Private Debt is an investment strategy part of the private capital category. Private debt investment involves financing the debt of small- and medium-sized enterprises seeking alternative, instead of traditional (banks or public markets), sources of financing.
One of its main characteristics is the security offered to investors. Certain guarantees are negotiated when formalising the loan, so the investor is protected in the event of default. In addition, if a company is liquidated, the debt is always paid first, before, for example, equity.
In this post we explain what private debt is and why it is an interesting option to include in your portfolio.
It consists in financing companies or projects by private investors. Unlike traditional loans awarded by banks or other financial institutions, private debt involves the participation of other investors such as investment funds, private equity firms or individual investors.
Returns are obtained by charging a previously agreed interest, which is usually higher than that obtained from safer investments, such as government bonds or debt in public companies. Unlike other private capital investment strategies, private debt investment contracts have a fixed term.
One of their main characteristics is flexibility. Usually, the agreements are structured in a personalised way and are adapted to the specific needs of each company. This is why it is a source of financing that enables companies to obtain capital under more favourable conditions. In addition, this flexibility when establishing conditions also benefits the lender/investor, which can establish protection clauses and guarantees to protect themselves from defaults.
It is also an attractive source of financing for companies that do not meet the requirements of traditional lenders and that, due to their lack of credit history, cannot access loans.
Private debt offers several advantages for investors:
Source of diversification: due to its nature and its flexibility, investing in private debt enables you to make the most of the diversity of situations and investment strategies provided by this type of asset.
High returns: because you assume more risk than, for example, when investing in public debt, the potential returns are also higher, since the rates at which the money is lent are higher. According to Preqin, between 2009 and 2018, private debt funds had an average net IRR of 9.4%.
Safety: when compared to other strategies, private debt can also provide further safety. It is often backed by guarantees, which provides some protection in the event of the company defaulting. The risk level of a private debt vehicle will depend on the debt segment that the management company operates in (Senior, Junior or Mezzanine) and the financial situation of the companies that are lent the funds.
Protection against the rise of rates: most interest is floating interest (Euribor plus a margin); therefore, valuations are not sensitive to interest rates.
Regular income: thanks to the interest payments, private debt can become a regular source of income for investors.
Although investment in private debt is less risky than other strategies such as equity (because of the priority when it comes to collecting what has been invested if there are any problems in the company), like any investment, it entails different risks:
Credit risk or the company's creditworthiness:the investor must consider if it generates enough revenue to pay the expected return and to repay the loan at maturity.
Illiquidity risk: as it is a contract between two companies, there is no secondary market to go to sell early as in traditional public fixed-income markets<.
Economic or credit cycle risks.
Operational risks: these risks depend on how the loan is managed throughout its life, how the various covenants or the different criteria that the company must meet during the life of the loan are overseen.
Legal or jurisdictional risks: if it is a jurisdiction that favours more the investor or the borrower
As we have seen, investment in private debt has different types of risks that you have to oversee, which is why it is important to always choose fund managers that understand these risks well and that have a history of generating attractive returns with their investment strategies.
There are several types of private debt, but in order to differentiate them we must first understand how a company's capital is structured. Capital structure refers to the way a company is financed based on the proportion of debt and type of debt and capital on its balance sheet. This defines how and in which order the capital is returned in the event of bankruptcy.
Senior debt is at the top of the capital structure and is returned first, so it has the lowest risk. Own funds have the lowest priority and is returned last, making it high risk capital.
Private capital funds can be classified in two ways: by type of strategy (direct lending or fund of funds) or by type of debt (senior debt or mezzanine).
Direct Lending: non-bank lenders that grant loans to small and medium-sized enterprises (SMEs). The type of debt issued (senior or subordinated) depends on the type of fund.
Distressed Debt: purchase of debt from companies that are in bankruptcy proceedings or may enter into bankruptcy. The debt issued tends to be preferential in nature and, therefore, high in the capital structure, due to the considerable threat of liquidation.
Debt can be purchased with a significant discount, with the aim of improving the company's value after investing in the debt.
Mezzanine: a hybrid of capital and debt financing. The debt issued can be converted into stock, with embedded options in the event of default by the borrower.
Private Debt/Fund of funds: a private debt fund of funds that invests in various third-party debt funds according to the fund's strategy. It provides greater diversification.
Special Situations: a fund for special situations focuses on companies whose value may be affected by a specific event, such as divisions of companies, mergers, takeovers or takeover bids. It may include debt and capital investments.
Venture Debt: loan granted to a newly created company or a company in its initial stage. This is the most common type of debt in Venture Capital investing.
If you want to know more about this strategy, you can watch the Learn and Grow masterclass here.
This content is merely indicative. This content is merely financial training offered to you by Crescenta, without the intention of giving any type of personalised investment recommendation.
It is neither any type of advertising of financial instruments nor a recommendation or purchase offer.
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Crescenta
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When you click on any underlined term, you can see a definition and example of each concept
When you click on any underlined term, you can see a definition and example of each concept
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