5 Risks You Need to Consider before You Invest in Private Debt

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: 

1. 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. 

2. 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. 

3. 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.  

4. 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. 

5. 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.  

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Here’s How to Use Alpha and Beta to Balance Risk When Looking at New Investments

One of the key considerations in investing is risk. Over time, your risk tolerance is likely to change, which means that your strategy will also shift. As you determine your risk tolerance and consider how to mitigate the risk currently present in your portfolio, you can use various tools to gather the information necessary for this process.  

Two statistical tools that can be especially important in the evaluation of risk are alpha and beta. If you understand these tools and their application, you can make more informed investment decisions and increase the chances of realizing a positive return—or at least protecting the nest egg you have already built.  

While many other statistical tools exist, alpha and beta are some of the values that investors study as they hunt for new opportunities. Here’s what you need to know: 

Alpha and Beta – the Basics 

Both alpha and beta are calculated using the historic performance of the asset in question and comparing it to a particular index. However, the two calculations analyze different things. Alpha looks at the returns the asset has generated compared to the index, while beta helps measure the volatility of an equity.  

Typically, alpha and beta use a benchmark index like the S&P 500, but it is important to know which specific index was chosen, since this affects the interpretation. Generally, investors use alpha to evaluate mutual funds; measuring their performance in relation to the S&P 500 can tell you if funds are over- or under-performing. Beta measures volatility and is usually used to measure risk. A higher beta indicates greater risk. 

To calculate alpha, you subtract the return on investment of a specific index from the same return of a mutual fund. A positive alpha means that the fund has historically performed better than the index, while a negative alpha indicates underperformance. If the alpha is zero, the mutual fund performs identically to the chosen index.  

Alpha is expressed as a whole number, but it actually represents a percentage. For example, an alpha of 5 indicates performance 5 percent higher than the index, while -5 indicates performance 5 percent lower than the index after volatility has been accounted for. This percent can mean radically different things depending on the overall value of the asset and index. 

The calculation of beta generates a ratio. A beta greater than one indicates the asset is more volatile than the index to which it is being compared. For example, a beta of 1.2 tells you that the investment is 20 percent more volatile than the index. A beta less than zero indicates lower volatility in comparison to the index. If the beta is 1.0, then the asset and the index have the same volatility.  

How to Use Alpha and Beta When Making Investment Decisions 

Alpha and beta help you answer some of the questions that you may have as you decide on investments. For example, if you only want to consider mutual funds that have outperformed the stock market, you can narrow your search to those with a positive alpha.  

You should look up the alpha of the investment in question as well as that of a relevant comparison index, such as the S&P 500. The difference between these numbers can help you rank investments based on their performance. However, you need to remember that high performance often goes hand-in-hand with high volatility. Thus, the risk of these investments might prove quite high. This is where beta can enhance your analysis; choosing only the investments that perform above an index can expose you to excessive risk. 

People who want to minimize their risk exposure depend heavily on beta. Comparing the beta of different investments can help you understand the relative risk of each. This number can help you ensure that the risk of your portfolio aligns with your tolerance, especially as that tolerance changes over time.  

Almost always, investors consider beta in the context of alpha and vice versa. Having both values can help you judge the relationship between risk and return for a particular investment. Importantly, both high and low beta can lead to market outperformance. Imagine a mutual fund weighted towards growth stocks. This fund likely has high beta and may outperform the market to get high alpha. However, a conservative fund with only bonds may also outperform the market, yet have a very low beta.  

When considering alpha and beta, it is also important to keep in mind that these calculations are based on historical performance. These numbers do not guarantee that the investments will act similarly in the future. Furthermore, alpha and beta calculations largely depend on the comparison index used.  

Always make sure you understand how the calculations were done and determine whether the choices were appropriate. Choosing a market that is inappropriate can make either number falsely elevated or lowered, so think critically about the comparison given and the validity of the result.  

3 Major Risks Associated with Oil and Gas Industry Investments

One of the most popular alternative investments in the United States is commodities, especially oil and gas. Oil and gas have seen a new spike in interest as commodities prices soared in large part due to the conflict between Ukraine and Russia. 

In recent years, investors have been more hesitant about these investments because of the climate crisis and growing interest in renewable energy sources. However, this may change with more people turning to oil and gas and realizing the profitability of the industry. Still, oil and gas investments come with significant risks that investors need to know before they pursue opportunities.

The Price Volatility of the Oil and Gas Commodity Markets

The biggest risk of investing in oil and gas is price volatility, which is well demonstrated by the recent gains driving investment. In 2014 and 2015, there was a significant oversupply of crude oil and natural gas. This glut caused the industry to experience sharp drops in price. Likewise, spring 2020 brought a collapse in oil prices due to the larger economic slowdown caused by the COVID pandemic. At this time, the industry saw 20-year lows. In July 2014 oil sold for $107 per barrel—in March 2020, it was selling for $20 per barrel. Natural gas prices fell as well, but it is worth noting that natural gas prices are even more volatile than oil because of the seasonality of the product. As demand increases in the winter, prices also rise, but only for a few months.

Beta is used as a measurement of the volatility of a stock relative to the overall market. The betas of the oil market tend to be significantly higher than the S&P 500, which sets the standard with a beta of 1.0. In December 2021, the beta of ConocoPhillips reached 1.61. During that time, Chevron and ExxonMobil also had very high betas. 

Volatility like this means that the value of your investment will fluctuate greatly. If you are impulsive or emotional with your investments, you likely need to consider other options. Historically, however, the industry has always recovered. From the record lows of 2020, the industry is now seeing incredible highs. 

The Real Possibility of an Accident Affecting Investment Value

One of the more unique risks associated with oil and gas investments is the possibility of an accident like an oil spill. When this happens, it spells disaster for a company, and its stock prices will plummet. A great example of this is the Deepwater Horizon oil spill of 2010 after which BP stock fell from $60 per share to $26.75. This disaster released nearly 5 million gallons of oil into the Gulf of Mexico and destroyed the habitats of millions of marine animals in the process. Currently, BP is still dealing with lawsuits from this incident. This risk has become more substantial because of increased connectivity and awareness. After the 1989 Valdez spill, Exxon stock fell just 4 percent, and the price recovered in a month. At that time, the spill was less publicized. Today, spills are a major news story.

Gas companies also face a lot of risk due to accidents. After all, natural gas is highly flammable and the pipelines that transport it stretch hundreds of thousands of miles. The potential for disaster is very high even if an incident does not have the same environmental impact as an oil spill. At the same time, natural gas is also toxic, so the potential for injury to humans is very high. The problem with this accident risk is that there is no guarantee of recovery. BP continues to struggle, and if another disaster occurs, then the company would likely fold. Investors should be sure that the companies they invest in take safety seriously and do everything possible to prevent a disaster. 

The Potential for Deep Dividend Cuts at Any Given Time

Many companies in the oil and gas sector will pay dividends to their investors. Dividends provide investors with regular income on top of whatever gains in value the stock has over time. At the same time, it is important to know that these dividends are not guaranteed. In other words, companies can cut the dividends at any time if they are unable to raise the money required to pay them. This risk is closely related to the volatility of the market. Whenever commodity prices fall, which can be quite often, companies will earn less revenue from what they sell and thus become less likely to pay dividends to investors. Therefore, on top of stock prices likely falling, investors get hit with a cut to dividends at the same time. 

A great example of this risk is Seadrill, which operates drilling rigs. The company offered large dividend payments until they were cut in November 2014 to the shock of many investors. At the same time, the price of the stock dropped more than half. Investors not only failed to receive the regular income they had been expecting from the company, but the investment itself lost a lot of value. 

Investors in the oil and gas industry always need to consider the possibility of a cut to dividend payments and have a plan for dealing with this surprise. This means that investors should never come to rely on these payments. 

What Is Private Debt and Why Is It So Appealing to Investors?

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.