After the 2008-09 financial crisis, many middle-market businesses found themselves in a pickle. They needed capital to fund growth activities and overcome the economic slump, but banks hampered by post-crisis regulations were unwilling to create flexible loan terms to make that happen.
Direct lenders offered an attractive alternative: private debt investing. These types of loans were much more accommodating and responsive to sector-wide challenges than the loans offered by traditional banking institutions. And while the private debt market was already morphing into a formidable asset class prior to 2008-09, the economic downturn further accelerated that process.
Many small and middle-market businesses find themselves in a similar position today amid the coronavirus crisis. Thankfully, many more private debt investors exist today, filling the gap left by banks and seeking promises of high yield, portfolio diversification, and consistent returns.
But just what is private debt? Why has it become such a staple in both the US and global economy? And, most importantly, how do companies know if private debt funds are the right financing option for them?
This article will explore all that, and more. Let’s dive in.
What is Private Debt?
Private debt is an umbrella term that refers to any debt accumulated by private businesses and individuals. When a privately-held company takes out a business loan, or when an entrepreneur borrows money from a family member, those are both examples of private debt.
Private debt can take many forms, but commonly take the form of credit card debt, corporate bonds, business loans, or personal loans.
The most prevalent type of private debt involves alternative financial institutions making loans to private companies. These institutions are referred to as “alternatives” because they stand outside the banking institutions that traditionally offered loans to businesses. Typical examples include business development companies (BDCs), debt investors and wealthy individuals.
The private debt funds these financial institutions provide may include direct lending, distressed debt for the purchase of securities on the secondary market, and mezzanine (or subordinated) debt.
It’s very common that the loan will be secured against existing assets and used to fund day-to-day operations, improve infrastructure, or obtain capital goods. Private debt funds may also be used for infrastructural investment in existing physical assets or special situation funds, wherein a company’s control is relinquished during periods of financial distress.
Though the term is often confused with private equity, those offering private debt do not seek ownership of the companies in which they invest. Moreover, private debt funds are more flexible since they’re often open-ended, whereas private equity funds feature a closed-ended, limited lifespan. While private equity generates interest by increasing the value of the company, private debt achieves returns through loan interest rates.
The Current State of the Private Debt Market
Today, most privately managed middle market companies have some debt, so it’s perhaps no surprise that the private debt market has expanded to comprise 10 to 15 percent of the total assets managed by private investors.
How do we account for the growing precedence of private debt funds in the total assets of the private market?
Even before the ’08-09 financial crisis, banks were hesitant to hand out loans to small and middle-market companies. As expected, the situation only worsened after the onset of economic contraction: companies with limited credit history sought out alternative investment sources like business development companies (BDCs).
Though the market improved steadily over the past decade, banks did not widen their loan-giving circle to small and medium-sized enterprises. New regulations, like the Dodd-Frank Wall Street Reform and Consumer Protection Act, limited the ability of banks to hand out sizable loans; that’s not to mention the effect of Basel III measures and updated US Guidance on Leveraged Lending, which further pushed banks into the bed of big businesses.
In addition to the decreasing role of traditional financing institutions, investors have become more financially invested in the private debt market. In 2007 and 2008, investors demonstrated their commitment to the private debt sphere by contributing $60 billion to alternative lending. Of course, interest has only grown since then as the industry has become even more developed.
By 2019, the assets invested into private debt reached a record high of $812 billion, with the pre-pandemic expectation that it would exceed $1 trillion by 2020. That same year, the number of asset managers reached a high of 1,764, more than double the number of five years previous.
Advantages of Private Debt Investing for Investors
There are three primary reasons investors get excited about the private debt sphere: risk reduction, asset diversification and increased access to infrastructure debt.
First, investors are able to reduce credit risks and peripheral risks associated with rising interest rates by reducing the number of fixed income portfolios. In this low-risk space, private debt has proven to be a source of sustainable and reliable income for investors despite ongoing turbulence.
Private debt has become a broadly accepted category to diversify assets and is now part of many asset allocation strategies. Since many private credit funds are backed by floating-rate securities, investors are secured with protection against rising interest rates.
Additionally, private debt provides access to markets that are otherwise completely inaccessible to investors. Private infrastructure debt makes inroads to up-and-coming markets like renewable energy, providing more direct ways for investors to diversify their returns.
Though private debt suffers from hampered liquidity, investors’ returns generally exceed the public debt market, in part due to greater transparency and flexibility.
Yet even the age-old adage of private debt’s illiquidity has recently come into question. Depending on the strategy employed, private debt investors can commit capital that is drawn down and invested over an extended period of time, with interest income paid out quarterly to create consistent cash flow and some level of liquidity for the investor. In some ways, private debt liquidity is “wetter” than might be otherwise expected.
Perhaps most enticing is that private debt funds offer unitranche facilities, allowing investors to uniquely combine senior and subordinate debt in a hybrid-style deal. Not only are the flexible terms more appealing to borrowers, private debt can be managed with relative ease compared to labor-intensive private equity funds.
All in all, private debt funds provide clear-cut advantages for investors in the current lending market. High yields, low risk, and portfolio diversification are all strong attractants for investors in the private debt sphere.
Advantages of Private Debt Investing for the Companies They Invest In
Private debt funds may be advantageous for investors, but they’re absolutely critical for the businesses that use them.
For many small and medium-sized companies, the limited lending options provided by banks simply aren’t flexible enough to suit their needs. By contrast, private debt funds aren’t beholden to the same strict federal guidelines that banks are required to adhere to.
While banks are unlikely to invest in businesses with negative EBITDA or in the midst of a restructuring, private debt lenders are often willing to fill that gap. As a result, companies in a wide range of financial conditions are able to secure greater amounts of capital with lighter covenants depending on the loan type.
Private debt lenders are also much more willing — and have greater means — to oversee a restructuring process. Since lenders form long-term relationships with the companies they invest in, they are more likely to see out a mutually beneficial solution when problems crop up.
Moreover, private debt investors are willing to connect their portfolio companies with strategic advisors to help their businesses grow. That flies in the face of traditional bank loans, where the banks will generally not dedicate time or effort to help companies meet specific goals.
Since both parties have direct contact with each other, private debt funders are able to make granular changes to loan structures that can’t be paralleled by the more rigid bank lending terms. Those slight structural changes in the loan agreement may be all that’s needed to push a deal to its conclusion.
Even during the COVID crisis, lenders have proven considerably flexible and adaptable. As traditional sources of capital have dried up, companies have found success by reaching out to private debt funders.
Currently, a total of 457 private debt funds are seeking a record $201 billion from investors, with 47 percent of the total related to direct lending. Some investors are worried that highly-leveraged borrowers will struggle to meet their debt obligations during the COVID crisis, but it’s expected that investors in private debt will adopt a cautious approach over the next 12 months.
That said, the increasing demand for private debt funding shows just how critically important these loans are for the middle-market, especially in times of crisis.
The Verdict: Private Debt Funds in the Wake of COVID-19
Nearly all asset classes were affected by the COVID pandemic, and private debt funds were no different. It’s unclear when the market will fully recover, but in the meantime, middle market companies are likely to seek out distressed debt funds with even greater frequency.
Far from hampering private debt, the turbulent landscape has actually generated greater opportunities for investors. Companies are seeking out investors that offer strategic oversight and consulting services while investors expect hybrid funds to offer more predictable returns and enhanced liquidity, helping to boost the probability of mutual success during periods of crisis.
While deal making will likely take a hit, due in part to increased scrutiny and inclusion of investor-friendly loan terms, the industry is likely to improve as a result of the greater transparency, due diligence, and earlier negotiation over fees.
Will the government respond to this economic recession much like it did in the ‘08 financial crisis, tightening regulations and further discouraging banks from lending to small and middle-market businesses? Only time will tell, but in the meantime, private debt investing remains a critical lending opportunity, for both investors and the companies they invest in.