Fewer companies are tapping banks and bond markets for the capital they need to grow, make acquisitions or refinance. Instead, they have increasingly turned to private debt, which has quickly become a $1.7 trillion industry.
What is private debt?
Private debt refers to loans provided by nonbank lenders that are not traded on public markets.1 Although it has been around since at least the 1990s, it didn’t take off until the spate of banking reforms that emerged in the fallout from the Global Financial Crisis (GFC) made it harder and less attractive for banks to service small- and middle-market companies.2
Private debt strategies vary in risk, return and seniority in the capital structure (Figure 1). There are several to know:
- The largest and most common strategy, direct lending refers to senior secured loans typically made to small or midsize companies.3 It offers borrowers flexible terms and faster access to capital. Because the interest rate “floats” at a premium to the risk-free rate, direct lending can protect investors from inflation and duration risk.
- Mezzanine debt is a hybrid form of direct lending that combines elements of debt and equity. It is typically unsecured (i.e., doesn’t require collateral) and subordinated but offers investors higher return potential for assuming greater risk. Mezzanine loans often have longer durations than direct loans and may include fixed-rate or floating coupons.
- Distressed credit involves investing in the debt of companies facing financial trouble or bankruptcy. It is a high-risk but
(potentially) high-return strategy that requires specialized legal and operational expertise to execute properly. - Opportunistic loans are made to stressed but otherwise sound companies that may require innovative financing to fix a complex situation. Here, lenders hope to capture value from misunderstood (i.e., inefficient) companies.
- Specialty financing is a broad category that spans loans made to consumers (e.g., auto or credit cards) as well as borrowers in niche markets (like IP or aviation) who require customized solutions or have unique collateral or risk profiles. Because of the complexity, specialty financing may provide higher returns without necessarily adding risk. That its returns aren’t based on contractual cash flows makes it a good diversifier in PD portfolios.
Regardless of the strategy, private debt general partners (aka GPs, sponsors or managers) are critical to monitoring the health of their portfolio of borrowers. They proactively look for early signs of distress, work with borrowers to restructure loans to maximize recovery and minimize defaults, and work closely with company management to stay on course.
Why invest in private debt?
Equity-like returns
Historically, private debt has performed in line with equity markets and generated higher returns than other credit strategies (Figure 2).
Protection from interest rate volatility
Private debt GPs add a fixed spread (e.g., 600 bps) on top of the benchmark rate.4 When the reference rate rises, interest payments to the GP also increase, boosting returns. Many private debt agreements include a floor (or minimum return) to protect lenders if the benchmark rate drops too low.
Downside protection
In general, the longer the duration, the more sensitive the loan is to interest rate movements. Because private debt agreements reset periodically (quarterly is common), they have much lower duration risk than traditional fixed-income investments—and superior downside protection (Figure 3).
Diversification
Investors gain exposure to middle-market companies that are underrepresented in the public markets. As a result, the asset class has a low correlation with public markets, thus helping investors diversify their portfolios and reduce overall volatility.
Investment structures
Closed-ended funds (aka commingled or primary funds) are pools of capital whereby an investor (i.e., a limited partner or LP) commits capital up front. Depending upon when
they come into the fund, they may have more visibility into the underlying portfolio. Once the GP finds a borrower, the LPs contribute a portion of their committed capital. The invested capital is typically held for seven to eight years. This uncertainty around the timing of when capital is called and returned makes liquidity management a challenge for investors. However, by committing to many funds every year, investors can have relatively predictable cash flows from their PD portfolio. Owing to high commitment floors, investing in closed-ended funds is typically available only to institutions and high-net-worth investors.
Co-investments allow investors to invest alongside a GP—often without paying management or performance fees. This helps them gain critical insights into the strength of the borrower and the GP’s investment team. Co-investors must move quickly and often deploy specialized deal teams. Having a primary fund relationship with a GP is often a prerequisite for becoming a co-investor.
Secondaries refer to purchasing stakes in a closed-ended fund, often at a discount. The sales process can be GP- or LP-led. Because the buyer is entering a mature, diversified portfolio, their capital is deployed quickly and potentially returned sooner. Like co-investments, investing in secondaries requires teams with advanced financial skills and access to proprietary data.
Evergreen funds (aka semiliquids) have emerged as a convenient and efficient way for individuals to access PD. Because these structures draw and deploy investors’ capital instantly and continually, they can resolve some of the liquidity challenges that other structures can present. Though evergreens were initially conceived with the individual in mind, institutions are increasingly using them in their PD portfolios.
Semiliquids have many advantages including instant deployment into a diversified portfolio, lower minimums and higher liquidity. However, their fees are higher than other retail products, including mutual funds.
Conclusion
Private debt has evolved into a dynamic asset class that can provide investors with stable cash flows, diversification and enhanced risk-adjusted return potential. As innovations like evergreen funds expand access, small institutions and individuals alike can participate in strategies once reserved for the largest investors.
Each PD strategy and fund structure offers benefits and considerations, from potentially high returns and enhanced diversification to varying levels of liquidity and fees. Working with experienced managers can help investors navigate risks, optimize portfolios and unlock value.
