Introduction
The uptake of private debt is a relatively new trend in alternative investments.
Following the Global Financial Crisis in 2008, traditional lenders, such as banks, cut back the granting of riskier financing and pulled back from leveraged lending, creating a gap in the market that private or direct investors such as private debt fund managers filled, providing alternative sources of lending.
Over the years, this attitude has developed and private credit has become increasingly important as a source of financing, particularly noticeable in the last few years.
But, let’s take it one step at a time. First of all, let’s talk about private debt and the funds that manage it.
What is Private Debt?
Private debt consists in the debt financing to both SMEs, companies and individuals by non-traditional lenders, that is by entities other than banks.
In contrast to public debt, which involves securities traded on public markets, private debt transactions are not publicly traded, but they involve forms of lending (loans or debt securities) that are issued and traded directly between the borrower and the lender (or a group of lenders) without engaging public trading platforms.
How does a private debt fund work and who is involved in it?
After the financial crisis in 2008, U.S. banks stopped taking on investments that they deemed to be risky and, since smaller companies oftentimes have difficulty obtaining funding for their business, they turned to private investments, which allowed private debt funds to increase in popularity.
A private debt fund is a specialized investment vehicle that focuses on providing loans outside of traditional banking channels. These funds operate by raising capital from investors, which can include institutional investors, high-net-worth individuals, and other entities, and lending it to a wide range of borrowers, including corporations, small and medium-sized enterprises (SMEs), or also individuals. This form of financing can be used for expansion, restructuring or other business needs.
As a result of changes in the regulations that have occurred in recent years, an increasing number of private investors can benefit from putting their money towards a private debt fund.
In addition to financial organizations and professional or institutional investors, we can find different types of private lenders: direct lenders, mortgage brokers, mortgage companies, individuals, online lenders and also P2P lending networks.
Exploring private debt investment strategies and instruments
Until few years ago, debt strategies were a sub-category of private equity investing and only after the financial crisis they became an established asset class. The private debt market continues to grow due to the increasing demand for private debt from companies and new sources of capital were born to provide that financing.
Private debt funds employ various strategies to generate returns while managing risk, that are tailored to the specific goals and risk tolerance of the fund. Here are some common strategies used by private debt funds:
- Direct lending – The fund directly lends money to companies, without engaging traditional financial intermediaries; in this way it allows for more customized loan structures and terms.
- Senior secured loans – It is a money lending to companies with a priority claim on the borrower’s assets in case of default. This ensures a higher level of security for the lender.
- Junior debts – A junior debt refers to bonds or other forms of debt with a lower priority for repayment than senior debt in the case of default: they are repaid only after senior debt obligations have been satisfied. As a result, they tend to be riskier for investors and thus carries higher interest rates, but often offer higher returns.
- Mezzanine debt – It is a hybrid form of financing that combines elements of debt and equity, and it is subordinated to a senior secured debt. A mezzanine debt may be used to prioritizes new owners ahead of existing owners in case of bankruptcy.
- Distressed debt – The fund provides financing to companies facing financial challenges or undergoing restructuring, with the aim to capitalize on potential recoveries as their financial situation improve.
- Special situations – Funds may provide financing in special situations that may not fit traditional lending models, such as mergers and acquisitions, management buyouts, or growth initiatives.
- Real estate debt – This can include financing for real estate projects, such as property development, acquisitions, or refinancing existing real estate assets.
- Venture debt – It is a form of debt financing that is provided to startups and emerging companies, to support operations and growth initiatives.
- Floating rate loans – A private debt fund can structure loans at interest rates that can be periodically adjusted, providing a degree of protection against interest rate fluctuations.
Benefits – The strategic edge of private debt fund investments
In the current landscape of uncertainty affecting public markets, private debt funds offer several advantages to investors. Here below, we list the main ones.
- Diversification: Spreading investments across different industries, sectors, and borrowers, allows to reduce concentration risk and enhance overall portfolio resilience.
- Geographic focus: Some funds concentrate on specific geographic regions or markets, leveraging local expertise to identify attractive investment opportunities and manage regional risk factors.
- Non-publicly trading and Customized terms: Private debt transactions are preceded by direct negotiations between the borrower and the lender through private platforms to customize loan structures, terms and conditions that suit both parties.
- Wide range of instruments with different risk and return profiles: Private debt funds offer a spectrum of instruments with different risk and return profiles in order to meet the specific needs of borrowers and lenders.
- Use in Corporate finance: Private debt is frequently used by companies to fund growth or address specific financing needs.
- Tailored strategies: Private debt fund managers often adapt their strategies to market conditions, economic outlook, and the risk-return profile sought by their investors. The goal is to generate attractive risk-adjusted returns while preserving capital and managing downside risk.
- Alternative to Public Markets: Private debt provides investors with exposure to unique opportunities that may not be available in public markets and that can be advantageous during periods of market volatility, as private debt returns may not be directly influenced by public market fluctuations.
- Long-Term Investment Horizon: Private debt investments often have longer durations compared to publicly traded bonds.
- Less risk and Steady cash flow: Private debt funds offer investors higher yields and lower risk, compared to traditional investment debt securities. Private debt investments generate stable income streams in the form of regular interest payments from borrowers and often offer an additional fixed final return on investment.
These advantages make the private debt asset class an attractive opportunity compared to other fixed income assets.
Challenges and risks
Investing in a private debt fund, as for all investments, involves also risks, some of which are described below.
- Credit risk: The debt instruments are subject to the risk that the borrower will default on the payment of principal or interests. The financial strength and solvency of the company affect credit risk (for example P2P lending).
- Interest rate risk: Sensitivity to a change in interest rates, that can negatively affect the value of debt instruments, is more pronounced and less predictable.
- Illiquidity: Private debt instruments are often less liquid than publicly traded securities, as they are not listed on an exchange, traded in the secondary market and are generally not transferable. Investors in private debt may not be able to easily sell or trade their positions.
- Use of leverage: it amplifies opportunities for gains, but also its risks of loss and results in a greater fluctuations in net assets. Use of leverage increases the fund’s interest expenses.
- Fees: Investors bear significant fees, including startup, placement, management, administrative service, and performance-related fees tied to fund returns.
- Conflict of interest: the manager of a private debt fund may make riskier investment than it is deemed appropriated by investors, in order to generate higher returns and earn performance-related fees.
- Asymmetric information: Private credit funds often do not provide much information about their investments to the public.
- Lack of regulation: A private credit fund is usually not registered as an investment company, also the manager may not be registered as an investment adviser as well as all the investment acts. As a result private credit fund are not subject to regulations and investors may not have protections.
- Higher degree of complexity compared to traditional lending.
Conclusion
In conclusion, the private debt asset class continues and will continue to be an attractive choice for investors as it can help mitigate the potential impact of rising inflation and interest rates in 2023 and as it represents an interesting opportunity, especially in the current climate of uncertainty that affects public markets.
However, due to the complexity of this investment instrument, a well-informed and cautious approach is needed: before investing in a private credit fund, potential investors should assess the benefits and risks of this investment to make sure it is consistent with their investment objectives, financial needs, liquidity expectations and risk profile.
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