Private Debt

Bank lending remains a traditional source of debt, despite the decrease in activity following the Global Financial Crisis (GFC) in 2008 and the tightening of various banking regulations. Traditional lenders cut back financing following the GFC, which created space in the market for investors such as private debt fund managers to provide alternative sources of lending. Debt strategies were previously a sub-category of private equity investing, becoming an established asset class in its own right post-crisis. 

Capital structure refers to the way a corporation is financed based on the proportion of debt, and type of debt and equity, on its balance sheet. This determines how, and in what order, capital is repaid in the event of bankruptcy. Senior debt is at the top of the capital structure and repaid first, making it low risk. Equity is ranked the lowest and is repaid last, making it high risk.

The majority of institutional investors allocating capital to private debt focus on commitments to unlisted private debt funds. These unlisted private debt funds differ according to strategy, for example direct lending or fund of funds. They also differ depending on the type of debt provided, such as senior debt or mezzanine debt.



The following are considered important aspects of private debt, though not interpreted as strategies: 

Collateralized loan obligation (CLO): this is an investment instrument. It is a security backed by a pool of debt, featuring several levels of credit ratings and repayment structures.

• In a CLO, the investor gains exposure to a diverse portfolio of existing bank loans.

• The investor receives scheduled interest payments from the underlying loans.

• If the borrower defaults, the investor assumes most of the risk.

Business development company (BDC): a tax-efficient, US-based, publicly traded private debt fund, structured as a corporate fund. This is perceived as an investment opportunity, rather than a strategy. 

• A BDC is designed to help small companies in their early stages of development.

• Bears similarities to a private venture capital and venture debt fund.

• Publicly listed on a stock exchange.

• Most often provides short-term unsecured loans ($2-50mn).

• Often takes an equity position in the company.

Each of the private debt strategies’ risk/return profiles are dictated by the investment and its position within the capital structure. Strategies with lower risk tend to yield lower returns than those with higher risk.

Private debt is widely regarded as a low-risk investment compared to other alternative asset classes, and a viable alternative to fixed income investing. Investors commonly invest in private debt through commitments to unlisted private debt funds, which offer attractive risk-adjusted returns, particularly in a low interest rate environment.

A conservatively-managed private debt portfolio presents the following attractive characteristics for an institutional investor:

• Portfolio diversification.
• Low correlation to public markets.
• Attractive risk-adjusted returns in a low interest rate environment.
• Predictable and contractual returns based on interest rate charged.
• Lower risk than private equity, since debt sits higher than equity in the capital structure.
• Potential to acquire debt in companies at below par value. 
• Good alternative to fixed income investments.

In this lesson, we explored how private debt became its own asset class after the Global Financial Crisis. From the different sources of debt to the capital structure and strategies, you now know the ways investors can allocate to private debt, and why they choose to do so.