Alternative investments have become more common in recent years, with none more popular than private debt. According to the CEO of Brookfield Asset Management, the market for private credit has now exceeded USD$1 trillion worldwide. Not only is this a staggering threshold, but the market should continue to grow exponentially. An August 2020 survey published by Preqin found that 67% of investors polled plan to increase, or significantly increase, their allocation to private debt by the year 2025.
The private credit asset class has won over both institutional and individual investors and could be a suitable investment for your portfolio as well. This guide will provide an overview of private debt, discuss why it is an attractive investment, and explain how to gain exposure to the asset in your portfolio.
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What is private debt?
Private debt, sometimes referred to as private credit, is a subcategory of the non-traditional, alternative investment asset class. Conventional asset classes include cash, publicly-traded fixed income, and equities that trade on a public stock exchange. Any investments that do not fall into these categories can be considered part of the alternatives class and have specific risk and return characteristics.
The category of private debt involves financing for businesses or individuals from an alternative source rather than a major bank. A borrower will turn to private lenders if, for example, they cannot secure traditional credit from financial institutions. The borrower can negotiate privately, and the loan terms are customizable based on the parties’ preferences. As a result, the non-bank lender can charge a premium for the credit they offer.
It is important to note that private credit does not necessarily stem from loans that are high risk. Companies may be unable to secure financing from traditional sources due to a change in lending regulations resulting from the 2008 financial crisis. With additional rules now in place, major banks may not be able to provide loans to every creditworthy business.
With private debt, as with traditional fixed income, there are different subcategories of lending that each have a distinct risk profile. For example, within the private credit category, distressed debt will have a significantly higher risk than senior real estate debt. These subcategories of private debt in Canada may include:
- Commercial Real Estate Debt (CMLs)
- Residential Mortgage Debt
- Infrastructure Debt
- Corporate Lending
Why is private debt attractive?
Over the past decade, interest rates have been at historic lows, pushing fixed-income investors to seek different options for higher returns. Investors have turned to alternatives to replace traditional fixed income assets, which were paying an ultra low-interest rate. Private debt became popular as the asset class offered higher yields than publicly traded debt.
With inflation now becoming a widespread concern in the markets, central banks may begin raising interest rates over the next couple of years. Even with rising rates, private credit will remain attractive as the interest charged by the lender and earned by the investor will be even greater still.
Not only does private debt provide investors with a higher yield, but the return profile tends to be uncorrelated with conventional assets. By adding an allocation of private debt, investors can further diversify their portfolios. With the optimal level of diversification, they can achieve an efficient portfolio that offers the best return for the level of risk taken.
Is private debt fixed income?
Private credit has unique qualities that differentiate it, though it does have some similar characteristics to traditional fixed income. Historically, private lending has a risk and return profile uncorrelated to the public markets and conventional fixed-income assets.
Traditional fixed-income tends to have a vast publicly-traded secondary market, minimizing the liquidity risk. On the other hand, private debt is less liquid as it does not trade on a public exchange. A lack of liquidity in the asset class demands borrowers pay a liquidity premium to their lenders. This is one of the reasons why private credit has higher returns than conventional fixed income.
With more and more investors getting into private debt, the secondary market is becoming more liquid than ever before. This should be a boon for private debt investors overall. However, it is important to note that increased liquidity does not always equate to less risk. Sometimes it can give the illusion of security. Proper due diligence and professional advice should be sought before jumping into the asset class, as liquidity tends to drop as defaults increase — especially in the private markets.
Private debt vs. private equity
Private debt and private equity’s risk and return characteristics are quite distinct even though they are both alternative investments. The only area where the two overlap is that the underlying assets do not trade on a public exchange.
Private debt, as outlined above, involves financing for a borrower from an alternative lender. Often, they are for companies, or sometimes individuals, who cannot secure credit from traditional sources. Small or mid-sized companies often rely on this type of financing.
With private credit, the borrower must pay interest on the loan and repay the principal at an agreed-upon future date. In contrast to private equity, there is usually no opportunity for the lender to participate in the company’s future growth unless the debt instrument is convertible. The investor will instead make money based on the interest paid to them.
For example, a mid-sized firm may need additional funding to expand its business. Instead of applying for a loan with a major financial institution, they could seek alternative lenders to offer a more flexible loan agreement. This loan would be considered private debt and require the firm to pay the lender a higher interest rate than a traditional bank loan.
Conversely, private equity represents an ownership interest in a company. In exchange for monetary investment in the company, the investor receives equity shares. The growth of the underlying business will cause those shares to appreciate and the investor to profit.
What is a private debt fund?
A private debt fund is similar to any other fund in that it includes a collection of underlying investments. Managed by an experienced professional, the fund will usually specialize in a particular type of private debt. Investors in the fund will essentially buy into a collection of loans that the fund manager has chosen. To be included, the fund manager must first perform due diligence and evaluate each private credit investment individually. They will then proceed with lending money and provide the fund’s investors with a stake in the pool of private loans. The fundholders will benefit from the interest earned on the private credit investments.
The private debt firm makes money by charging investors a management fee. Sometimes firms also have a performance bonus structure. Funds charge a performance bonus when the manager achieves a profit above a particular benchmark or performance level.
How to invest in private debt
Turning to a private debt fund is one of the most practical ways for investors to gain portfolio exposure to private credit. There is an opportunity to invest directly with companies; however, this typically requires a substantial up-front commitment making it impractical for all but the ultra-high net worth.
An offering memorandum fund is one of the best ways for investors to get involved in private credit. These funds consist of a pool of private debt loans, with investors benefiting as the borrowers pay the interest charges.
Private debt funds have a higher liquidity risk as the underlying credit does not trade on the public market. Less liquid funds are typically available to accredited investors with a higher net worth or specific industry knowledge. Of course, consulting a professional is the best way to find the best private debt funds available. Due diligence is of utmost importance, and if you do not have substantial knowledge or experience, it can be a risky asset class.
Investors have been turning to private debt in record numbers in search of higher yields. The asset class provides diversification as it has a return profile that has been historically uncorrelated to conventional assets. Turning to a private debt fund is one of the best ways for retail investors to gain exposure to private credit and diversify the holdings within their portfolio.
As always, consulting a professional is the best way to gain exposure to riskier asset classes. Be sure to reach out to your wealth manager to discuss how an allocation to private debt may benefit you.