Private debt – a closer look

In the aftermath of the Global Financial Crisis, many banks were forced to reduce their lending capacity as a result of increased regulation and oversight. This created an opportunity for specialty lenders and institutional investors to step in and provide an alternative source of debt across a variety of sectors. 

The private debt market, as it is known, possesses some similarities to the mainstream public debt markets, such as sovereign credit and investment-grade corporate bonds. There are also many differences between public and private debt markets, and in this article, we explore the key characteristics of this emerging asset class.

What is private debt

Private debt is an alternative way of accessing the attractive risk and return characteristics offered by the fixed income asset class. To put it simply, investing in private debt involves holding a credit security that is not publicly tradable, meaning investors must embrace liquidity risk because the investment they hold cannot be easily bought or sold.

The private debt investment universe is very broad and multi-faceted. Individual securities can be complex, which again adds risk, but investors should expect to be rewarded with higher returns.

There are four main areas of the private debt market, which all have subtly different characteristics.

Real estate and infrastructure debt

These are loans that are used to finance the construction, improvement or maintenance of property or structures that support society, such as roads, bridges and energy assets. The loans are backed by the value of the assets they are financing and tend to represent relatively low risk with a modest return. Individual securities in this category will vary in maturity terms, with commercial real estate debt tending to mature within five years, with much longer durations for some infrastructure debt.

Corporate direct lending

Public debt markets provide an important source of financing for larger corporations, but most businesses are too small to access them. Corporate direct lending is a viable alternative for these smaller companies, and the benefit to investors is that they tend to offer a higher yield in return for the lack of liquidity. Occasionally, larger companies will also raise debt directly through private placements. Direct lending deals can be quite complex – for example, deals will vary significantly in terms of maturity terms, seniority and the level of protection offered to investors – so an understanding of the specific features of each issue is very important.

A changing regulatory environment and bank disintermediation led to a growing pool of private direct lending opportunities. For example, a private business may be looking for expansion and further growth and, instead of attracting private equity or seeking a bank loan as a source of capital, they may prefer to access private direct lending. Private lending can be structured as a senior loan provided to a business to enable it to grow its product line, expand geographically or modernise its operations. The business will pay its lender an interest rate and a service fee.

Specialty finance

These are niche financing strategies that can be accessed either directly or through investments in specialist strategies including litigation finance, films and insurance. In the example of litigation finance, a third party that is unrelated to the lawsuit provides capital to a plaintiff involved in litigation in return for a portion of any financial recovery from the lawsuit. Under most litigation finance arrangements, funds are advanced on a non-recourse basis. In other words, if there is no recovery of proceeds through settlement or adjudication, the claimant owes the funder nothing. These are higher risk and higher return strategies and knowledge and experience of the specific niche that is being financed is key.

Distressed lending

As the name suggests, distressed debt involves lending to businesses or institutions that are undergoing some form of stress, such as the threat of bankruptcy. Unsurprisingly, this is a high-risk pursuit, because capital is likely to become impaired if the company involved does not survive. The returns can be very attractive if the stress diminishes as the company starts to pull through.

Why should investors consider private debt for their portfolios?

As previously explained, investors should expect a higher return for embracing the complexity and illiquidity of private debt, when compared to more mainstream fixed-income assets. There are several further factors that contribute the attractiveness of this alternative asset class.

Access to inefficient markets

The lack of liquidity in private debt means that the market is less efficient, so asset prices may not reflect their true values. This provides an opportunity for skilled investors to identify mispriced assets. This is particularly the case in Australia, where the private debt market is still emerging, being many years behind the maturity of Europe and the United States.

Longer time horizon

The illiquidity of private debt means that investors are forced to take a longer-term view, which is a good discipline in the world of investment. Private debt funds tend to have a time horizon of at least three years, with many focusing on a seven-to-ten-year investment period in order to unlock value.

Diversification

The illiquid and unlisted nature of private debt means that prices do not move in response to the day-to-day swings in sentiment that afflict public markets. Consequently, private debt can play a usefully differentiated role in a diversified portfolio, with lower levels of volatility.

A growing opportunity set

Private debt markets grew strongly in the aftermath of the Global Financial Crisis, with specialty lenders stepping in to fill the gap left by the mainstream banks. Now that these alternative lenders have proven themselves, this growth appears well-placed to continue. Technology too, is playing a role in this growth, with digital platforms making it easier for lenders and borrowers to find each other without the need for an intermediary.

Income

Private debt is usually seen as an asset class for income generation, with limited opportunities for capital appreciation. Investors benefit from an attractive regular income stream, typically from the outset of a private debt investment.

What are the risks?

Although we cite complexity and the lack of liquidity as reasons for investors to expect greater returns from private debt investments, they also represent tangible risks. As the long history of financial market data amply demonstrates, risk and return always go hand in hand. Private debt investment requires very specific skills and knowledge to effectively manage these risks. Not many investors possess these skills, but those that do have evidenced an ability to add significant value in the asset class over time.

It takes time to deploy capital in a private debt strategy. Typically, deployment will take around 12 months to complete, which represents another source of risk, should market dynamics change during the period in which capital is being put to work.

For a large part, private debt is lowly correlated to other asset classes. But some evidence suggests in times of market stress these alternative strategies may suffer alongside public markets. Investors may not see the diversifying benefits of private debt at the times they are most needed.

Finally, with inflation being a topic of discussion in financial markets currently, the outlook for interest rates must be cited as a risk for all fixed income investments, whether private or public. Indeed, some parts of the private debt universe may be relatively well-placed should we see a prolonged period of higher inflation and interest rates. For example, direct corporate lending deals typically have floating rates, which means that investors would be rewarded with a higher coupon should interest rates rise.

What is the outlook for the Australian private debt market?

By some estimates, the global private debt market has grown tenfold in the past decade. The impact of this additional capital has been to gradually compress yields. When capital was scarcer, the opportunities to earn premium returns were more abundant. This slowly attracted more demand from more market participants and returns have consequently started to normalise.

In other words, the private debt market has become more efficient over the last decade, but it remains far from a perfect market. In Australia, which is still a relatively immature private debt market compared to the US and Europe, the opportunity for excess returns remains attractive.

Within corporate direct lending, private equity managers are actively looking to deploy capital that has accumulated in recent years. Deals are typically financed with 50% equity and 50% debt, so a buoyant outlook for private equity inevitably fuels demand for private debt, so the outlook for new opportunities here looks particularly bright.

In an environment where many investors are hungry for yield, there are sound reasons to expect the private debt asset class to continue to grow in popularity in the years ahead. Demand is likely to gradually increase as the asset class matures, with more market participants entering and retail investors able to access it through alternative investment portfolios. As demand rises, we should expect returns from Australian private debt assets to continue to normalise towards the global average. In the meantime, the outlook remains attractive.

WAM Alternative Assets provides retail investors with exposure to a portfolio of real assets, private equity and real estate. The company aims to expand into new asset classes such as private debt and infrastructure.

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