HomePreqin AcademyLesson 4: Asset Class 101sPrivate Debt

Private Debt

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The uptake of private debt is a relatively 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. The size of the private debt market is expected to cross the $1tn threshold in 2020 or 2021.

What is Private Debt?

Private debt, or private credit, it 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.

Sources of capital for private debt funds include:

Collateralized debt obligations (CDOs)
Business development companies (BDCs)
Hedge funds

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.

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.

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.

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.

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.

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.
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.

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