Q2 2024 Lincoln Senior Debt Index

The LSDI represents years of research and analysis of data and was developed by professionals from Lincoln’s Valuations & Opinions Group in collaboration with Professor Pietro Veronesi of The University of Chicago Booth School of Business.

The results of the LSDI were no surprise as they continued to showcase the same trends and observations seen over the last 18 months. The LSDI yielded 11.4%, reflecting another stable yield relative to the prior quarter as SOFR rates ceased their upward trajectory. Similarly, Q2 2024 finished with a fair value of 98.6 for the LSDI, a modest improvement relative to the 98.4 fair value from the previous quarter. Continuing the trend of stability, the rate of companies defaulting on covenants only declined 10 basis points since Q1 2024 and represented the fifth consecutive quarter of declines in the default rate. Lincoln once again saw a sizeable number of amendments with more than 240 amendments completed in Q2 2024. The most prevalent type of amendment driving up the count seen in Q2 2024 consisted of repricings, as increased dry powder in the market continued to prompt a resurgence in the broadly syndicated loan (BSL) and direct lending markets. Even with increased amendments for repricings on lower-levered deals, Lincoln observed a consistent quantity of sponsor infusions, maturity extensions and covenant holidays relative to the first quarter of the year. We continue to believe the decline in default rates demonstrates that borrowers and lenders anticipated defaults and proactively addressed the issue by amending the loan documents.

As the competition to deploy capital has persisted in the market, returns in the BSL and direct lending markets have remained at levels consistent with the last 18 months. Between the end of 2023 and H1 2024, yields in both the direct lending and BSL markets have remained stable.

To review the results of an independent study on the quality and breadth of Lincoln’s private market database, click here.

The LSDI provides insight into the direct lending market as it is a fair value index consisting of four components:

Total return (income return plus capital gain return);
Price (i.e., fair value);
Spread; and,
Yield to maturity

Each of the four components are then categorized into three types of senior loans:

All senior loans – consisting of first lien, Unitranche, and second lien loans;
Senior loans consisting of first lien; and
Second lien loans

Quarterly Overview
- IMPORTANT DISCLOSURE
- The LSDI provides insight into the direct lending market as it is a fair value index consisting of four components: 1. Total return (income return plus capital gain return); 2. Price (i.e., fair value); 3. Spread; and, 4. Yield to maturity.
- Each of the four components are then categorized into three types of senior loans: 1. All senior loans – consisting of first lien, Unitranche, and second lien loans; 2. Senior loans consisting of first lien and 3. Second lien loans.
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In addition, we provide additional descriptive statistics including: (a) loan-to-value; (b) the impact of interest rate (SOFR) and credit changes (spread) on total return; (c) default rates and (d) historical yields by EBITDA size.

The U.S. non-investment grade corporate loan market has two segments: the BSL market, which attracts investors investing in broader syndicated deals and the direct lending market for investors investing in club deals. While correlated, there are subtle but significant differences between the two markets. Both markets primarily provide floating-rate loans; however, divergences exist in terms of market liquidity, company size and credit facility size. Given the greater liquidity in the BSL market, pricing and terms are a function of the technical market and competitive factors, whereas the more illiquid direct lending market has a stronger orientation to assessing company fundamentals.

In contrast to the Morningstar LSTA U.S. Leveraged Loan 100 Index, which is comprised of companies borrowing in the BSL market, the constituents in the LSDI are virtually all companies borrowing in the direct lending market.

The direct lending market is a significant source of capital for private equity backed middle-market companies. The LSDI benefits market participants by providing information to facilitate a greater understanding of the attributes of this important source of capital to the private sector.

How We Obtain the Information

On a quarterly basis, Lincoln values more than 5,500 private companies primarily owned by over 170 alternative investment funds and lenders to funds. Most of these companies are levered via borrowings from the direct lending market. A significant percentage of the LSDI constituents are based upon valuations of loans provided for nonpublic business development companies and other private investment vehicles and, therefore, not disclosed in public filings.

For many of the private companies valued quarterly, Lincoln advises on the fair value of at least one senior debt security in the capital structure. All valuations conform with GAAP and fair value principles and have been reviewed by fund management, fund boards, limited partners, and auditors.

Additional information can be found in our methodology discussion and on our website.

98.6

Average Fair Value of Loans in the Index as of Q2 2024

Lincoln Senior Debt Index – Key Observations – All Loans – Q2 2024

The LSDI returned 2.8% for the quarter ending June 30, 2024, and represented a decrease of 0.5% relative to the return in Q1 2024 as the marginal increase in fair value was lower in Q2 relative to Q1.
- The primary investment benefit is interest income from investing in private credit; total quarterly returns from interest were 1.6% while the total return from capital gains was 1.2%.
The 2.1% gap between the yields derived from the LSDI and Morningstar LSTA in Q2 2024 continued to be lower than the historical average of 3.7% as competition to deploy capital has remained high, reducing the return differential between the two markets.
Prices within the LSDI fared better than those in the BSL market, with prices in the second quarter stepping up $0.20 to 98.6 and $0.01 to 97.7 within each index, respectively.

Results

Total Return

Comparison of Total Return – Lincoln Senior Debt Index (All Loans) to Morningstar LSTA U.S. Leveraged Loan 100 Index

Observations

Investment return is generated from two sources: (1) capital gains and losses; and (2) income return. In the leverage lending asset class, income returns dominate capital gains or losses, resulting in a positive quarterly total return.
Since the inception of the LSDI, both the Morningstar LSTA, which measures the performance of the BSL market, and the direct lending market have experienced an increase in total return. BSL returns for the quarter ending June 30, 2024, were 2.1% versus the LSDI of 2.8%. On average, returns for the LSDI have been higher than those for the BSL as the average returns since inception of the LSDI have been 1.9% for the LSDI versus 1.1% for the BSL.
Given the continuing high level of interest rates, we expect returns to remain high by historical standards.

Correlation and Comparison of Quarterly Returns – Lincoln Senior Debt Index (All Loans) to B Market

Observations

The correlation between the LSDI and Morningstar LSTA is high at approximately 80.6%. However, there are a few distinct differences:
- The standard deviation of returns for the life of the LSDI was 1.1% versus the 2.9% for the Morningstar LSTA over the same time period;
- The LSDI is significantly less volatile; and
- The LSDI generates higher returns.
The direct lending market experiences negative returns much less frequently than the BSL market, given its higher yields and lower standard deviation.
- Since the inception of the LSDI on September 30, 2014, through June 30, only the quarter ending March 31, 2020, reported a negative quarterly return whereas the BSL market has experienced eight quarters of negative returns.

Yields

Comparison of Yields – Lincoln Senior Debt Index (All Loans) to B Market

Observations

The yield of the LSDI was 11.4% for the quarter ending June 30, 2024, which continued to be higher than the average yield of the index of 9.8% given the current interest rate environment.
Volatility in SOFR rates between the end of 2023 and the first half of 2024 continued to be virtually non-existent, with the SOFR rate decreasing only one basis point over that time period and resulting in a stable yield for the LSDI of 11.4%. The BSL market followed suit, with the yield remaining at 9.3% at the end of Q2 2024.

Comparison of Yields – Lincoln Senior Debt Index (All Loans) by Size

Default Rates

Direct Lending Default Experience

Note: Defaults defined as loan covenant defaults (not monetary defaults)

Observations

The beginning of 2024 saw the continued trend of the decline in default rates, with the observed instance of default decreasing 50 basis points from 3.4% in December 2023 to 2.6% in June 2024. The five quarters of consecutive decline in defaults continues to be the longest run observed since the inception of the LSDI and demonstrates lenders’ ability to anticipate upcoming defaults within their portfolio companies and react accordingly.

Direct Lending Default Experience by Size

Source: VOG Private Market Proprietary Data. Data as of: June 30, 2024

Observations

When bifurcated into defaults by company size, small companies tend to have higher instances of default than larger companies. This further illustrates the risk and return tradeoff given the higher yields associated with investments in smaller businesses. This can also be attributed to the trend of smaller EBITDA deals being underwritten with tighter covenants.
Between Q1 and Q2 2024, Lincoln saw increased instances of default in companies with less than $30 million in EBITDA, while the rates of default continued to decline for larger companies. This trend further emphasized the struggle smaller companies were having with managing their debt obligations within the high interest rate environment.

Decomposing Yields in the Direct Lending Market – LIBOR/ SOFR Floors and Spreads

Decomposing Yield – LIBOR, LIBOR / SOFR Floors and Spreads – All Loans

Note: LIBOR/SOFR floor reflects fair value weighted average for each period while LIBOR / SOFR above reflects the extent to which LIBOR / SOFR is above the floor. LIBOR / SOFR reflects the spot rate as of the last day of the quarter.

Observations

The average yield of the LSDI since inception has been approximately 9.8%.
From 2016 until the quarter ending June 30, 2022, yields in the direct lending market had remained in a band between 8.0% and 10.0%. However, as reference rates began to increase in Q2 2022 and Q3 2022, yields increased as well and have exceeded 11.0% since Q3 2022.
Yields over the past 12 months have remained stable as SOFR rates have halted their steep increases. SOFR rates for the past year have hovered between 5.3% and 5.4%, which is well above the approximately 2.2% average SOFR rate between 2016 and Q2 2024.
Spreads through the first half of 2024 have been declining since the peak in 2022 given the increased competition seen within the direct lending market.

Fair Value – Price – Trends

Fair Value – Lincoln Senior Debt Index (All Loans) Compared to the S&P / LSTA U.S. Leveraged Loan Index

Observations

The LSDI was 98.6 as of June 30, 2024, up $0.20 from the prior quarter’s price of 98.4.
The fair value of 98.6 continued to surpass the historical average price of 97.7. Despite being above average, the fair value as of Q2 2024 was not the highest price seen in the LSDI as that designation belonged to the 99.2 fair value in Q1 of 2018. In contrast, the index reached its lowest point in Q1 of 2020 at 92.7.
There are several reasons for the phenomenon whereby loans in the direct lending market do not experience the same price volatility as observed in the BSL market:
- Loans in the direct lending market trade much less frequently than loans in the BSL market.
- Investors in the BSL market have a greater ability to liquidate their investment should they decide to exit, as trading is a viable option. In contrast, investments in direct lending funds are structured whereby investor redemptions are limited. Therefore, capital flows are not as volatile as the BSL market.

Bifurcation of the Impact on Total Return Due to Credit Risk and Interest Rate Risk

Decomposition of Index Returns: Interest Rate versus Credit Risk

Observations

The LSDI returned 2.8% for Q2 2024 versus 3.3% in Q1 this year.
Decomposing the quarterly return of 2.8%, the return was attributable to changes in credit risk and interest rate risk with credit risk accounting for 1.2% of the return and interest rate risk making up the remaining 1.6% of the return. The primary driver of the decline in quarterly return relative to Q1 2024 is the lower credit risk associated with the loans comprising the LSDI as fair value increased.

Methodology

Source of Data and Sample Size

On a quarterly basis, Lincoln determines the enterprise fair value of over 5,500 portfolio companies for approximately 170 private equity sponsors and lenders. These portfolio companies report quarterly financial results to the sponsor (i.e., private equity group) or lender. Lincoln obtains company and loan level information to create the Lincoln Senior Debt Index.

All information is prepared in accordance with the fair value measurement principles of generally accepted accounting principles. Finally, each valuation is then vetted by auditors, company management, boards of directors and regulators.

Additional information about the methodology of the LSDI can be found at: www.lincolninternational.com/perspectives/an-overview-of-the-lincoln-senior-debt-index.

Academic Advisor

Professor Pietro Veronesi is the Chicago Board of Trade Professor of Finance at the University of Chicago, Booth School of Business. He is also a research associate of the National Bureau of Economic Research and a research fellow of the Center for Economic and Policy Research.

Professor Veronesi’s research has appeared in numerous publications, including the Journal of Political Economy, American Economic Review, Quarterly Journal of Economics, Journal of Finance, Journal of Financial Economics and Review of Financial Studies. He is the recipient of several awards, including the 2015 AQR Insight award, the 2012 and 2003 Smith Breeden prizes from the Journal of Finance, the 2008 WFA award, the 2006 Barclays Global Investors Prize from the EFA, the 2006 Fama / DFA prizes from the Journal of Financial Economics and the 1999 Barclays Global Investors / Michael Brennan First Prize from the Review of Financial Studies. Professor Veronesi teaches both masters- and Ph.D.-level courses. He is the recipient of the 2009 McKinsey Award for Excellence in Teaching.

His undergraduate work was in economics at Bocconi University where he received a laurea magna cum laude with honor in 1992. He earned a master’s degree with distinction in 1993 from the London School of Economics. He joined the Chicago Booth faculty upon obtaining his Ph.D. in Economics from Harvard University in 1997.

Independent Academic Validation of Lincoln’s Data

In January 2024, an Assistant Professor of Finance at Penn State University’s Smeal College of Business conducted a study to evaluate the statistical significance of Lincoln’s private market Database as compared to other independent sources, like Pitchbook, BDC Collateral, and Preqin. The test was akin to an FDA pharmaceutical drug effectiveness test wherein Lincoln’s data was tested in relation to the independent data sets, measuring overlap of deals detailed and congruency of reported terms. The results were robust and concluded that Lincoln’s data was representative of the private debt universe, and comprehensive of sponsor backed deals, in particular. Lincoln’s Database featured 53% of reported private debt deals with terms in Pitchbook and 48% of sponsor backed deals with reported debt terms that appeared in BDC Collateral. However, beyond the abundance of pure deals, Lincoln’s database goes a step beyond and includes vital operating performance figures from the portfolio company level that the other databases don’t feature. Lincoln’s data is more comprehensive, inclusive of enterprise value and financial performance metrics that allow for a much clearer picture of the state of the private markets.

Summary

Q2 2024 Lincoln Senior Debt Index

From 2014 through June 30, 2024, a portfolio of direct lending loans has yielded higher returns and lower volatility relative to BSLs.

The LSDI provides market participants with many unique valuation insights into the fair value of direct lending loans and represents a significant enhancement to the information available within an opaque market.

IMPORTANT DISCLOSURE: The Lincoln Senior Debt Index is an informational indicator only, and does not constitute investment advice or an offer to sell or a solicitation to buy any security. It is not possible to directly invest in the Lincoln Senior Debt Index. Some of the statements above contain opinions based upon certain assumptions regarding the data used to create the Lincoln Senior Debt Index, and these opinions and assumptions may prove incorrect. Actual results could vary materially from those implied or expressed in such statements for any reason. The Lincoln Senior Debt Index has been created on the basis of information provided by third-party sources that are believed to be reliable, but Lincoln International has not conducted an independent verification of such information. Lincoln International makes no warranty or representation as to the accuracy or completeness of such third-party information.

The LSDI should not be construed as an offer to sell or buy, or a solicitation to sell or buy, any products linked to the performance of the LSDI. The use of the LSDI in any manner, including for benchmarking purposes, is not endorsed or recommended by Lincoln International and Lincoln International is not responsible for any use made of the LSDI. Lincoln International does not guarantee the accuracy and/or completeness of the LSDI and Lincoln International shall not have any liability for any errors or omissions therein. None of Lincoln International, any of its affiliates or subsidiaries, nor any of its directors, officers, employees, representatives, delegates or agents shall have any responsibility to any person (whether as a result of negligence or otherwise) for any determination made or anything done (or omitted to be determined or done) in respect of the LSDI and any use to which any person may put the LSDI. Lincoln International has no obligation to update the LSDI and has no obligation to investors with respect to any product based on the performance of the LSDI. Any investment in such a product will not acquire an interest in the LSDI. Lincoln International is not an investment adviser and will not provide any financial advice relating to a product linked to the performance of the LSDI. Investors should read any such product offering documentation and consult with their own legal, financial and tax advisors before investing in any such product.