Stocks have fallen 10% in response to tariffs. The decline coupled with unprecedented volatility could presage an economic slowdown or recession. The bad news for private debt is the potential for higher losses from future defaults. The good news is that potential losses are forecastable given any recession’s severity and buy-and-hold investors should be rewarded for their patience from higher offsetting interest income. Nonetheless, the “all-weather” moniker we’ve previously attached to private debt will be tested.
A typical recession consisting of a 2% GDP contraction and one year duration could produce private debt (Cliffwater Direct Lending Index) returns equal to -0.5%, 13.5%, and 11.0% in 2025, 2026, and 2027, respectively. BDCs and drawdown funds that operate with leverage could expect after-fee returns equal to -9.0%, 17.5%, and 11.9% in 2025, 2026, and 2027, respectively. Three-year annualized recession-scenario returns are 7.8% for the CDLI and 6.2% for BDCs and drawdown funds.
Recession impacts private debt performance in two ways: (1) markdowns in loan values in anticipation of future loan defaults, and (2) loan defaults which permanently impair loan principal and interest.
Markdowns produce unrealized losses reflecting forecasts of future default losses by independent valuation firms. Unrealized losses, though real in the sense that they impact short-term loan portfolio value and return, are reversed over a few (1-3) years and replaced by irreversible realized losses from defaults.
In a perfect valuation world, short-term losses from markdowns exactly match and are offset by permanent subsequent default losses so only default losses are left to affect valuation and performance. In practice, valuation firms tend to overestimate default losses which are subsequently rectified by higher reversals in unrealized losses.
The Global Financial Crisis (GFC)
The worst post-war recession occurred during the GFC, arguably a 3-sigma economic event. Exhibit 1 displays unlevered private debt performance from 2008 to 2010, represented by the CDLI, comprised equally between senior and second lien loans at the time.
Exhibit 1: Direct Lending (CDLI) Performance Through the Financial Crisis
The maximum downside for unlevered private debt (CDLI) was -8% (blue line) during the GFC, with interest income partially offsetting unrealized losses from loan markdowns. Exhibit 1 also reflects early markdowns in loan prices being reversed in later quarters as defaults produced realized losses totaling 10%. Levered private debt accounts saw a maximum downside of -16%, net of fees, during the GFC.
Baseline Recession Scenario
Exhibit 2 provides forecasted returns and components during a typical recession whose severity would be approximately one-half that found during the GFC, covered in Exhibit 1. In addition to a CDLI forecast, one is also provided for a levered BDC and private drawdown fund on an after-fee basis.
Exhibit 2: Private Debt Returns in Baseline Recession Scenario
Recessions and their severity are impossible to reliably predict but past data provides useful data to understand the performance consequences for private debt. Without leverage, the impact of a typical recession may be short-lived and modest. Leveraged accounts do not perform as well, however, and drawdowns in the first year can approach or exceed 10%.
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Authors
Stephen L. Nesbitt
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The views expressed herein are the view of Cliffwater LLC (“Cliffwater”) only through the date of this report and are subject to change based on market or other conditions. All information has been obtained from sources believed to be reliable but its accuracy is not guaranteed. Cliffwater has not conducted an independent verification of the information. The information herein may include inaccuracies or typographical errors. Due to various factors, including the inherent possibility of human or mechanical error, the accuracy, completeness, timeliness and correct sequencing of such information and the results obtained from its use are not guaranteed by Cliffwater. No representation, warranty, or undertaking, express or implied, is given as to the accuracy or completeness of the information or opinions contained in this report. This report is not an advertisement, is being distributed for informational and discussion purposes only, should not be considered investment advice, and should not be construed as an offer or solicitation of an offer for the purchase or sale of any security. The information herein does not take into account any investor’s particular investment objectives, strategies, tax status or investment horizon. Cliffwater shall not be responsible for investment decisions, damages, or other losses resulting from the use of the information. This report is not intended for public use or distribution. The information contained herein is confidential commercial or financial information, the disclosure of which would cause substantial competitive harm to you, Cliffwater, or the person or entity from whom the information was obtained, and may not be disclosed except as required by applicable law.
The information in this report is not intended as a recommendation to invest in any particular asset class or strategy or as a promise of future performance. Note that these asset class and strategy assumptions are passive only, and they do not consider the impact of active management. References to future returns are not promises or even estimates of actual returns a client portfolio may achieve.
Statements that are nonfactual in nature, including opinions, projections and estimates, assume certain economic conditions and industry developments and constitute only current opinions that are subject to change without notice. Further, all information, including opinions and facts expressed herein are current as of the date appearing in this report and is subject to change without notice. Unless otherwise indicated, dates indicated by the name of a month and a year are end of month.
There can be no assurance that any expected rates of return or risk will be achieved. Expected rates of return and risk are subjective determinations by the Cliffwater based on a variety of factors, including, among other things, investment strategy, prior performance of similar strategies, and market conditions. Expected rates of return may be based upon assumptions regarding future events and conditions that prove to be inaccurate. Expected rates of return and risk should not be relied upon as an indication of future performance and should not form the primary basis for an investment decision. No representation or assurance is made that the expected rates of return or risk will be achieved.
This report may include sample or pro forma performance. Such information is presented for illustrative purposes only and is based on various assumptions, not all of which are described herein. Such assumptions, data, or projections may have a material impact on the returns shown. Nothing contained in this report is, or shall be relied upon as, a representation as to past or future performance, and no assurance, promise, or representation can be made as to actual returns. Past performance is not indicative of future returns, which may vary. Future returns are not guaranteed, and a loss of principal may occur.
The Cliffwater Direct Lending Index (the “CDLI”) seeks to measure the unlevered, gross of fees performance of U.S. middle market corporate loans, as represented by the underlying assets of Business Development Companies (“BDCs”), including both exchange-traded and unlisted BDCs, subject to certain eligibility requirements. The CDLI is an asset-weighted index that is calculated on a quarterly basis using financial statements and other information contained in the U.S. Securities and Exchange Commission (“SEC”) filings of all eligible BDCs. The CDLI will be reconstituted typically within 75 calendar days, but no later than 90 calendar days, following the current Valuation Date. The precise date of reconstitution is within Cliffwater’s discretion. If a BDC meets the eligibility criteria, but has not filed its report on Form 10-K or 10-Q with the SEC at the time the index is reconstituted, asset information from its report will be included in the index at the time of the next reconstitution. The eligibility criteria for inclusion in the CDLI is - all assets held by BDCs that meet the following criteria: (1) Regulated by the SEC as a BDC under the Investment Company Act of 1940, (2) substantial majority (approximately 75%) of reported total assets are represented by direct loans made to corporate borrowers, as categorized by each BDC and subject to Cliffwater’s discretion and (3) File SEC form 10-Q (or 10-K, as applicable) within 75 (or 90) calendar days following the current Valuation Date. Cliffwater believes that the CDLI is representative of the direct lending asset class. The CDLI is owned exclusively by Cliffwater and is protected by law including, but not limited to, United States copyright, trade secret, and trademark law, as well as other state, national, and international laws and regulations. Cliffwater provides this information on an "as is" and "as available" basis, without any warranty of any kind, whether express or implied. Past performance of the CDLI is not indicative of future returns. Any CDLI returns or other information shown are not based on actual advisory client returns and do not reflect the actual trading of investible assets. The performance of the CDLI has not been reviewed by an independent accounting firm and has been prepared for informational purposes only and should not be considered investment advice. Index returns do not reflect payment of any sales charges or fees a person may pay to purchase the securities underlying the CDLI or a product that is intended to track the performance of the CDLI. The imposition of these fees and charges would cause the actual performance of these securities or products to be lower than the CDLI. The CDLI data contained herein cannot be reused in whole or in part for any purpose without the expressed written consent of Cliffwater. The CDLI is derived from sources that are considered reliable, but Cliffwater does not guarantee the veracity, currency, completeness or accuracy of the CDLI or other information furnished in connection therewith. The CDLI may include inaccuracies or typographical errors. Due to various factors, including the inherent possibility of human or mechanical error, the accuracy, completeness, timeliness and correct sequencing of such information and the results obtained from its use are not guaranteed by Cliffwater. No representation, warranty or condition, express or implied, statutory or otherwise, as to condition, satisfactory quality, performance, or fitness for purpose are given or duty or liability assumed by Cliffwater in respect of the CDLI or any data included therein, omissions therefrom or the use of the CDLI in connection with any product, and all those representations, warranties and conditions are excluded save to the extent such exclusion is prohibited by applicable law.
Any information presented prior to the launch date (September 30, 2015) of the CDLI is back-tested. Back-tested performance is not actual performance but is hypothetical. Unless otherwise indicated, the back-tested calculations are based on the same methodology that was in effect when the respective index was officially launched. Please refer to the CDLI methodology paper (available at www.CliffwaterDirectLendingIndex.com) for more details.
Prospective application of the methodology used to construct the CDLI may not result in performance commensurate with any back-tested returns shown. The back-test period does not necessarily correspond to the entire available history of the CDLI. Another limitation of back-tested hypothetical information is that generally the back-tested calculation is prepared with the benefit of hindsight. Back-tested data reflects the application of the index methodology and selection of the constituents in hindsight. No hypothetical record can completely account for the impact of financial risk in actual trading. For example, there are numerous factors related to the financial markets in general which cannot be, and have not been, accounted for in the preparation of the information set forth, all of which can affect actual performance.
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