Tariffs May Test Private Debt's "All-Weather" Label

What's New: 

Cliffwater's latest analysis forecasts that a typical recession triggered by recent tariffs could still deliver positive three-year returns for private debt investors, despite significant first-year losses. According to Cliffwater's report, unlevered private debt could return 7.8% annualized over three years even through recessionary conditions, while leveraged vehicles would return 6.2%.

Why It Matters: Private debt has been marketed as an "all-weather" asset class, but this claim will be tested if recent stock market volatility (down 10%) and tariff impacts lead to an economic contraction. The analysis provides a roadmap for investors to understand potential performance in a downturn scenario.

Big Picture Drivers:

• Markdowns affect short-term loan valuations as prices adjust in anticipation of future defaults, creating unrealized losses.

• Defaults cause permanent principal and interest impairments, creating irreversible realized losses over time.

• Interest income significantly offsets losses, providing a cushion that benefits patient buy-and-hold investors.

• Leverage amplifies both negative and positive returns, with BDCs and drawdown funds experiencing roughly twice the volatility of unlevered investments.

• Timing matters greatly, with significant first-year drawdowns followed by strong rebounds in years two and three.

By The Numbers:

• -0.5%: Projected year-one return for unlevered private debt (CDLI) in a typical recession

• -9.0%: Projected year-one return for leveraged vehicles like BDCs in the same scenario

• +13.5%: Expected CDLI return in year two as unrealized losses reverse

• +17.5%: Projected year-two BDC return showing strong recovery potential

• -8%: Maximum historical drawdown for unlevered private debt during the GFC (2008-2010)

Key Trends to Watch:

• Valuation practices tend to overestimate default losses, potentially creating buying opportunities when markdowns exceed eventual realized losses.

• Spread widening in year two (projected at 7.0% over SOFR) could provide attractive entry points for new capital deployment.

• Default timing typically lags market declines, with realized losses peaking in the second year of economic contraction.

• Recovery patterns follow predictable sequences, with unrealized losses being reversed over 1-3 years.

The Wrap: 

Private debt investors facing recession should prepare for significant paper losses in year one but hold firm for the recovery, particularly as higher interest income and eventually reversing unrealized losses drive stronger returns in subsequent years. The math suggests patient capital will be rewarded.