Private Debt

CHAPTER 11Should Direct Loan Portfolios Be Leveraged?

Many investors in US middle market direct lending use leverage (borrow), typically at the fund level, to enhance return. Whether and how much to leverage is an important decision in constructing a direct lending portfolio. This chapter addresses how leverage impacts direct lending return and risk and provides some guidance as to how the leverage question might be answered.

Exhibit 11.1 provides underlying fee and leverage assumptions that are representative of an institutional private fund vehicle. Those assumptions are then used in conjunction with the historical Cliffwater Direct Lending Index (CDLI) returns to project return and risk outcomes at varying leverage levels.

EXHIBIT 11.1 Indicative fee and leverage specifications for a direct lending portfolio.

Direct lending asset returns	Cliffwater Direct Lending Index (CDLI)
Leverage (borrowing/net assets)	0.0 unleveraged 0.6 average leverage for BDCs 1.0 leverage 1.5 leverage 2.0 leverage
Cost of debt	3.96%, equal to the average 2004–2017 historical financing cost of all BDCs in the CDLI, taken from 10‐Qs/Ks
Management fee	1.00% of gross assets
Administrative expenses	0.20% of gross assets
Carried interest/preferred return	10%/6%

As an illustration, the net of fee return for this direct lending portfolio example is calculated in Exhibit 11.2, assuming leverage equal to 0.61 (61%) of net assets. This is the average leverage used by BDCs on their loan ...