Last year served as a clear example of the importance of diversifying investments beyond stocks and bonds. The traditional 60/40 portfolio, consisting of 60% public equities and 40% public fixed income, lost nearly a tenth of its value (-9.6%) over the course of the year[1]. The S&P 500 performed even worse, with a return of -18.1%[2], while U.S. high-yield bonds also suffered at -11.2%[3]. However, there were assets that delivered positive returns, such as U.S. middle-market direct lending, the prominent segment of the private debt market, which returned +5.9%[4].
Exposure to alternative assets was the main reason the Nicola Core Portfolio Fund ended 2022 with +7.5%. With the Nicola Core Portfolio Fund, we seek to give investors both current income and long-term capital growth using allocations to public assets, real estate, and private capital (private debt, private equity, commercial mortgages and infrastructure equity). The Nicola Private Debt Fund, which posted a +5.3% net return in 2022[5], is just one component that played an important role in providing our clients with stable returns even in the face of major turmoil in investment markets.
In a memo shared with clients last December, Oaktree Capital co-founder Howard Marks highlighted the “sea change[6]” occurring in the investing world, marking only the third such shift in his 53-year investment management career. This new era, referred to as the "full-return world," presents opportunities where “investors can now potentially get solid returns from credit instruments, meaning they no longer have to rely as heavily on riskier investments to achieve their overall return targets. Lenders and bargain hunters face much better prospects in this changed environment than they did in 2009-21.” This aligns with our objectives through the Nicola Private Debt Fund, with U.S middle-market direct lending being a crucial component of our strategy.
Direct lending generally refers to senior secured loans made to middle-market companies. Within the private debt market valued at U.S.$1.3 trillion, direct lending accounts for 44% of assets under management (AUM)[7]. Our primary focus is investing in privately syndicated U.S. middle-market loans led by market leading direct lenders provided to profitable and recession-resilient companies owned by private equity sponsors. This is a mature asset class that has grown quickly since the Global Financial Crisis, driven by tighter bank regulations that created opportunities for private lenders. The secular trend has continued, with bank retrenchment accelerating in recent history since the failure of Silicon Valley Bank and Credit Suisse's untimely acquisition by UBS. Prominent players in this space include large asset management firms like Antares Capital, Ares Capital, Blackstone, Golub Capital, and MidCap Financial. Moreover, major Canadian pension funds have also committed substantial capital to direct lending. We find direct lending, especially in the U.S. middle market, appealing for the following reasons:
- Floating interest rate: Direct loans typically have floating interest rates, benefiting from rising base rates. This feature played a significant role in generating positive returns for the asset class in 2022.
- Senior secured risk: We favour first lien term loans ranked at the top of the capital stack. These loans typically exhibit defensive characteristics, including priority of payment over other investors in the company, leading to higher recoveries in a default.
- Financial covenants: Most direct loans have at least one financial maintenance covenant, which provides protection for the lender. Having a financial covenant in the loan structure will allow lenders to diagnose and respond to a borrower with performance issues by “having a seat at the table” before value materially erodes. We believe this conservative structure contributes to the overall performance of the asset class.
- Collaborative relationships: Direct loans involve fewer participants compared to broadly syndicated loans or publicly traded bonds, fostering more collaborative relationships between lenders, borrowers, and sponsors.
In summary, we believe that the returns in direct lending are attractive relative to the risks, particularly in the current environment. We are proud to offer our clients institutional-quality exposure to this asset class through the Nicola Private Debt Fund, which is designed as an open-ended, evergreen investment vehicle. In addition to its core holdings in middle-market direct loans, the Nicola Private Debt Fund also includes exposures to other strategies, such as real estate debt, consumer loans, venture debt, and more.
We share the belief of Mr. Marks at Oaktree that investment market conditions may have shifted in favour of credit investors over the long term. If this holds true, investing in private debt could be a key strategy for constructing a diversified portfolio.
For more information on The Nicola Private Debt Fund, please visit: nicolawealth.com/private-capital/strategies/private-debt
This material contains the current opinions of the author and such opinions are subject to change without notice. This material is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. This investment is intended for tax residents of Canada who are accredited investors. Residency restrictions apply. Please read the relevant documentation for additional details and important disclosure information, including terms of redemption and limited liquidity. Returns are quoted net of fund/LP expenses but before Nicola Wealth portfolio management fees. Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may gain or lose value. Please speak to your Nicola Wealth advisor for advice based on your unique circumstances. Nicola Wealth Management Ltd. (Nicola Wealth) is registered as a Portfolio Manager, Exempt Market Dealer and Investment Fund Manager with the required securities commissions.
[1] Source: The 60/40 portfolio constituents include: iShares Core Canadian Universe Bond ETF, iShares Core S&P 500 ETF, iShares Core S&P/TSX Capped Composite ETF, iShares Global Government Bond ETF, and iShares MSCI ACWI ETF
[2] Source: Bloomberg. S&P 500 total return from Jan 1, 2022 – Dec 31, 2022
[3] Source: Bloomberg. U.S. Corporate High Yield Bond index return from Jan 1, 2022 – Dec 31, 2022
[4] Source: Cliffwater Direct Lending Index (Senior-Only Direct Loans) index from Jan 1, 2022 – Dec 31, 2022
[5] Nicola Private Debt Fund generated since Inception, 5/4/3/2/1 year returns of 7.2%, 7.2%, 7.6%, 8.3%, 8.7% and 8.1%, respectively as of May 31, 2023
[6] Source: Sea Change by Howard Marks, Dec 13, 2022
[7] Source: BlackRock, Preqin as of June 2022.
