Primer on Private Debt
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TL;DR: Private debt refers to debt not financed by banks or issued in public markets. This debt is provided by private lenders who underwrite and structure a customized loan. The most common use is to provide debt to companies owned by private equity firms (called ‘sponsors’) which is referred to as direct lending. In the wake of the financial crisis, banks limited this kind of lending to mid-size and smaller borrowers (larger borrowers have access to the high yield market). It’s important to note that these loans are significantly higher yielding and riskier, due to the amount of leverage or nature of the business, than a typical bank loan to a private company.
Generally, the appeal of private debt lies in its consistent and contractual returns and relatively higher yields than public fixed income investments. In addition, the floating rate of its loans can be attractive in an environment of rising interest rates. Private debt holds a lower risk profile than private equity and can act as a diversifier and income producing component of the portfolio.
What are key categories of private debt?
One key difference among private debt strategies is the amount of equity participation. The expected return in direct lending is based on yields and fees. Subordinated debt often has some amount of equity participation. Distressed and opportunistic strategies air for more equity-like returns by either acquiring control or negotiating equity participation.
- Direct Lending - This debt is senior in the capital structure, meaning that lenders have a priority claim on the cash flows and assets in the event of default or bankruptcy. The lender either “originates” the loan themselves (i.e. negotiates the loan directly with the borrower) or purchases a share of the loan from another lender (syndication or club deal).
- Mezzanine - This debt is junior to the senior lender in the capital structure and therefore higher risk. To compensate for this, it has a higher interest rate which is often split into a cash and a non-cash component (a so-called payment in-kind or PIK interest). This subordinated debt also often has some participation in the equity through warrants.
- Distressed - Debt of distressed borrowers is often sold by the lenders and acquired by firms specialized in bankruptcies and turnarounds. This category blurs the line between public and private markets and private equity and private credit, since buying a distressed company’s securities will often result in ownership of equity and control of the underlying business.
Why does private debt exist as an asset class?
Private debt evolved alongside private equity which has grown substantially since its emergence in the 1980s. Buyouts were initially funded by a mix of senior bank debt and high yield bonds (also known as junk bonds). To manage their risk and generate origination fees, banks started to sell off their loans to institutional investors in what is now known as the broadly syndicated loan market (sometimes simply called the liquid loan or bank loan market). These loans are typically bundled and securitized as so-called collateralized loan obligations or CLOs.
Most private lending is done to mid-size companies which are too small to access the broadly syndicated loan and high yield bond markets. The market has grown rapidly since the 2008 financial crisis as banks exited the market due to tighter regulation and a diminished risk appetite (Ares Capital shows banks’ declining market share on slide five). Since the financial crisis, direct lending and private debt have also seen an explosion of investor demand due to the low interest rate environment.
While lenders mostly compete on cost of capital and terms (e.g. length of the loan and restrictions imposed the credit agreement), there are other reasons why a borrower may choose a private lender over a bank or the high yield market:
- Faster underwriting and closing the loan;
- Certainty of close and terms offered;
- More flexibility in structuring the loan;
- No credit rating required reducing both speed and cost.
Where does private debt fit within fixed income?
Compared to other fixed income categories, private debt offers relatively high returns. Due to its illiquid nature, its price is also less volatile than comparable debt that is publicly traded (such as high yield bonds).
Risk and return (15 years, annualized):
Credit and source: Blackstone; Morningstar, Cliffwater Direct Lending Index. Volatility is measured using standard deviation (using trailing monthly total returns for 15 years. Monthly standard deviations are annualized and expressed as a percentage.
Illustrative capital structure of a leveraged buyout:
Private equity-owned companies are a typical borrower for direct lending and it is helpful to understand how their capital structure comes about.
In a typical buyout, the private equity sponsor might acquire a company for an EBITDA multiple of 12x. A senior lender may offer senior secured debt at 4-6x. The remainder would be financed by equity from the sponsor and junior debt (options include unsecured debt, a second lien loan, preferred stock). In some cases one lender provides the entire debt structure which is be called a unitranche loan.
For example: a hypothetical private equity firm called Compound Partners decides to acquire a small manufacturer of plant pots and vases, PlantCo, with a plan to improve operations and eventually sell the business for a profit. PlantCo generates $10 million of annual EBITDA and is sold for $100 million (ten times the EBITDA). To improve its expected return, Compound Partners only contributes $30m of capital to buy the company and raises the remaining $70 million in debt. A senior lender offers a $50 million senior secured loan and a subordinated lender offers another $20 million. To compensate for the higher risk, the junior lender receives some equity warrants as well as a higher rate. Having $100 million lined up, Compound Partners is off to the races.
Senior and subordinated debt is often repaid ahead of maturity due to either a refinancing or a sale of the company.
What makes direct lending an interesting investment?
Among the different types of private debt, direct lending has emerged as the largest and most relevant area for investors seeking a stable cash flowing diversifier in their portfolios. This is what the remainder of this piece will focus on.
As a reminder, direct lending mostly means providing the senior senior part of the capital structure. The typical senior loan has several attractive characteristics:
- Yield: to compensate for credit risk, all of private debt carries higher yields than safer fixed income assets. In the case of senior loans, the yield is composed of a credit spread and the Secured Overnight Financing Rate (SOFR; previously the spread was over LIBOR).
- Floating rate: senior loans pay floating rate interest which reprices as rates change. This means their duration (price sensitivity to changes in interest rates) is very low. It makes them particularly attractive in an environment of rising interest rates.
- Protection: these loans are senior to other parts of the capital structure and typically have credit protection (covenants) that offer some protection in case of deteriorating business performance. However, during years of good performance and capital inflows lenders start to compete on terms and recent years saw the emergence of so-called covenant light loans whose covenants are weak. This could lead to higher loan losses during the next downturn.
- Call protection: senior loans are often repaid ahead of maturity due to either a sale of the company or a debt refinancing. Lenders typically receive a fee to compensate for the risk of early repayment.
Like other fixed income instruments, private debt offers diversification from equity risk. However, because of its high leverage, private debt performance is closely tied to the economic cycle and the performance of private equity.
Because the loans are illiquid and only marked occasionally by a valuation firm, loan prices don’t fluctuate much and show a low correlation to public markets. Despite this lack of observable volatility, the economic value of the underlying loans still changes if market conditions change. For example, if credit spreads in public markets rise significantly, a potential buyer of a private loan would take this into account and offer to buy at a lower price (this is analogous to venture capital portfolios and the performance of public technology companies).
What is the expected return profile of direct lending?
Typically, an investor in a direct lending fund could expect a high single digit return based on:
- A credit spread (this is often around 4-6% depending on the market environment, leverage, and other factors affecting the loan’s riskiness such as business quality)
- The current Secured Overnight Financing Rate
- Less expected credit losses
- Less investment management fees
A fund’s return is often increased through the use of additional leverage in the portfolio (which also increases the risk in a downturn).
What are the risks?
Debt securities in general are subject to a number of risks while senior loans are different in important ways.
- Credit risk: all corporate debt has credit risk associated with the borrower. Senior loans are made to highly leveraged companies and this is one of the key risks. Loans are also made to middle market companies that are less diversified and can prove less robust than large corporations during a downturn.
- Interest rate risk: debt securities are sensitive to changes in interest rates (duration). However, senior loans have floating rates which negate this risk.
- Inflation risk: debt securities offer contractual payments whose value declines with inflation.
- Liquidity risk: senior loans are privately negotiated and not traded. While they can be sold the discount to face value may be substantial.
- Market risk: debt securities are priced off the risk free rate. If the market reprices risk in general, the security will be affected.
Importance of the credit cycle
Credit risk is the key risk for direct lending and credit spreads change significantly over the course of the cycle. During a boom, lenders compete on price and offer low or “tight” spreads as well as favorable terms. Risk tends to be underpriced and protection for creditors declines.
In the subsequent downturn, spreads can rise quickly in anticipation of defaults. A long-term chart of high yield credit spreads can be helpful in understanding different levels of spreads over the course of the cycle (see J.P. Morgan Asset Management slide 38).
Defaults are often concentrated in sectors that were booming during the expansion and financed by debt. In some cases these sectors experience default cycles without a broader recession.
- 2001-2002: telecom companies
- 2008-2009: financial services, real estate, industrials and automotive
- 2015: energy and particularly shale oil and gas
- 2020: travel, tourism, aerospace
Losses depend on two factors: how many portfolio companies become distressed (go into payment default or violate their covenants and have to be restructured) and how much the lender is able to recoup (the recovery rate). One proxy of the direct lending market, the Cliffwater Direct Lending Index, experienced realized annualized losses of 1.08% since inception in 2004 (as of Q1 2022).
Recoveries depend on the quality of the business, the strength of loan protections (covenants), and the lender’s ability to manage and create value in the workout process. Some lenders are experienced and staffed to take control of a distressed company and turn it around. In some cases the recovery value can be higher than 100% if the lender receives equity in the business and the company is later sold for more than the loan amount. Other lenders prefer to sell their defaulted loans. This can be a challenge given the illiquid nature of the loans and lead to significant mark-downs and is a source of opportunity for distressed funds.
Ways to segment the direct lending market
The direct lending market has evolved into a diverse ecosystem with different players and products:
- Type of lender: ranging from large institutions (such as credit arms of private equity firms covering both private and public markets) to niche firms focused on particular sectors. Lenders typically raise capital through private equity-like drawdown funds or through permanent capital vehicles called business development companies (BDCs; these can be either publicly-traded or private).
- Borrower size: the market is segmented into lower, core, and upper middle market though definitions of EBITDA vary. On the larger end companies can choose between private and public markets where they face, all else being equal, lower borrowing costs. In recent years private lenders with growing funds have increasingly pushed to take market share from public markets.
- Sponsor vs non-sponsor: while the typical loan is made to a private equity-owned (“sponsored”) company, non-sponsor deals are not uncommon. These companies choose private lenders over banks for different reasons including a high risk profile, deal complexity, or a need to close quickly.
- Portfolio leverage: private lenders often borrow from banks against the loan portfolio to enhance returns. Leverage is often 1-1.5x the amount of equity though some firms are comfortable with higher amounts.
Factors in assessing managers
Private debt has grown substantially and there is strong competition among lenders. Numerous new players have entered the market, some without a history of disciplined investing or a track record of working out problems in the portfolio.
- Track record: both performance and credit losses.
- Origination capability and reputation: sourcing loans is a relationship business and firms with a long-established network can benefit from additional income for syndicating their loans to other market participants.
- Breadth of capabilities: larger managers may have multiple funds and teams covering the entire market. This flexibility can allow them to capture deals that are more complex, don’t neatly fit into boxes, or change during underwriting. Some managers differentiate themselves with niche expertise in select sectors (such as energy, technology, or retail). Others may benefit from an institutional-scale platform that unlocks opportunistic deal flow. Undifferentiated lenders may struggle to source attractive investments by comparison.
- Staffing and expertise: a lender’s growth in AUM can outstrip the growth of its team. This can become an issue once there are problems in the portfolio and a lack of resources because workouts of bad loans are particularly time consuming.
- Capital discipline: Lenders focused on AUM growth may become undisciplined towards the end of a credit cycle.
Compound’s Bottom Line
Private credit offers a higher yielding alternative to liquid fixed income with the benefit of a floating rate. While seniority in the capital structure and covenants provide some downside protection, the loans are made to risky borrowers and the credit cycle can significantly impact returns.
The asset class has grown substantially since the financial crisis and investors have to consider factors such as length of the track record, ability to originate new loans, experience with workouts, and the team’s stability and experience. At the tail-end of a long economic expansion, manager selection can become an important determinant of returns.