An introduction to Private Debt
Most asset classes have recovered nicely since March, when concerns about the Covid-19 outbreak and government shutdowns rattled global financial markets. The winners of the current crisis, especially technology, software and communication stocks have rallied impressively, leading to expensive valuations. What is more, the situation in the fixed income area has never been worse. 86% of the USD 60 trillion global bond market is yielding less than 2%, which is a new record.
In this complicated environment, alternative investments, such as private debt, have continued to attracted investors, including large pension funds, insurance companies and other institutional investors. According to the alternative data and research provider Preqin, private debt’s total assets under management surpassed $800 billion in 2019, from below $100 billion 15 years ago. The Great Financial Crisis in 2008 is widely seen as the inflection point for the asset class’ stellar growth – and the current Covid-19 crisis might well act a further accelerator. Private lending has mainly benefited from new regulations and higher costs of capital in the traditional banking industry, which led them to reduce their loan books and retreat from lending to small and medium-sized enterprises. This paved the way for emerging, innovative asset managers and lending platforms to fill the funding gap.
Private debt is still a relatively new asset class, and thus not fully understood. Private debt, or private lending, typically refers as loans made by any parties other than banks, credit unions and government entities. Investors can get access via specialized asset managers or, though less recommendable, via online lending platforms.
Private loans can have different characteristics in terms of type of borrowers (size and type of corporates, consumers), duration (from a 3 month bridge facility to a 25 year lease), as well as the level of protection. Also, it is important to remember that loans have different priorities in borrowers capital structures. Some loans are secured by collaterals, such as property or other real assets. This means that in case of a default, the lender can take possession of the collateral and eventually sell it. If the sales proceed exceed the value of the loan, there is no loss in a default scenario. Most loans, however, are unsecured, supported only by the borrower’s creditworthiness. In this case, if a company goes bankrupt, the issuers of senior debt are paid first, followed by junior debt holders, preferred stock holders and common stock holders.
Investors typically consider private debt strategies as income and capital preservation strategies. In fact, one of their biggest advantages is the stable income and relatively low volatility. For example, a short-term bridge loan to a corporate borrower that is fully secured by a first lien charge on a property that is worth twice the size of the loan, can be seen as relatively safe and as an attractive fixed income alternative, yielding around 6-12%. Some managers, however, might consider second-lien as “senior”, because they enjoy priority over all but first-lien lenders. Similarly, a loan might appear senior at the first look, but it might be second lien if another lender has secured working capital, fixed assets are other collaterals. Also, investors should be aware of legal risks and procedures related to the enforceability of a pledge. Therefore, investors should count on specialized managers that offer a high level of transparency and expertise in these areas. On the other side of the risk spectrum, distressed debt, subordinated debt or venture debt can offer total returns of up to 20%, combining income elements with significant capital appreciation potential. Finally, short-term lending strategies enable investors an easy exit and liquidity. Longer-term loans, leases and mortgages are typically illiquid and need to be held until maturity.
Interestingly, short-term niche lending strategies with strong protection might offer higher returns than large, long-term loans This is because banks are no longer competing for smaller bridge loans, due to higher costs of compliance, bureaucratic processes and other regulatory hurdles. At the same time, borrowers are willing to pay higher rates for short-term bridge loans that enables them to take advantage of unique business opportunities. Actually, a recent survey from Ernst & Young shows that in the UK bridge lending market, the most important consideration when choosing a lender is the speed of execution, followed by the quality of service, flexibility and reputation. Pricing only ranks 5th. This is why specialist short-term private lenders in niche markets offer the best risk/return profile.
Some of the largest private debt players, however, have become victims of their own success. Given their size, they need to focus on larger deals with longer durations to be able to deploy their investors’ capital. Ares Capital Corp, for example, a private debt giant that is structured as a Business Development Company (BDC) with around USD 14 billion in assets, in late 2018 participated in a $792 million loan for the refinancing a private equity-backed operator of veterinary hospitals. This is an area that is typically dominated by bank syndicates, but some private debt players managed to get traction and still achieving higher rates compared to banks. However, fiercer competition has led to a surge of so called covenant-lite loans. This refers to a type of financing that is issued with fewer restrictions on the borrower and fewer protections for the lender. Still, the private debt market has been more disciplined than the leveraged loan market. In the latter, nearly all deals are covenant-lite due to higher competition between lenders.
Private debt continues to attract massive inflows from institutional and private investors. The economic environment remains uncertain and the potential reduction of stimulus measures represents an economic risk. This could especially affect traditional asset classes, but also the riskier areas of private debt. Therefore, conservative investors are well advice to focus on low-risk strategies with strong levels of protection. Particularly niche areas where there is less competition offer superior risk-adjusted returns for investors that are seeking fixed income replacements. These niches can be best accessed via boutique asset managers with less than 1 billion assets under management.
Graph: Expected annual returns of different asset classes
Source: Katch Investment Group