Private debt helps companies grow and offers an appealing new type of debt investments for investors. What is this rapidly growing asset class all about?
Focused mainly on funding mid-sized companies, private debt is an evolving asset class that offers investors appealing yield compared to traditional bond investments. According to Preqin, private debt funds have had an average return rate of +9.4% p.a. (IRR) between 2005 and 2017.
At the moment, companies need capital, making private debt high in demand. The asset class is projected to grow from 1,050 billion euros to 1,500 billion euros in 2025.
In this blog post, we dive into the features and strategies of private debt, explore its role in an investor’s portfolio and give tips on selecting the right fund.
Private debt finances growth with multiple strategies
In a nutshell, private debt means financing the growth and development of companies, usually in the mid-size range. As the financial crisis led to a tighter regulatory framework, banks became more hesitant and constrained in lending money for companies. This in turn led to a growing demand for alternative financing sources. Private debt is one of these mechanisms, focusing on companies that are not willing or able the get loans from the financial market.
Private debt is a diverse asset class where each loan is tailored to the company’s needs and according to the fund’s strategy. Various loan terms also reflect on the risk and return level of the funds.
In the lower end of the risk, there are so-called Direct Lending and Mezzanine loans that are mainly used to finance growth and where the main source of returns is the coupon payments. Direct Lending loans are typically senior secured loans, so they have first priority to company assets relative to other outstanding loans and equity. In the other end of the risk spectrum are so-called Special Situations and Distressed loans for companies with a skewed balance sheet. Here, risks and returns are naturally bigger, and the main source of returns is company growth and at a lesser extent cash coupon payment. However, a significant part of the loans in the asset class are Direct Lending loans that are lower in risk and make the asset class less volatile from the investor’s point of view.
Most of the current private debt market is in North America, as the region has a longer tradition of non-bank financing than Europe. Due to tailored loan terms and country-specific legislation, most private debt funds focus on a relatively small number of companies in a single market or even a specific type of loans or financing a narrow sector.
Private debt has good earnings potential during uncertain times
For an investor, the easiest way to get into the private debt market is a fund of funds that invests in several funds combining several strategies and covering a broader range of the asset class. A fund of funds offers better diversification in terms of investment strategies, geographies and companies.
For an institutional or an experienced private investor, private debt offers an appealing bond investment and access to companies you cannot get via stocks or high yield bonds. Since there is virtually no daily fluctuation in the asset class, there is a steady earnings profile also during uncertain times.
From the investor’s point of view, another key factor is that private debt bonds are typically floating rate loans. This makes the asset class very appealing, should interest rates rise from their current level in the coming years. According to Preqin, 67% of institutional investors will grow their investments in the asset class during the next five year.
Private debt is a good addition to the bond or alternative investments portfolio, bringing versatility and new sources of yield. It also offers a steady and relatively high cash flow (typically 3 to 5% p.a.), another feature appreciated by many investors.
Historically, private debt funds have reached an average return rate of over 9% p.a. (IRR) and returns start to occur faster than in many other alternative asset classes.
Strategy, diversification and responsibility are key in selecting a private debt fund
As the companies financed by private debt loans, or the funds themselves, are not a homogenous group, selecting the right kind of fund is crucial. Keep these four factors in mind when you pick a private debt fund for your portfolio:
- Fund strategy
What is the investment strategy of the fund? Does the fund finance companies directly or does it offer access to the leading specialist funds via a fund of funds? What kind of companies, sub-funds and loan strategies are preferred? Instead of single investments, it’s wise to pay attention to the bigger picture and how different loans and strategies are weighed in the portfolio.
Are the investments diversified effectively? In addition to sectors and company types, pay attention to geographic diversification. The European private debt market is still relatively narrow, so adding North American loans adds variety to the portfolio. In bonds, efficient diversification is important.
How are the different aspects of ESG considered in the fund? What kind of exclusion criteria is in place? The key is to understand how responsibility factors are integrated into the investment process and how the process is developed.
- The team
Who are the people behind the fund and what kind of expertise do they have? Due to the variety of players and strategies in the asset class, the due diligence must be careful and systematic. A fund of funds offers access to broad professional resources and specialist funds.
Read more about Evli Private Debt Fund I >