Private Debt

CHAPTER 18Expected Returns and Risks from Direct Lending

Previous chapters discussed the different dimensions of corporate direct lending. This chapter and the next provide an institutional framework for assessing direct lending relative to other asset classes and determining the appropriate allocation to direct lending within an overall portfolio.

Somewhat surprisingly, the institutional approach to asset allocation has not changed much over the past 40 years. Prior to 1980, a centralized top–down approach to asset allocation did not exist. Instead institutional investors allocated assets to a few good balanced managers who made decisions as to how to allocate assets across different asset classes, which at that time were only a handful. Pensions, endowments, and foundations (collectively called fund sponsors) moved to a single‐allocator model in the 1980s because the balanced manager approach showed poor returns, charged high fees, and was not integrated with benefit obligations and spending rates. Consultants, who previously focused almost exclusively on manager selection, emerged to assist their institutional clients with asset allocation and asset‐liability management.

With control of asset allocation, fund sponsors and their consultants forecast long‐term return and risk for individual asset classes, define an efficient frontier of asset mixes that maximize return at different levels of risk, and select the asset mix from the efficient frontier that best fits the risk‐taking ...