally defined as companies with EBITDA, or earnings before interest, taxes, depreciation and amortization, of between $10 million and $100 million and which are considered by many too small to access capital in the broadly syndicated market in a cost-efficient manner). “Shadow banking” emerged with independent asset managers funded by capital from institutional investors, replacing banks as providers of secured, first-lien commercial loans.
The growth in direct middle-market loans originated by asset managers is partly explained by the growth in middle-market private equity. Those loans are referred to as “sponsor backed.” Private equity sponsors often prefer to borrow from asset managers rather than traditional banks because asset managers offer faster speed, certainty of execution and greater financing flexibility.
Performance Update
Each quarter, Cliffwater provides an update on the performance of private loans in its “Report on U.S. Direct Lending.” Its performance analysis relies on the Cliffwater Direct Lending Index, or CDLI, an asset-weighted index of approximately 15,600 directly originated middle-market loans totaling $337 billion as of March 31, 2024. The CDLI is used globally by institutional investors and asset managers as the index of choice for understanding the return and risk characteristics of U.S. middle-market debt. Launched in 2015, the CDLI was reconstructed back to 2004 using publicly available quarterly SEC filings required of business development companies whose primary asset holdings are U.S. middle-market corporate loans. Importantly, SEC filing and transparency requirements eliminate common biases of survivorship and self-selection found in other industry universes and index benchmarks.
The CDLI produced a 3.02% total return in the fourth quarter, bringing the trailing four-quarter total return to 12.49%. Interest income was 2.93%, which was somewhat offset by -0.23% in realized losses for the quarter. Unrealized gains equaled 0.32% for the quarter, representing the conversion of prior unrealized losses to realized losses and a reversal of spread widening. For the trailing five and 10 years, the total return was 9.14% and 8.85%, respectively. From its September 30, 2004, inception, the CDLI has produced an annualized 9.50%...