Private debt

The uptake of private debt is a relatvely new trend in alternative investments. The recent rise in private debt AUM was born out of the Global Financial Crisis as banks, the more traditional lenders, shied from riskier loans and private, or direct, lenders filled the void. Private debt funds bring several advantages to the table for investors, particularly higher yields than traditional investment-grade debt securities. Additionally, the breadth of offerings from their underlying loans offers investors a diverse spectrum of industry exposures and risk/return profiles.

What is private debt?

Private debt, or private credit, is the provision of debt finance to companies from funds, rather than banks, bank-led syndicates, or public markets. In established markets, such as the US and Europe, private debt is often used to finance buyouts, though it is also used as expansion capital or to finance acquisitions.

Private debt expanded rapidly after the Global Financial Crisis (GFC), when banks pulled back from leveraged lending and concentrated their corporate operations on larger clients, creating a gap in the market that private debt funds filled.

Private debt funds pursue a range of strategies, for example, direct lending, venture debt, or special situations, as well as by the type of debt provided, such as senior, junior, or mezzanine. Lending private debt can be to both listed or unlisted companies, as well to real assets such as infrastructure and real estate.

Assets under management in private debt has now surpassed $812bn, with the number of active investors in the industry currently more than 4,000.

History of private debt

Bank lending remains a traditional source of debt, despite the decrease in activity following the Global Financial Crisis (GFC) in 2008 and the tightening of various banking regulations. Traditional lenders cut back financing following the GFC, which created space in the market for investors such as private debt fund managers to provide alternative sources of lending. Debt strategies were previously a sub-category of private equity investing, becoming an established asset class in its own right post-crisis.

Private debt assets under management, 2010 - Q2 2022

Understanding the capital structure

Capital structure refers to the way a corporation is financed based on the proportion of debt, and type of debt and equity, on its balance sheet. This determines how, and in what order, capital is repaid in the event of bankruptcy. Senior debt is at the top of the capital structure and repaid first, making it low risk. Equity is ranked the lowest and is repaid last, making it high risk.

A loan to be repaid first if the borrower defaults.

Senior debt has priority over more junior debt within the capital structure. Typically secured by collateral or assets over which the lender has 'first lien' (first claim). Less risky than more junior debt or equity. The interest rate charged by the lender is often lower than for junior or subordinated debt.

A combination of senior and subordinated debt in one instrument.

Issued by one debt provider and usually used to facilitate a leveraged buyout. Created to simplify the debt structure, as one lender can satisfy the whole debt requirement. As a combination of senior and subordinated debt, the interest rate charged often falls between the two.

Also called 'junior debt' – a loan that is repaid after senior debt in the event of bankruptcy.

Subordinated to senior debt in the capital structure. More risky than senior debt and attracts a higher interest rate. Sits above equity in the capital structure meaning lenders are repaid before shareholders or owners.

Also known as 'hybrids' - a hybrid of equity and debt finance.

Senior only to common shares and equity in the capital structure. Debt capital with rights to convert to equity ownership if the borrower defaults. Contains 'embedded equity options' or 'kickers' such as stock call options, rights, or warrants. Unsecured debt issued without collateral, therefore demanding a high interest rate.

The shares of a company are repaid last in the capital structure. This is therefore the highest risk for shareholders in the event of bankruptcy.

Subordinated debt

Debt owed to an unsecured creditor, which in the event of liquidation, can only be paid after the claims of secured creditors have been met.

Unsubordinated debt

Debt owed to a secured creditor, which must be paid first in the event of liquidation. This is therefore less risky than investment in subordinated debt.

Investment strategies

The majority of institutional investors allocating capital to private debt focus on commitments to unlisted private debt funds. These unlisted private debt funds differ according to strategy, for example direct lending or fund of funds. They also differ depending on the type of debt provided, such as senior debt or mezzanine debt.

Non-bank lenders extending loans to small and medium enterprises (SMEs).

A direct lending fund issues loans directly to companies.
The type of debt issued, such as senior or subordinated, depends on the fund’s strategy.

Buying the debt of companies that are in bankruptcy or likely to enter bankruptcy.

A distressed debt fund is similar to direct lending, but only targets distressed opportunities.
The debt issued tends to be senior, and therefore high in the capital structure, due to the substantial threat of liquidation.
Debt may be bought at a significant discount, with the goal being that the value of the company improves after the debt investment.

A hybrid of equity and debt finance.

A mezzanine fund only issues mezzanine debt to companies.
Debt issued has conversion rights to equity with embedded equity options if the borrower defaults.

A private pool of institutional investor capital that invests in several private debt funds.

A private debt fund of funds invests in a variety of third-party debt funds depending on the fund strategy.
Provides greater portfolio diversification for institutional investors.

A loan based on a ‘special situation,’ referring to something other than underlying company fundamentals.

A special situations fund focuses on companies whose value may be impacted by a certain event, including company spin-offs, mergers & acquisitions, or tender offers.
This can include both debt and equity investments.

A loan provided to a start-up or early-stage company.

Provides loans to act as growth capital for equipment financing, or as accounts receivable finance.

The following are considered important aspects of private debt, though not interpreted as strategies:

Collateralized loan obligation (CLO): this is an investment instrument. It is a security backed by a pool of debt, featuring several levels of credit ratings and repayment structures.

· In a CLO, the investor gains exposure to a diverse portfolio of existing bank loans.

· The investor receives scheduled interest payments from the underlying loans.

· If the borrower defaults, the investor assumes most of the risk.

Business development company (BDC): a tax-efficient, US-based, publicly traded private debt fund, structured as a corporate fund. This is perceived as an investment opportunity, rather than a strategy.

A BDC is designed to help small companies in their early stages of development.
Bears similarities to a private venture capital and venture debt fund.
Publicly listed on a stock exchange.
Most often provides short-term unsecured loans ($2-50mn).
Often takes an equity position in the company.

A borrower defaults when:

They fail to repay debt and/or interest to loan distributors. This includes missing one or more scheduled payments or the inability to complete any payments at all.

Private debt risk and return

Each of the private debt strategies’ risk/return profiles are dictated by the investment and its position within the capital structure. Strategies with lower risk tend to yield lower returns than those with higher risk.

Private Debt: Risk/Return by Fund Type (Vintages 2011-2017)

Direct lending vehicles invest across the capital structure. The fund’s investment strategy and the parts of the capital structure it focuses on will dictate the risk/return profile, but this tends to be the lowest risk, with the lowest return potential across debt strategies.
Mezzanine comprises investments in debt subordinated to the primary debt issuance and senior to equity positions. As such, the investments within mezzanine vehicles are riskier than more senior debt.
Distressed debt will yield greater rewards due to the higher risk of default by companies. In order to reap the greatest returns for this strategy, debt would be purchased at a significant discount.
Special situations targets investments for companies in distress. There is a significant price dislocation as the value is impacted by certain circumstances. Returns within this strategy are similar to distressed debt, but may be subject to greater risks.

Why invest in private debt?

Private debt is widely regarded as a low-risk investment compared to other alternative asset classes, and a viable alternative to fixed income investing. Investors commonly invest in private debt through commitments to unlisted private debt funds, which offer attractive risk-adjusted returns, particularly in a low interest rate environment.

Institutional investors’ main reasons for investing in alternative assets

A conservatively-managed private debt portfolio presents the following attractive characteristics for an institutional investor:

Portfolio diversification.
Low correlation to public markets.
Attractive risk-adjusted returns in a low interest rate environment.
Predictable and contractual returns based on interest rate charged.
Lower risk than private equity, since debt sits higher than equity in the capital structure.
Potential to acquire debt in companies at below par value.
Good alternative to fixed income investments.

In this lesson, we explored how private debt became its own asset class after the Global Financial Crisis. From the different sources of debt to the capital structure and strategies, you now know the ways investors can allocate to private debt, and why they choose to do so.

Marketing Communication. This material is provided for informational purposes only and should not be construed as investment advice. Views and opinions expressed in this article are as of October 2024 and are subject to change, and there can be no assurance that developments will transpire as may be forecasted in this article. The reference to specific securities, sectors, or markets within this material does not constitute investment advice, or a recommendation or an offer to buy or to sell any security, or an offer of services.

Past performance is not a guarantee of future results. All investing involves risk, including the risk of loss. No investment strategy or risk management technique can guarantee return or eliminate risk in all market environments. Investment risk exists with equity, fixed income, and alternative investments. There is no assurance that any investment will meet its performance objectives or that losses will be avoided.