Private debt is garnering increasing headlines in financial news and becoming an important component of today's alternative portfolios. However, for many investors, private debt remains less understood than its better-known cousin – private equity.
So, what is private debt, and why should it form part of an overall alternative portfolio? [Editor’s note: An alternative investment is one that does not fall into conventional asset classes, such as equities, fixed interest or cash.]
Private debt is debt issued by a company that is "private", not "public". Public debt, better known as bonds, is listed and trades on an exchange; information is publicly available to every (potential) investor, and there is typically a high degree of secondary-market liquidity.
Private debt is debt – usually in the form of a loan – issued by a company (typically owned by a private-equity sponsor) that is not listed and does not trade on an exchange. Financial information on the company is not publicly available.
Lending to companies has been around for hundreds of years and long before the development of the corporate-bond market. However, for many investors, loans, and therefore private debt, has remained relatively unknown until recently.
Historically, loans were private financings arranged by commercial banks as bilateral transactions, whereas bonds were underwritten by investment banks and sold to third-party investors. The introduction of large "buyout" loans, which are required by private-equity sponsors as their funds, began to change this dynamic as institutional investors started to join traditional bank syndicate groups as lenders in these loans.
The banks supported this process to be able to underwrite larger loans and thus capture lucrative arranging fees while managing their limited balance sheets. The process accelerated as a broader range of institutional investors participated and banks structured term loan (non-amortizing) tranches designed to meet the needs of those investors.
These loans often termed “senior secured corporate loans”, are the most senior debt obligations of non-investment grade companies; the same group of companies that issue corporate high-yield bonds. While investors will be exposed to the same type of credits as when investing in high-yield bonds, loans have some important distinctions.
As senior secured lenders, investors benefit from a first-ranking priority claim and so credit losses have typically averaged around half those of high yield.
Additionally, loans have interest rates set off LIBOR or EURIBOR and therefore rising interest rates benefit returns, unlike other traditional fixed-income asset classes.
Today, this market has grown to a substantial size at over US$1.5 trillion, covering a vast number of companies in the US and Europe, and offering a real alternative to the more traditional allocations of high-yield bonds.
Given that loans benefit from rising interest rates and have a priority position in the corporate capital structure, they represent a way for investors to take credit exposure but with an eye to relatively stable and predictable returns.
Importantly, as interest rates rise, we would expect loans to outperform as they have done historically. Or, put another way, generate attractive levels of income with lower levels of price volatility and less downside risk than bonds.
While the advent of the senior secured loan and private debt markets came about as banks were looking to syndicate larger buyout loans to other institutional investors and maintain their fee levels, banks are now seeing their role disappear altogether in some circumstances.
This is particularly the case in the “middle market” (companies with EBITDA [underlying earnings] of approximately US$75 million or less, and total debt of US$500 million or less).
Given the growth of the institutional investor base (which unlike banks is not governed by strict capital rules), private-equity sponsors are now able to go "direct" to one or a small number of institutional investors for a loan to the company in question; no banks are involved and there is no syndication process, coining the phrase "direct lending".
While the instrument may still be a senior secured loan, which benefits from first-ranking priority claims, the fact that no banks are involved allows those investors to capture better economics on the loans they provide.
In addition, the private-equity sponsor typically values the fact that the lender group will be very limited and is thus willing to agree to tighter documentation terms, with those investors sacrificing any secondary-market liquidity in return for those better terms and deal economics.
This direct-lending trend began in the US in the early 2000s and accelerated after 2007-2008 as strict capital rules were forced on banks. Those rules, and the general move away from local relationship banking in the European Union, allowed similar growth in Europe to take hold, such that this market is now substantial in its own right at close to US$1 trillion.
With capital rules unlikely to be eased, it is likely that this growth will continue, particularly in regions such as Asia and Australia, where direct lending is less prevalent.
We have seen private debt go through a continuous evolution over the last 20 years, and the market is more than ever an area where investors can seek more stable returns in credit, with a variety of investment options and strategies available.