Private debt is becoming a viable investment opportunity in today’s economic environment as companies are forced to seek alternative sources of financing according to Claire Madden, Managing Partner at Connection Capital.
In a harsh economic climate with no end in sight for public market volatility, private investors focus ever more intently on portfolio diversification, looking for alternative sources of returns to smooth out risk and shore up performance. One option that has emerged as a credible contender in recent years is private credit – also known as private debt. Assets under management now top USD1 trillion, with the market expected to continue to grow rapidly, according to the 2022 Global Private Debt Report, published by Preqin. For investors looking to branch out into alternative investments – or to diversify the types of alternative assets they hold – it’s worth understanding what private credit is, why the opportunity set is expanding right now, and what strategies exist.
What is private debt?
Private debt is lending to businesses which, instead of being provided by high street banks, comes from sources such as private credit funds or direct from collectives of private investors.
Loan repayments can provide reliable income streams for investors. Returns depend on the risk profile of the transaction and the ability of the investee company to make repayments, but investors can expect fund and direct investments to typically generate in the region of 15%+ internal rate of return (IRR). Loan terms usually have a small equity stake attached, and the upside typically means investors can potentially receive around two times their money back, sometimes more. Private debt is often partially secured and is less correlated to public markets than public debt.
It offers companies flexibility compared to banks’ rigid terms and can therefore be tailored to their needs. For instance, it can be structured to allow for interest to roll up into one bullet payment at the end of the term so capital can be used for growth, provide payment holidays or impose lighter covenants that ease the pressure to continuously meet strict requirements.
What is the opportunity set?
While the likes of Blackrock run major funds in the corporate credit space, there are significant opportunities for lending to small and mid-sized enterprises (SMEs). Here, there is plenty of demand but less competition on debt pricing, which should translate into better risk-adjusted returns.
Private credit was already an appealing option for businesses and providers of debt capital alike when the economy was in better shape. Now, even more so.
Today, plenty of good SMEs require funding to cover temporary difficulties or would benefit from restructuring balance sheets with more flexible debt. Now is also a good time for companies to snap up struggling rivals or complementary businesses, providing an attractive opportunity for investors to back these acquisitions with a debt solution.
Just as SMEs are looking for funding to support them through recovery, banks are retrenching from the market, creating a gap for providers of debt capital to step in. This is also a period when companies value flexibility of debt structure over the headline rate of interest charged, and with interest rates rising, they tend to be more comfortable with a fixed rate over banks’ standard variable rates (SVRs).
What strategies are available?
A whole host of strategies fall into this bracket, meaning that there is wide scope for diversification even within this asset class.
In the current challenging conditions, distressed debt and special situations strategies enable investors to buy debt at a discount and support business recovery. Historically, investing in tough environments has led to vintage returns for these types of funds, for example in 2008 following the financial crisis, distressed funds achieved a median net IRR of 15.2%, according to the Prequin report. These are complex, higher risk investments that require specialist expertise, so investors should participate via experienced fund managers with the know-how to find and capitalise on the best opportunities.
Secondary strategies where investors pick up single assets or portfolios from motivated sellers also tend to do well in times like this. Funding for growth is always in demand, whether that is start-up venture debt or for companies with longer trading histories, as is straightforward direct lending.
Taking the plunge
Private debt investing is no longer niche: it is an established alternative asset with advantages for investors both in turbulent and calmer times. For those with the liquidity and appetite to invest at this point in the cycle, there are lots of opportunities to be seized.