#25 - Stephen Nesbitt: Cliffwater, Private Debt

0:06Welcome to the Insightful Investor Podcast, a weekly series that seeks to share industry, investment, investment, and market insights. We define insights as concepts that are counterintuitive, widely misunderstood, or underappreciated. In other words, unique ideas that you probably won't hear elsewhere. I'm Alex Shahidi, the host of the podcast and co-CIO of Evoke Advisors, one of the nation's leading investment advisory firms. Learn more about our show at insightfulinvestor.org.

0:43Today's guest is Steve Nesbitt. Steve, thank you for joining us today. You're welcome. Steve is the co-founder and CEO of Cliffwater, which is a$78 billion investment advisory firm that invests in alternative investments. Today, we're going to focus on private debt. Steve is also a portfolio manager for two funds, the Cliffwater Corporate Lending Fund and the Cliffwater Enhanced Lending Fund, which total about$23 billion in assets under management. Steve, why don't we start with going back a few decades, how you got started in the industry and your overall investment philosophy and whether it's shifted over the past few decades?

1:25Well, thanks again for having me, Alex. I've had a pretty simple career in the investment business. I've had three jobs covering 45 years. My first job was very, very interesting when I got out of business school in 78 on the East Coast at Wharton. I got hired in San Francisco for Wells Fargo Investment Advisors and a couple of things. Very interesting about that. One is they were at ground zero in terms of modern portfolio theory. So basically, at the time, there was a transition from Graham Dodd to modern portfolio theory, and they created some of the first index funds. They're basically the original DNA for what BlackRock is today.

2:09They hired me to help them create specialized index funds. I also got to work with some very smart people, including a Nobel laureate, Bill Sharp. So heavily influenced my investment philosophy. And basically, that philosophy has not changed over the last 45 years. It's interesting. We still operate under the modern portfolio theory paradigm today, alpha, beta, and all the other Greek symbols. It's become more complex, but basically, philosophy hasn't changed. And that's basically markets are fairly efficient. You can derive some excess return either through active management in some of the markets.

2:50And specifically for this conversation in the private markets, there is a return premium for illiquidity. And with the founding of Cliffwater, that's basically what we take advantage of, that illiquidity premium. You launched Cliffwater about 20 years ago. What motivated you to start your own firm? Well, after Wells Fargo, I worked for 20 plus years at an advisory firm called Wilshire Associates. I headed up consulting there for approximately 15 years. I reached my peak in that organization. But secondly, I felt as a professional, I could add much more value in alternatives than I could in traditional stocks and bonds.

3:33So I decided to start my own firm, focused entirely on alternatives. And I was fortunately, some other people at Wilshire decided to make that leap with me. So Cliffwater, we started as really the first alternatives investment advisory firm, focused on all alternatives, not just hedge funds, not just private equity, but looking at all alternative investments and helping asset owners integrate alternatives into their investment portfolios. Today, we're going to focus on private debt, which has been extremely popular lately. What led you into private debt and that focus? And would you just talk about the background there?

4:13Yeah. Well, the holy grail of investing is high return, low risk, what they call the Northwest quadrant. And that was easy when I started in my career, bond yields were double digit and all you had to do was clip coupons and double digit returns with relatively low risk. That became over the decades following, that became more and more difficult. It became impossible after the financial crisis where the yield curve collapsed and the Fed basically kept rates, the yield curve, close to its zero lower bound. So I was very interested in trying to find something that could produce yield. And I had some familiarity with private debt, primarily through some insurance companies I consulted to in the 1990s and early 2000s.

5:02But basically, that market started to expand. I did some original research in that market. I became convinced that that was going to be a growing market and that it could provide a solution for that Northwest quadrant. That's why I became interested in private debt. That makes sense. Before we dig in on private debt, would you talk about how Cliffwater has evolved since you launched and has the vision changed or is it just coming to fruition over time? Basically, the playbook for Cliffwater is the same playbook I used at my prior firm, and that was build credibility in the marketplace through an advisory business, particularly with large institutional investors, which arguably are the most challenging clients to have.

5:54And then gradually morph into asset management, take discretion. Once you have customer confidence, transition into asset management, being an allocator, but with discretion. Basically, we've been implementing that same playbook. What's different was a surprise to us is when we started morphing into asset management, we felt that the wealth management channel, we could provide the greatest value to that channel. So instead of moving into discretion in the institutional channel, we said, hey, about five years ago, let's move into this wealth management channel. We think we can be very accretive to it.

6:35And that's our path today. And I suppose that's partly because you saw the need for particularly private debts in that space, not much availability, not much understanding. So you saw a great opportunity there. Is that accurate? Yes, exactly. Basically, there was a hunger for yield, both in the institutional and individual marketplace. Couldn't make any money on cash. And I think the institutional market had some answers. They went the hedge funder out. But I think that was out of reach for individuals and not very tax efficient. Consequently, we decided to bring private debt to the individual market.

7:16You've also launched in your career a couple of industry-leading indexes. to help investors track various alternative markets. And you've also published a couple of books that share long-term historical data. Would you talk about those and what motivated you to go through that process? Well, my feeling is as a fiduciary, generally asset classes don't exist without an index. It's a requirement for allocations to be made. And it's a requirement because fiduciaries need a benchmark against which to evaluate return, risk, make allocations, evaluate, manage your fees, et cetera. So back in 2009, 2010, when we started doing research on private debt, we said, hey, we can't recommend this asset class to our clients without an index.

8:05Looked around, there were no indexes. So we said, okay, we got to do it ourselves. And so we created the Cliffwater Direct Lending Index, which has now really become the go-to index for managers and allocators and asset owners alike. And so with that benchmark, we can say with some level of confidence, here are the historical yields, here's the credit losses, default rates, etc., provides a basis for making an informed decision on allocation. I suppose that recognition that you need an index first before products that manage to that index, That recognition probably came from your years of experience on the institutional consulting side at Wilshire.

8:48Is that correct? Well, absolutely. It came from both at Wells Fargo, building index funds at Wells Fargo and their index fund group at Wilshire, knowing what asset owners need to make allocations. And so it was all that knowledge base that gave us the confidence to move forward with indexing and private debt. It's remarkable when you look back on these key inflection points. It's so obvious in hindsight. There was no direct lending index. And so if there isn't one, let's create one. And you look back and say, how could that even be? It's such an efficient market. There's so much interest in it.

9:27There's so many eyes on it, so much money flowing in. It's amazing that that didn't exist until relatively recently. It's obvious in hindsight, but during the time, it's not obvious. Yeah, exactly. So let's talk about private debt. To get our audience all on the same page, would you describe the lending market landscape at a high level so everybody has a lay of the land? Yeah. So basically, private debt is primarily lending to corporate America. There is global lending, but let's just leave outside the U.S. Let's just put that aside for a second. But basically, it's about a$15 trillion market lending to U.S.

10:07corporations. Approximately half of that is investment-grade corporate debt, buying Exxon bonds or lending money to large U.S. corporations. So that's half the market. The other half of the market, called$7 ,000,$8 trillion, is divided into really four parts. One part is high-yield bonds. This would be non-investment-grade. It would be high-yield bonds. That's$1.5 trillion. got levered loans, bank loans, bank lending, in other words, through the traded market, one and a half trillion. You have direct bank lending, which is about two and a half trillion. And the rest, about a one and a half trillion is middle market lending.

10:51That's the market that we call private debt. So it's bilateral loans between investment management firms and borrowers. So in the total landscape of lending to corporate America, it's really a sliver, but$1.5 trillion is a significant sliver. And most importantly, it's the fastest growing piece of the pie. And why do you think that is? Well, because many of the other slivers have become unreliable, particularly the banks to increase regulation and also their switch to fee-oriented income. Basically, they're slowly exiting lending to middle market companies. Also unreliable are the public markets, leverage loan market and the high yield bond market.

11:42It's sometimes good, sometimes not so good. Most corporations, what they want is reliability and predictability. What's happened is these private transactions or private loans between lender and borrower have become very normalized and predictable in the part of the borrower's. it reduces uncertainty for the borrower. So that's why it's been successful, I think. So would you discuss this gradual evolution from commercial lending to alternative lending and perhaps where you think it's headed? Let me just back up one second here. So the major megatrend, I think, over the last 20 years, since we formed Cliffwater 20 years ago, has been the growth of the private ecosystem.

12:29And that involves not only private debt, private equity. The private ecosystem has been growing at about twice the rate of the public markets. And so one data fact is when I started Cliffwater, there were approximately 7 ,000 publicly traded stocks. Today, there are half as many, maybe 3 ,500 publicly traded stocks. The reverse of that is the expansion of the private ecosystem, private companies. So it's only natural to think that as private equity has grown, private debt will grow as well. And so that is, I think, in terms of looking ahead, I don't see any change in that. It's very difficult to run a publicly traded company unless you need to raise a lot of money.

13:16So bottom line, I think the prospects for private debt and private equity are very positive for the years ahead. Okay. And then I guess that is part of this transition from public lending to private lending. And I guess that makes sense that that will continue. Yes. Okay. So let's talk about private debt. You mentioned earlier this illiquidity premium. So if you're an investor in private debt, you should get a higher return than if you invest in public debt because you're giving up some liquidity. Would you just talk about that premium and compare it to public market equivalents? Yeah. So if you look at the evidence or yield differentials, whether it's equity or fixed income or real estate, generally research has shown a 2 % to 3 % premium return for giving up liquidity.

14:09So two equivalent assets. One is in a world where there are no exchanges, where it's not traded. Another in a world where things are continuously traded. the yields or the returns in the illiquid world or the private world are 2 % to 3 % higher. We've verified that with our own data, with the Cliffwater Direct Lending Index. We've verified that with our own original research in public debt. And we've also verified that in private equity with our study on private equity returns for large public pension plans, both covering 20 plus years, both showing pretty much the same excess return of two to 3 % for buy and hold private strategies versus exchange traded securities.

15:03Obviously, there's been a significant increase in demand for private assets and partly to chase those two to 3 % premiums above public market equivalents. I'm curious what your thoughts are about if there's excess demand for private assets, is it reasonable to expect that that premium will shrink? I don't know. It's supply demand. Remember that any large allocations to private debt are going to look big compared to the relative size of the market. What I mean by that is over the last 10 years, it was a really small market. It's getting bigger and bigger. So the growth rate looks large. But in relation to the demand for financing, yes, supply is increasing, but the demand is increasing significantly as well.

15:47Private equity is growing at a significant rate. They have a lot of dry powder as well. Our research shows that supply and demand has been in rough balance over the last 10 years. And I think private debt has grown at a little greater rate, but it's primarily taking share from commercial banks. So I guess you have to look at that balance between supply and demand. If the demand is growing, the supply may be growing as well. So you have to just look at the net. Yes. And the final arbiter of supply demand is yield, or in this case, yield spread. And it varies between that spread between 5 % and 7%.

16:28Sometimes you get to 8 % in the distress period, but it's cyclical. There's no evidence that there's a secular decline in yield spreads for private debt. And obviously the demand for private debt has increased significantly and the supply has also increased. Is there some risk given all this demand into private debt and the launching of products? Is there some risk that goes beyond what you can observe in just the spread? Well, I don't see it myself. I mean, generally, bubbles, in my experience, gone through several now, are primarily a byproduct of leverage, too much leverage in the system. I don't really see that now.

17:11Most private debt funds use maybe a turn of leverage, which is pretty modest, particularly modest compared to 10 turns of leverage used by commercial banks just before the financial crisis. So I don't see the excesses. Maybe there's a little pressure in the CLO market, collateralized loan market, but I don't see any warning signs, at least in my crystal ball. You talked about markets being relatively efficient. And the way I think about that is every asset has risk and expect a return that exceeds the rate of cash relative to that risk. The more risk, the higher their expected return and so on.

17:49But private debt, when you look at the history, has had relatively good returns with relatively low risk. Is that sustainable? Are there risks that go beyond what you can observe in just that high sharp ratio or high return to risk ratio? In our analysis, I think the private debt market is fairly efficient. If we're talking about spread somewhere between 5 % and 7%, let's break that down. Obviously, there's credit risk. The credit risk is probably 3 % of that 5 % to 7%. And then a large part of the remainder, let's say 2 % to 3%, is the liquidity premium. So that gets you the 5 % to 6 % range.

18:32And then you can have higher yield or lower yield, if you do really small companies or you do non-private equity-backed companies, there are second-order types of risk. In an efficient market, those 5 % to 7 % spreads should persist. Active management is really about underwriting, select those credits or making loans to borrowers that are less likely to have a future default problem. We consider that alpha. So active management is really about limiting losses. That's the alpha. But we consider yield beta and pretty efficient in the market. As an allocator, I look at various markets. And when I look at private debts, and currently the yields are 10 % plus, and you think of that as an equity-like return, and the risk you would think, other than the liquidity, the risk is lower than equities.

19:26You're higher up in the capital structure. So when I look at that, it seems like a relatively attractive market segment to focus on when I just look at that high level. But is it reasonable to expect equity-like returns with less risk in that asset class? Let's talk apples to apples. So basically, long-term, public stocks have outperformed public bonds by about 3.5%. Over the last decade, it's been more like 5%. So in the public markets, traded markets should expect 3 % to 5 % premium for equity over equivalent fixed income, publicly traded fixed income. So let's compare private to private. So you're right, 10 % returns on private debt, but private equity is basically outperforming private debt by about 3 % to 5 % per year.

20:17So there's an equivalency. I think private debt looks very attractive against the public markets. But if you look at the data on private equity, I think the trade-off between private equity and private debt over a long period of time is fairly efficient. Right now, we're probably in a period where private debt looks more attractive than private equity, but that's not always the case. If we zoom out a little bit and we look at the last three or four decades, you've had falling interest rates. And now there's a potential for rates to stay higher for longer, certainly higher than they've been for a long time.

20:53Does that potential shift in regime change what the future returns might be relative to historical data that we've observed? Yeah, well, regime shift is always disruptive. So in other words, I would say higher interest rates, I think are very manageable, but they need to be absorbed. In other words, pricing needs to reflect the new regime. So I think right now you've seen more economics going to private debt than the private equity. I believe we're going to have higher for longer. Private equity has to adjust to that. And they're in that process of adjusting to that. I believe private debt's going to be very high single digit return, if not a low double digit return for quite some time.

21:39And if rates stay higher for longer, I assume that increases the risk for borrowers. How do you think about that relative to potential default rates? To me, it's all about economic growth. So far, private debt has dealt with higher interest rates through bottom line earnings per share growth and net income top line revenue growth. So basically, it would be a different story if we went into a recession. Basically, private debt should do well, except in a recessionary period. But even in a recessionary period, the high yields really protect against losses. So generally, at one sigma recession, it's a 3 % to 5 % loss rate.

22:22At most, it might take a third or two or a half of your yield. But generally, it's still a very attractive return, even at one sigma recession. Great financial crisis was three sigma. The downside there was, I believe, 6 % loss. That higher yield gives you a pretty nice cushion to start with. Absolutely. You talked about studying historical data, and obviously you've had an index for a long time. How do you think about survivorship bias in calculating that data, particularly relative to public markets? In the alternative world, a lot of the indices that have been created, particularly the hedge fund indices, some of the private equity universes, fraught with two or three different biases, and a lot of it's not very reliable.

23:09The two indices that we created, the Cliffwater Drug Index, that data comes from SEC filings, and SEC filings of companies that were both successful and failed. So they don't drop their records for bad companies. So we were very lucky when we put together our index that the SEC had a complete filings going back about 20 years now. And so our index does not suffer from any of those other biases. And also when we studied private equity, putting together a private equity index, basically relying on a closed group of state-level public pension systems, their reporting, which again, there's no survivorship bias there.

23:55We still have 50 states and as we had 20 years ago. So we've always been very careful to create indices that do not represent those biases. That's great. I've seen some of your writings where you talk about underperforming years in private credits. It'll go through underperforming years, but those have historically been followed by outperforming years as the assets converge towards their yield. Would you talk about that? The bottom line is the effective maturity of private loans has averaged three years, but generally can range from two years to five years. These are not 30-year bonds. These are intermediate floating rate notes.

24:38So either principal is going to pay off in three years or it's not going to pay off in three years. And if it's good credit, you know what its value is going to be in three years. So valuation is not going to differ too much from 100. And if it declines, for whatever reason, it can't decline too much because as that maturity approaches, it's going to be 100 or there's going to be a problem and there's going to be a default and it's going to be worth something else. So that pull to par is very powerful and fairly short term in private debt. Is there any particular environment where that could be challenged?

25:18I assume it's a bad recession or even stagflation. I think the answer is pretty much no. Even in the great financial crisis, loans were marked down pretty significantly. Private loans, I think it was 6 % during the financial crisis. But as soon as investors figured out that the world wasn't going to end, it took maybe a year to a year and a half for prices to revert and get pretty close to parity. Unlike stocks, where it can take quite a bit of time before people have confidence in long-term economic growth. It's different with debt. There's a stated obligation, if you're going to make it or not.

26:00It's not where our earnings per share are going to be. I guess in the last few years, we've had two major shocks. We had COVID and we had the 2022 Fed tightening. And I guess those are two relatively good stress tests recently for this asset class. Would you talk about how the asset class survived those two periods? Well, COVID was very interesting because it was so different. The unique thing about COVID was basically the economy shut down. So everybody was in it. Everybody was dealing with a common enemy, so to speak. What happened there was there could have been a lot of defaults. technical cash defaults, but basically borrowers and lenders, which can happen in the private markets.

26:49Basically, they decide to work together. They know they have a good company. If there are cash flow problems to meet cash requirements, basically both sides gave a little. Private equity firms with a lot of dry powder, they would put more money into companies. And the flip side, lenders often pick their coupon, which basically means, okay, instead of paying us cash interest, we're just going to increase the principal. Basically, that negotiation you can't do in the public markets because there are too many ultimate lenders. But what you see in the private debt market, borrowers and lenders find a solution that optimizes the outcome for both, rather than clashing in a zero-sum game or a negative-sum game type of deal.

27:36So that was COVID. And fortunately, it was just maybe a year, two-year deal before we came out of it. In the case of the Fed tightening, it's kind of the same thing is going on for companies that first, fortunately, the backdrop is a growing economy. So that made the pressure somewhat less. But the same thing goes on. Where there are issues, where there could be impairments, there's generally been an agreement, private equity firms put in more money, lenders may be more accommodative. So again, it's a joint optimal solution amongst borrowing lender rather than going after each other. Private credit has had tremendous success for 20 plus years.

28:20Do you feel that the expectations based on that track record are reasonable or do you think they're perhaps too elevated, particularly as it relates to downside risk and illiquidity. You really haven't had a period where there was a mass rush for the exits and maybe you won't have one. And then even the downside, you talked about the great financial crisis, minus 6%. Most people would be thrilled with just the minus six. I don't know what the future holds. It's very difficult to predict. What I always tell our staff and our investors is let's put together a private debt product that we think is maybe not bulletproof, but basically is going to weather any kind of storm ahead.

29:06So to me, the key there is diversification, having a large portfolio with many loans, no single source of risk. And secondly, modest leverage. What always gets people in trouble is leverage. Make sure you don't get yourself in trouble with a 5%, 10%, 15 % downturn. And so that's, so far, it's served us well. Even with our funds, we went through COVID and we went through the Fed tightening without real incident. If you think about it from an allocator standpoint, where do you feel private credit fits within a total portfolio? And how does this asset class help improve diversification and potentially expect returns over time?