One of the quickest growing alternative investments across the globe is private debt. In the last decade or so, the private debt industry has exploded because of the opportunities for significant returns on investment.
Private debt essentially refers to any form of debt held by or awarded to a company. This broad category includes everything from corporate bonds to non-bank loans. While private debt offers guaranteed income to investors at a relatively high return, this category comes with its own unique risks that you must consider with each investment that you make. While some of the risks associated with private debt are shared with similar assets and other classes, private debt has risks unique to it as well. These risks include:
- Default risk
The primary issue you need to consider when investing in private debt is default risk. If the entity that holds the debt becomes unable to pay, you will lose out on your investment. A company’s ability to repay depends on several different factors, both intrinsic and extrinsic.
From an intrinsic perspective, the factors you must consider include the company’s finances and the loan agreement itself. Always do your research on the company to get an understanding of its likely financial trajectory and ability to cover debts. Also, ensure that the loan agreement is flexible enough to promote payback even during difficult times. From an extrinsic perspective, market risk affects the likelihood of default. Think about how foreign exchange rates and interest rates may affect the company’s business and ability to make a profit.
- Prepayment risk
Another possibility you need to keep in mind is when a borrower pays back part or all of a loan before maturity. Depending on the terms of your loan, this could end up costing you a lot of money in the long run in terms of missed interest. This can be especially problematic if you depend on the regular income from the loan repayments. You may not be able to find a loan with similar terms to take its place, meaning you may have to devise an entirely new strategy. This is especially problematic if interest rates have dropped. To protect yourself from this risk, you can build in a provision to the loan agreement that imposes a penalty for early payment. Doing this can discourage companies from repaying the loan early, but it can also make it more difficult to sign an agreement. Companies may agree to a higher interest rate without such a provision.
- Liquidity risk
Some investors avoid private debt because of the liquidity risk it presents. Private debt is fundamentally an illiquid asset, but it is important to think about liquidity along a spectrum. Compared to some other assets that are considered illiquid, such as private equity, private debt can usually be liquidated quite readily, at least after an initial investment period. During this time, selling a private debt can be difficult. However, this initial investment period is generally short.
Once the company proves its ability to cover its debts, you can generally liquidate a debt in a short period. This is because people seek out debts that have a good track record. This sort of debt has less risk than a completely new agreement even if the company has paid its loans back in the past. Thus, while it is important to consider liquidity risk at first, it may not be as much of a problem as you initially thought.
- Portfolio risk
When you invest in private debt, it is important to consider how that particular asset fits in with the rest of your portfolio. These debts tend to be quite large, which means that you may not have many of them in your portfolio. This makes diversification even more important. Portfolio risk happens when too many of your investments are concentrated in one particular area. This may mean a geographic area or a particular industry. Given that private debts are particularly vulnerable to market changes, a large hit to a particular geographic area or industry could mean disaster for a portfolio that is not sufficiently diversified. To ensure you have adequate diversification, think about how different debts could be related to each other and, importantly, to the rest of your portfolio.
- Interest rate risk
Many different market risks affect private debt investments, but one of the most important risks has to do with interest rate. When you create a debt agreement, you will need to decide on a fixed or variable interest rate. Either of these options has its potential drawbacks. If you choose a fixed interest rate and the federal rates increase, then you may end up earning a smaller return than you could have if you went for a variable rate. On the other hand, if you choose a variable interest rate and the federal rate decreases, then you will lose out on money that you otherwise would have earned with the higher rate locked in for the loan. You should pay close attention to interest rates and use your best guess about future movement to determine the best option for your situation.