Private debt, similar to public debt is an advance of money to a borrower with obligations to make interest payments on the amount borrowed (principal) and repay the principal at a predetermined maturity (typically 3-5 years). The term ‘private’ refers to these loans not being traded or issued in public markets albeit there is a limited secondary market for senior loans between private market participants. Private debt tends to be either Sub-Investment Grade loans or unrated by credit rating agencies. As with all debt transactions, the priority ranking is a key determinant of the level of risk and therefore yield. Debt offered ranges from senior secured to mezzanine finance with a key advantage of private debt solutions being a more tailored financing solution with more flexible financing structures (e.g. Payment in Kind (PIK) or preferred equity structures).
Private debt markets predominately comprise of three segments: commercial loans to businesses, consumer loans and residential mortgages. As of December 2020, the private debt market (excluding mortgages) was estimated to be US$848 billion in size. Within Australia, the largest segment is residential mortgages (62.5%) followed by commercial loans (32.7%). Historically loans have predominately been supplied by banks (>90%) while the remaining balance being provided by Non-Bank Financial Institutions (NBFIs). NBFIs are non-depositary financial institutions; meaning, unlike Authorised Deposit-taking Institutions, (ADIs), they do not hold deposits and are not beholden to the strict capital adequacy and lending standard regulations of Governments. Since the Global Financial Crisis (GFC), NBFIs have been gaining market share due to such regulations making it uneconomical in some cases for banks to participate in lending. Given the rise of NBFIs as an important source of capital, NBFIs have in turn developed investment products in order to finance their growing lending activities while also providing investors access to the asset class with more attractive yields than otherwise available in the public market.
Private debt consists of direct lending and syndicated financing solutions. Direct lending is where the investment manager acts as the sole lender. These transactions tend to be provided to small-mid sized businesses (i.e. US$10-75m EBITDA). Direct lending is highly selective and relationship driven given the close consultation between the lender, the management team and shareholders of the company. Direct lending typically involves a lengthy due diligence, are a highly tailored financing solution with the lender exhibiting a great deal of control over the structure, use of capital, covenants and terms. The lender also takes a more hands-on approach to monitoring the business, similar to that undertaken by direct private equity deals. Further, in the case of a default, the lender can take control of the business to greater ensure repayment.
In terms of syndicated financing, this offers groups of lenders the opportunity to lend to generally mid- to large-size businesses (i.e. US$75m+ EBITDA) for mergers, acquisitions and private equity buyouts, while allowing the lead financer to diversify their individual loan risk across a number of lenders. The terms of the loan structure are generally standardised and determined by the lead financer and therefore individual lenders have less control over the business and the loan structure more generally. Syndicated loans also allow for a single debt facility called Unitranche which combines varying levels of debt seniority and security. Syndicated loans are highly prevalent within the market and albeit the degree of information of the underlying company and covenant protection is far less onerous. In 2019, 87% of global leveraged loans were covenant-lite according to S&P Global market Intelligence, rising from 8% ten years earlier. As mentioned early, there is a limited but active secondary market for trading individual loan should liquidity be desired or to reduce exposure to an industry or company.
A conservatively managed, well diversified private debt strategy can offer investors a viable alternative to fixed income, particularly in a low interest rate environment. Private debt can offer a reliable income source with a low level of portfolio volatility and more broadly act as a diversify due to its lower correlation to public markets. The floating rate nature of the underlying loans also offer protection in a rising rate environment while being a lower risk investment compared to other alternative strategies including private equity.
Private debt is generally illiquid, can offer limited transparency and is largely unregulated. The private debt market has experienced tremendous growth in recent years which has led to a build-up of substantial dry powder and in turn competition for deals which has driven down yields. Disciplined lending standards are integral component of navigating the landscape, particularly given the low-doc, covenant-lite loan terms prevalent within the market. Understanding the market segment and robustness of the security of income to service the debt is critical, alongside the leverage multiple and security of assets written against. Knowledge and relationships are critically important, further, the ability to ‘step in’ to restructure, refinance and in some cases ‘take the keys’ by converting debt into equity to protect capital is crucial for asset managers undertaking direct lending.
Author: James Kirk
Manager, Global Equities and Alternatives, Lonsec Research
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