The Case for Private Debt: What, Why, and How
While Private Equity and Real Estate receive the most attention, the third largest alternative asset class - Private Debt - should not be overlooked.
As one would expect from an alternative asset, it offers the dual benefit of solid returns and low correlation with the public markets. This makes it a timely addition to one’s portfolio as the economy enters increasingly choppy waters.
As a debt investment, however, it is fundamentally different from the other two asset classes, and requires an introduction in its own right. Below, we briefly introduce the various factors for investors to consider and how to navigate them.
What is Private Debt?
While some debt is traded on an exchange (such as government bonds) with a public listing and rating, not all businesses are in a position to raise debt capital in this way. For small to medium-sized businesses, in particular, the bank has been the traditional source of debt capital to fund business activities, acquisitions, or expansions.
Following the Great Financial Crisis of 2008, bank lending practices came under heavier scrutiny, and regulations such as Dodd-Frank made it slower and in some cases impossible to secure funding this way.[1] A new private debt (PD) industry has sprung up, which allows investors to put up capital to be lent out at rates similar to those offered by banks.
The most straightforward kind of private debt is direct lending, which simply replaces bank loans with privately-sourced equivalents. Similar to a bank loan, the borrower should be able to demonstrate a solid future basis for repayment.
Another common type of debt is mezzanine financing, which contains the option to convert to equity, but retains seniority over common stock holders in case of default. More speculative strategies (such as Distressed Debt and Special Situations), also exist to cater to firms that are either underperforming or otherwise in a high-risk situation (e.g., litigation).
Private debt is also becoming increasingly popular for funding infrastructure or even real estate projects, where cashflows can reasonably be expected to cover the loan payments.
Why invest in PD?
In addition to the standard benefits of alternative asset classes - attractive returns, diversification, and low correlation with public markets - we believe that PD brings specific advantages:
Debt is a lower risk prospect than private equity and real estate, as returns are fixed and have a higher claim on the underlying assets in case of default.
Private lenders typically have a closer relationship with the borrower, in comparison to standard loans. This makes the process more efficient, and can also contribute to the success of the underlying business.
It provides a way to gain access to many sectors of the economy that might otherwise be out of reach (e.g., renewable energy), further increasing portfolio diversification.
Private Debt in 2022
As outlined above, the wave of post-crisis regulation has created a significant gap for alternative private lenders to enter the market. Demand for direct lending alone grew tenfold over the following decade.[2]
The recent spike in inflation and the accompanying hikes in interest rates in the US signals the start of a new era, and will make private lending more expensive. However, the challenged economic background will also drive SMEs to seek capital from a wider range of sources. Private debt is also known as ‘bear market capital’ for this reason.
Undoubtedly, some areas of the private debt market are better placed to adapt to the new environment. Floating-rate debt, for instance, will shield debt investors from inflationary pressures if they persist.
Overall, the market looks poised for continued growth. In its latest report, intelligence firm Preqin predicts that the 10-year annual growth rate of 13.5% will increase to 17.4% in the years leading up to 2026.[3]
How to access PD funds
The rapid growth of the private debt sector has created a large yet complex range of alternatives for potential investors.
A number of online platforms exist to allow individual investors to participate as lenders, (e.g. Cadence, Groundfloor). There are also large organizations such as Business Development Companies (BDCs) whose explicit purpose is to lend to small and medium-sized businesses, and are accessible to investors via the public markets.
However, we are of the opinion that the best returns are to be found via private debt funds with dedicated expert managers, who pursue specific strategies and invest in various kinds of debt (e.g., mezzanine). These have generally been restricted to institutional investors, but some funds are opening up to individual investors as well.
How Petiole can help
While it may be tempting to choose one of the publicly available options to gain exposure to the benefits of PD in your portfolio, it is not advisable to ‘plunge in’ without proper expertise on your side. Some projects are inherently riskier than others, and investments in private debt can be harder to exit as they are often illiquid.
At Petiole, not only do we apply strict criteria when assessing private debt opportunities, but we also offer our clients access to funds and deals that would ordinarily be exclusive to a small circle of investors. And of course, all recommendations are made within the context of your unique circumstances.
To find out more about how private debt investing could help you meet your financial goals, get in touch using the link below.
Interested in learning more?