One form of alternative investment that has gained a lot of traction in recent years is private debt. The category of private debt includes any debt held by or awarded to private companies. Everything from hedge funds and high-yield bonds to established companies obtaining loans from non-bank lenders fall under the umbrella of private debt.
Some of the most common forms of private debt include corporate bonds, hedge funds, and non-bank loans. Importantly, private debt is not the same as private equity—the latter implies some degree of ownership in the company. Instead, private debt generates a return for investors through interest paid on the principal. Here’s what you need to know about private debt and what makes it so appealing to investors:
The Size of the Private Debt Market
Currently, private debt accounts for up to 15 percent of all assets held by private investors. This makes sense considering that the majority of companies have some form of debt. The amount of private debt in the market has increased, in part due to the Global Financial Crisis in 2008. Even before that time, many companies struggled to secure traditional loans.
The crisis made the situation even more difficult, and now companies without an established credit history will generally seek out alternative forms of debt. Even as the market has improved since 2008, banks have not become more welcoming to smaller businesses or even medium-sized ones for fear that history will repeat itself.
At the same time, investors demonstrated commitment to the debt market, with $60 billion in alternative lending in 2007 and 2008 alone. Assets in private debt reached a record high in 2019 of $812 billion. Market analysts believed assets would surpass $1 trillion by 2020, although the COVID-19 pandemic caused this target to be missed. In 2019, the number of total asset managers reached a record number that was double the total from only five years prior. All of this has created a rich ecosystem of private debt, with investors continuing to be drawn to the market and more money being funneled into private loans.
The Attraction of Private Debt for Investors
Private debt has numerous benefits for investors, which is why they continue to explore the market. One of the main benefits is diversification—with an asset that protects against rising interest rates. This is because unlike other fixed income securities, these assets often have floating rates.
As a result, private debt offers reliable income that has the potential to increase if interest rates rise. Also, many investors use private debt as a means of getting exposure to sectors that would otherwise prove difficult, such as renewable energy. For many investors, private debt is the ideal way to achieve diversification while keeping risk within acceptable limits.
The other major benefit is the rate of return, which is typically higher than what is available in the public debt market. This is especially appealing for investors since private debt is often more liquid than public debt. Interest income is usually paid out quarterly to create cash flow, and there is a rich secondary market for these debts.
Private debt has traditionally been considered illiquid, but this is not necessarily the case, especially as new structures with flexible terms make them even more appealing for both borrowers and investors. Altogether, these investments have lower risk and high yields while promoting overall diversification.
The Effect of the Pandemic on Private Lending
The COVID-19 pandemic has had a dramatic impact on all asset classes, including private debt. The overall market has still not recovered fully, but the impact of the pandemic may actually benefit the private debt market. This is because middle market companies fighting to survive in the period of market recovery are turning to private debt frequently.
In other words, the turbulent landscape created by the pandemic has created new opportunities in private debt for investors. Overall, this shift has resulted in higher returns and more liquidity for investors. Furthermore, companies have become more likely to look for investors that can provide strategic guidance in addition to funding. With this additional support, there is greater likelihood that the company will survive and that the investor will continue to receive interest payments.
During the period of recovery, the overall volume of deals may decrease since terms will be stricter and rates may be higher. However, there is also the expectation that more due diligence and transparency, as well as an earlier discussion about rates, will ultimately result in better loan terms for investors. Banks have once again become more cautious about the loans that they make, which means that private debt will be the only option for many companies that need capital. All of this means the market may again experience a boost, especially as the threat of a recession looms and banks become even more conservative.