Let’s examine private debt’s definition, fund structure, recent growth, and more. What is private debt, and why is it growing in the institutional investing space?
In today’s dynamic financial landscape, investors are constantly seeking innovative avenues to diversify their portfolios and generate attractive returns. One such avenue that has gained significant traction in recent times is private debt. This guide delves deep into the intricacies of private debt, exploring its definition, evolution, strategies, risk-return profile, and industry trends.
What is Private Debt?
Private debt, also known as private credit, is a type of alternative investment where investors provide loans to companies directly, bypassing traditional bank intermediaries. These loans are not traded on public markets, and they generate returns for investors through interest payments.
Evolution of Private Debt as an Investment Strategy
The emergence of private debt as a prominent investment strategy can be traced back to the aftermath of the 2008 Global Financial Crisis This period witnessed a significant shift in the lending landscape, with traditional banks tightening their lending standards and reducing exposure to riskier loans. This gap in the market paved the way for private debt funds to become a key player in providing alternative sources of lending
How Private Debt Funds Operate vs. Private Equity Funds
While sharing some similarities with other private capital strategies like private equity and venture capital, private debt funds also exhibit distinct characteristics. Private debt investments are typically illiquid, with long lockup periods for investors’ capital. However, compared to equity investments, private debt is generally considered less risky due to its position in the capital structure and the ability to customize the risk profile of an investment.
Diverse Strategies and Capital Sources in Private Debt
Private debt funds employ a range of investment strategies to cater to the diverse needs of investors. These strategies include direct lending, venture debt, and special situations. Each strategy offers unique risk and return profiles, aligning with different investor objectives. The capital for these funds is sourced from various channels, including Collateralized Debt Obligations (CDOs), Business Development Companies (BDCs), and hedge funds.
Risk and Return in Private Debt Strategies
The allure of private debt investments lies in their diverse risk/return profiles. Strategies like direct lending generally offer lower risk but also lower returns, making them attractive for conservative investors. On the other hand, ventures like mezzanine debt carry higher risk, potentially leading to higher returns. This variety allows investors to choose strategies that align with their risk tolerance and investment goals.
Private Debt and the Capital Structure
Debt sits above equity in the private capital structure. This means that if a company were to declare bankruptcy, its debts are paid out before equity, making it less risky of an investment overall. Within each level of debt in the capital structure, there are a variety of debt vehicles and different levels of distress/risk as well as different loan terms based on the borrower’s status.
Common Types of Private Debt
Private debt loans can take many forms, but a few of the most common loan structures are as follows:
- Term loan: A term loan provides a borrower with a one-time lump sum of cash up front attached to certain borrowing terms, including a set repayment schedule and either a fixed or floating interest rate.
- Revolving credit facility: A revolving credit facility allows the borrower to borrow up to a set limit and pay back that money on a continuous basis.
- Convertible debt: A convertible debt arrangement stipulates that the money the borrower receives from the lender will be repaid in the form equity. Hence the name, the investment is ultimately converted from debt to equity.
Real-World Examples of Private Debt
Private debt can be applied in various scenarios, including:
- Leveraged buyouts (LBO): An LBO involves the acquisition of a company with borrowed money. The acquiree’s assets are then designated as collateral for the loan.
- Collateralized loan obligations (CLOs): CLOs describe a collection of separate loans that are pooled together and packaged into a security for purchase to investors by CLO managers.
- Venture debt: Venture debt describes loans made to small, early-stage businesses, usually in tandem with equity arrangements.
- Real estate debt: A real estate debt fund is typically set up by a private debt manager and backed by their investors. The fund then makes loans to real estate developers for the purpose of building or purchasing real estate properties.
- Infrastructure debt: An infrastructure debt fund is set up with the intention of loaning money to finance the building of essential societal and economic needs, such as roads, bridges, airports, power plants and beyond.
Growth of Private Debt
Private debt as an asset class has exploded since 2000. Market factors have shifted significantly over the past few years – thanks to Covid-fueled economic instability, global conflicts, climbing interest rates and beyond. Through it all, private debt, just like private capital in general, has seen its impressive growth sustain.
Why Investors are Turning to Private Debt
Private debt has become increasingly popular among investors for several compelling reasons. Its reputation as a low-risk investment relative to other alternative asset classes makes it a preferred choice for many. Additionally, private debt offers attractive risk-adjusted returns, especially in low-interest-rate environments. Investors value the portfolio diversification it provides, along with its low correlation to public markets. These characteristics, combined with the potential for predictable and contractual returns, make private debt a lucrative and strategic investment option in the diverse world of private capital.
Industry Trends in the Private Debt Space
With all the growth the private debt space has seen in the last few decades, exciting developments are on the horizon for this industry. Some key private debt trends to watch for include:
- Less market share for banks: Tightened regulations are keeping banks away from leveraged loans, pushing companies of all sizes to private debt as an attractive alternative to bank financing.
- Larger deals and funds: Private debt has encroached on the bank dominated broadly syndicated loan market, with several headline-grabbing $1 billion+ deals throughout
Less market share for banks
Tightened regulations are keeping banks away from leveraged loans, pushing companies of all sizes to private debt as an attractive alternative to bank financing. Between 1994 and 2020, banks saw an 80% drop in loan market participation.
Private debt in the capital structure, visualized
Loans that are prioritized as being paid back first in the event of a borrower’s bankruptcy are referred to as “senior debt.” Since senior debt has the highest priority, it is therefore the lowest risk. Because of this, senior debt usually has lower interest rates, which means a lower return profile for the investor. However, because the borrower is viewed favorably, there is also a lower risk profile. Senior debt is typically secured, meaning that in the event that the business is unable to repay it, it is backed by specific assets.
What is Private Debt?
FAQ
What is considered private debt?
Why do people go into private debt?
What is the difference between public debt and private debt?
Is private debt good?
What is private debt?
Private debt includes any debt held by or extended to privately-held companies. It comes in many forms, including loans and bonds, but commonly involves private credit, when other asset managers make loans to private companies. A variety of general partner (GP) credit investors manage private credit or other debt funds.
What is a private debt fund?
Private debt funds come in different shapes and sizes. For example, some private debt fund structures provide capital to sponsor-backed borrowers, others fund real estate development projects, and some invest entirely in the debt of distressed companies. You will sometimes see private debt and private credit used interchangeably.
What is the difference between private equity and personal debt?
Private equity is a form of investment. It involves the acquisition of an ownership stake in a company. In contrast, personal debt is a form of investment that involves lending money to a company or individual. Private equity investments bear higher risk/higher return, while private debt investments carry lower risk/lower return.
What is the difference between private debt and personal credit?
Private debt generally refers to loans or other forms of debt financing provided by private entities, such as banks, hedge funds, or private equity firms, rather than governments or public institutions. On the other hand, personal credit refers to a broader financing category that includes debt and equity.