January 9, 2020 • 6 min read
The Case for Investing in Direct Middle Market Loans
Myron Manternach
Clade & Co.
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Middle market loans (MMLs), typically defined as direct loans to middle market companies with EBITDA of less than $50MM, represent one of the fastest-growing asset classes in the global capital market. These loans are attractive to investors as they provide meaningful return premiums in exchange for being relatively small, illiquid, and costly to source, diligence, structure, and manage.

To capitalize on this opportunity, private equity-style direct loan funds have emerged over the last 10 years to acquire MMLs and offer institutions access to diversified portfolios of MMLs. These funds have proliferated and grown as more institutions seek to increase their allocation. According to Preqin, direct loan funds manage an estimated $637 billion of MMLs, and they remain the most popular way for institutions to increase their exposure to private debt.

Private debt assets under management by category
Source: Preqin; data as of June 30, 2017. Includes only closed-end fund assets tracked by Preqin.
Fund types that investors view as presenting the best opportunities, 2017 vs. 2018
Source: Preqin Investor Interviews, November 2017 - 2018

Why? Institutional investors have done the math and concluded that MMLs offer superior risk-adjusted returns relative to other asset classes. As shown below, Ares Management, a leading credit investment firm, shows the MML market exhibits lower volatility and has a higher Sharpe Ratio than several benchmark debt and equity indices. (The Sharpe Ratio is a standard measure of risk/reward defined as the average return less the risk-free rate divided by the standard deviation of return over a specified time frame.)

Lower volatility - Standard Deviation over 7 years - as of December 31, 2017
Source; Ares Management LP, Market Insights, April 2018
Attractive long term risk adjusted returns — Sharpe Ratios over 7 years - as of December 31, 2017
Source: Ares Management LP, Market Insights, April 2018

In addition, many institutions have concluded that MMLs offer diversification benefits for passive investors managing diversified portfolios. Some institutions have performed additional math to show that the MML market has relatively low correlation to the broader market. As shown below from TIAA Global Asset Management, this low correlation allows MMLs to improve the risk-adjusted returns of diversified portfolios.

Correlation of private debt and public assets: 1999 - 2015
Based on quarterly returns for the period January 1, 1999 through December 31, 2015. Sources: S&P LCD, Morningstar, TIAA Global Asset Management.
Impact of leveraged loans versus high-yield bonds (6)
Sources: S&P LCD, Morningstar, TIAA Global Asset Management.

Some naysayers claim the growth and outperformance of the MML market is unsustainable. They suggest that MMLs represent a relatively new sub-asset class that has not been tested over the cycle, and that correlations increase during a financial crisis/downturn and MMLs will not be immune. Proponents such as Clade, however, strongly disagree and argue that MMLs outperformed during the historical financial crisis of 2007/2008 and will similarly face lower losses during the next financial crisis/downturn. Due to the opaque nature of the MML market, there is limited high quality data to definitively prove this assertion. Notwithstanding, the leveraged loan market can serve as a reasonable proxy for comparing the MMLs to other asset classes. As shown below, over the credit cycle, leveraged loans exhibited meaningfully lower default rates and higher recovery rates relative to high-yield bonds.

Leveraged loans have historically exhibited low default rates and high recovery rates compared to high-yield bonds
Source: Moody’s as of December 2016. Default data is issuer-weighted. Allianz Global Investor.

Due to the unique characteristics of MMLs the MML market should perform even better than the leveraged loan market in a market downturn. The MML market is more diverse and serves a larger number of borrowers with a wider variety of business and financial risk profiles. Further, MML investment agreements are generally more restrictive and contain more investor-friendly features, including structural seniority, security, maintenance covenants, etc.

While market correlation generally increases across all asset classes during large market downturns, the correlations of MMLs are likely to remain low due in part to their limited trading liquidity.  Because of this limited liquidity, MMLs are generally not purchased by short-term investors or leveraged buyers who magnify market volatility during market downturns. In addition, MMLs are not frequently repriced and subject to “mark-to-market” accounting. Fund managers typically account for MMLs by conducting appraisals and testing for impairment on an annual basis or on evidence of an impairment.

There is no free lunch though. The same characteristics that support the MML market’s relative outperformance may also contribute to its relatively high dispersion of returns. However, active MML managers view high dispersion as a feature, not a bug.  It provides active investors the opportunity to overweight specific assets that tend to outperform and underweight those that underperform. As George Soros once said, “It’s not whether you’re right or wrong, but how much money you make when you’re right and how much you lose when you’re wrong.”  

While active management is critical to success in the MML market, managing an MML fund is expensive. Due to the bespoke nature of MMLs and the fragmentation of the market, fund managers must incur significant costs in order to properly source, diligence and evaluate individual MMLs and MML funds. Additional resources are required for fund administration services and professional staff with the required expertise. Fund managers often review dozens of individual loans for every investment they negotiate and close. Due to the to their complexity and illiquidity, MMLs require close monitoring, frequent corporate actions, and burdensome accounting appraisals.

Clade offers a new way to invest in institutional-quality MML loans directly — without some of the limitations of investing in MML funds or the costs of managing an MML fund. Clade users invest directly in MMLs and funds that were sourced, researched, and evaluated by professional investors with relevant experience and expertise. Risks and returns are presented so that users can select investments that reflect their individual preferences and circumstances. Clade’s online platform enables users to evaluate, transact and monitor their investments conveniently, efficiently and privately. The platform appeals to a broad range of both institutional and individual investors, including passive investors who seek diversification benefits of MMLs as well as active investors who seek to beat the market — one investment at a time.

(1) The Middle Market Index consists of middle market facilities drawn from the larger S&P/LSTA (Loan Syndications and Trading Association) Leveraged Loan Index. It is designed to measure the performance of the U.S. leveraged loan market. S&P/LSTA defines the middle market as deals with an EBITDA of less than $50 million.
(2) The U.S. Leveraged Loan 100 Index consists of 100 loan facilities drawn from the larger S&P/LSTA (Loan Syndications and Trading Association) Leveraged Loan Index. It is designed to measure the performance of the U.S. leveraged loan market.
(3) The ICE BofA Merrill Lynch US High Yield Index (H0A0) tracks the performance of US dollar denominated below investment grade corporate debt publicly issued in the US domestic market.
(4) Represented by the S&P/LSTA Leveraged Loan Index as a proxy for large, broadly syndicated loans.
(5) Loans to companies with EBITDA of $50 million or less within the S&P/LSTA Leveraged Loan Index.
(6) Mean-variance optimization generated a range of portfolios representing an efficient frontier for four different asset class combinations. The pie charts represent portfolios with the highest risk-adjusted returns (Sharpe Ratio) among portfolios on the frontier. Performance is based on quarterly returns for the period January 1, 1999 through December 31, 2015. Data reflect index returns for S&P 500 Index, BoA Merrill Lynch US High Yield Index, BoA Merrill Lynch US Corporate Bond Index, BoA Merrill Lynch 10yr US Treasury Index, S&P/LSTA Leveraged Loan Index. Middle market loans represent loans to companies with EBITDA of $50 million or less within the index. 

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