Considering Private Debt in Diversified Portfolios
Let’s set the stage by discussing how we think about portfolio construction and why we often look beyond traditional stocks and bonds in an attempt to build more robust client portfolios. Most of our clients' primary objective is to improve their odds of meeting their financial goals, such as retirement. We believe broad diversification helps portfolios because the more asset classes and strategies that provide positive returns over time and diversify one another, the more predictable the portfolio’s range of returns. Furthermore, the more independently each asset class moves related to one another, the closer the correlation is to zero, and the more positive its diversification benefits. The end result of a broadly diversified portfolio is that it should experience a smoother ride over the long run. Carl Richards of Behavior Gap does a nice job of simplifying this concept through the image.
The Allodium Investment Committee analyzes our recommended asset classes, strategies and portfolios eachyear. One newer asset class we’ve been evaluating is known as private debt. Without going into the specifics of any specific fund, let’s cover the basics of this asset class and why it is garnering attention.
What is Private Debt?
Private debt (also known as private credit) is comprised of direct loans made to U.S. middle-market companies bynonbank lenders. Borrowers typically have annual profits in the $10-100 million range and are similar in size to small and mid-cap companies in publicly traded equity markets. The word “private” refers to the fact that these loans are not publicly tradeable and are meant to be held to maturity. As a result, lenders are rewarded by an illiquidity premium that results in higher yields than most traditional bonds.
Direct loans have been a rapidly growing area of the investment universe in recent years, and direct lending increased 250% from its $400 billion size in 2019. Larry Swedroe, Director of Research for The BAM Alliance, explained in a recent blog, “The enactment of the Dodd-Frank Act in 2010 made it increasingly expensive for small banks to operate, cutting off their supply of loans to small and mid-sized companies. As a result, private debt funds stepped in to fill the gap.”