What is Private Debt?
Every business needs funding. Traditionally, most business owners rely on bank loans. However, in the fallout of the late-2000s financial crisis, demand for private debt has skyrocketed due to regulatory tightening in the banking sector, which made in more difficult for SMEs to rely on bank lending. That’s where Private Debt comes into the picture – it functions as a bank loan but lacks the same regulatory constraints.
The key point here is that lenders of private debt say yes to enterprises, or loan structures, that banks don’t want to take (more) credit risk on. Accordingly, this market is mostly driven by investors’ search for higher yields given the low-interest environment in the public bond markets.
Private debt is a relatively new asset class (~10y); a type of fixed income strategy, where the investor acts as lender and injects money into loans issued to enterprises or individuals. Basically, in private debt you can invest indirectly via private debt funds or balance sheet lenders or directly via a peer-to-peer (P2P) digital lending platform, which match-makes lenders with borrowers. However, not all investment opportunities are available to all investors. This is a topic we will investigate more in details in another blog post.
“Private debt is any form of lending that is not issued by a bank”
Today, the global market size of private lending exceeds USD 800bln measured in assets under management (AuM). That gives a market growth by 100% in the period 2011-2019. Seemingly, only the sky is the limit.
In most cases a private debt lender is an institutional investor, but parts of the market, i.e. P2P lending, is also open for individuals (aka retail investors). Borrowers of private debt can be an enterprise (legal entity) or an individual. Moreover, private debt is also called alternative lending, private credit, or shadow banking.
How private debt differs from commercial banking?
An important feature of the commercial banking model is that banks take credit risk on their balance sheet and produce safe deposit claims, using bank equity as the loss buffer. Conversely, private debt models transfer all the credit risk directly to investors by matching individually borrowers with a number of investors who provide the debt capital. And another major difference between commercial banks and private debt lenders is that they operate in different regulatory environments. For instance, non-bank lending is not covered by public deposit insurance schemes.
What’s in it for me?
The potential upside for the borrowing enterprise (vs. bank loans) is; increased flexibility (i.e. loan structure and legal documentation), possibility to carry higher leverage, less security, improved liquidity, and less administrative hassle/faster application turnover – to mention a few. However, it comes at the cost of higher fees and interest rates.
For investors, there are several benefits from private debt compared to publically traded, high-yield corporate bonds. Below are some of the most important advantages:
- High returns: Average compensation for mature loans is 4-6% above the basic benchmark interest rates, with some lower-ranking loans reaching as high as 15% returns. And if you can go for longer terms (and stay less liquid) you can yield even more;
- Predictive cash flow: In most cases, private debt investing provides regular income due to periodical and fixed interest payments and principal repayments;
- Lower volatility: Compared with the high-yield bond market, private debt market is (historically) considerably less volatile;
- Increased diversification: Private debt is an alternative asset class with low correlation to the performance of stock indexes.
Nevertheless, private debt also has some inherent disadvantages and risks that should be considered and weighted against its benefits. A few of the main drawbacks of private debt investing worth considering are:
- High management fees:Private debt investment managers (e.g. General Partners or Originators) charge higher fees than most listed investment opportunities;
- Illiquidity: Short-term sales of private debt assets are usually not feasible. In most cases, there are no liquid secondary markets available if you would need to urgently sell;
- Unpredictability: Private debt loan performance is still not reliably understood in the long-term. The asset class is not older than 10 years. And it remains uncertain how well they perform under financial crises;
- Credit risk: The chance of not receiving your money back due to default in repayment is larger in a private debt investment than in high yield bonds.
As with all types of investments, private debt lending has pros and cons that hit investors differently given your financial situation, portfolio composition, life goals, etc. Accordingly you should always consult a professional adviser before investing large amounts of money – especially into new types of asset classes.
In next blog post we will investigate further about the different types of private debt lenders and different investment offers available.
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Disclaimer: Maiyak is a facilitator of investments by independent information. We don’t offer advises or recommendations regarding offered investments. Moreover, Maiyak doesn’t embrace the purchase of any investment products.