Enthusiasm for private markets has been growing among investors ever since the Global Financial Crisis (GFC, 2007-09). The conjunction of that trend with that event is not a coincidence.

The crisis led to a wave of new banking regulations and laws across the OECD, led by America’s 2010 Dodd-Frank Act. By requiring banks to hold more capital against their loan books, these rules restricted the banks’ ability to lend freely, especially to higher-risk borrowers such as start-ups and new technologies.

Given the storied resourcefulness of the finance sector, combined with technology’s growing need for capital, it should not have been surprising that new lenders and investors rushed to fill the gap left by the chastened banks.

Additionally motivated by ever-diminishing returns from bonds and cash, hedge funds and pension schemes led the charge. They were closely followed by both private debt and private equity funds, as well as by other “non-traditional” sources of finance.

US startups financing deals with nontraditional investors*
Source: PitchBook

* “Nontraditional” refers to lenders and investors who are not banks or venture capital firms.

Private debt had started growing since the early 1990s, a period of significant bank consolidation, which had a profound impact on the supply of capital to small and medium-sized companies. However, the Global Financial Crisis was a turning point in both the American and European markets.

And now the private debt has caught investors’ attention again. After the worst-ever year for public markets, loans has outperformed stocks and bonds for just the third time in 25 years. According to the PitchBook, The Morningstar LSTA US Leveraged Loan Index returned -0.6% for 2022, compared to -15.7% for high-grade corporate bonds and -18.1% for the S&P 500.

2022 cumulative returns by asset class
Source: PitchBook

What, then, is private debt, also – and confusingly – called private credit and is it worth your attention? Essentially, it’s the provision of debt finance to companies, projects, and funds by almost anyone other than banks or the bond markets. As with private equity, there are various strategies, but also various instruments, each with its own risk characteristics.

Note: For this article, peer-to-peer lending (P2P) is excluded from consideration as private debt. It is mainly a retail facility, involving relatively small transactions, and the focus here is on the professionally-managed investment funds that dominate private debt.

Let’s take a look at some of the most common ways to invest in private debt and consider whether they are worth it or not.

Private Debt Funds

  • Direct lending funds

    Mostly, these make loans directly to individual companies, usually small and medium-sized enterprises (SMEs). However, some also specialize in loans to infrastructure projects, cleantech, real estate development, and even other funds, especially including hedge and buy-out funds.

  • Distressed debt funds

    These target companies in difficulty, seeking to buy their debt at a significant discount with the aim of selling at a profit when those businesses recover or liquidates (given the discount). Because of the increased risk of default with such companies, the funds tend to invest mainly in so-called “senior” debt (q.v., below), which has repayment priority over other types of loans.

  • Mezzanine debt funds

    Mezzanine debt is a tranche of debt that sits between traditional debt and equity. Borrowers use it when they have maximized traditional leverage and don’t want to use equity to raise more money. It also has an embedded equity element, usually in the form of warrants or call options that can be converted into the issuer’s shares under prescribed terms and conditions. It’s frequently encountered in leveraged buy-outs (LBOs) and M&A (mergers and acquisitions) activities. The equity part makes these bonds riskier than senior debt, but also offers the prospect of better returns than from ‘straight’ bonds.

  • Private debt funds of funds

    These vehicles should be self-explanatory: they invest in a range of debt funds, aiming to reduce investment risk through such diversification.

  • Special occasion debt funds

    These funds could also be termed “event-driven”. They seek to profit from one-off corporate developments, such as mergers, takeovers, and spin-offs, by offering bridge finance and other loan facilities to one or other of the participants. If they use mezzanine debt, some are also exposed to equity risk and, thereby, equity-like returns also.

  • Private debt venture funds

    Parallel to venture capital funds in the private equity sphere, these lend to start-ups and early-stage enterprises.

  • Non-performing credit funds

    This discouraging classification refers to funds that invest in loans which are in default, i.e., are “non-performing”. Typically, the fund manager uses a variety of initiatives to mitigate or even eliminate that non-performance and, thereby, sell the bonds at a higher price.

Private Debt Instruments

By their very nature, private debt funds rarely invest directly in listed debt securities such as government, corporate, or municipal bonds. Because they are private, they can tailor their lending arrangements to the specific circumstances of each transaction. Nonetheless, the loans in which they invest often conform to certain distinct types and risk profiles.

Private debt capital structure
Source: Preqin

Some of these, such as mezzanine debt and non-performing loans, have been outlined already, but here are a few more.

  • Collateralized loan obligations

    CLOs group a range of debt obligations into a single security. Their reputation suffered in the GFC, which arose from a default crisis among mortgage-backed securities, a type of CLO. The subsequent economic recovery and the accompanying need for non-bank sources of finance have brought about a complete rehabilitation.

  • Senior debt

    As the name implies, investors in these corporate loans are the first to get paid if the issuing company goes bankrupt or is forced by deteriorating financial performance into restructuring its capital. Usually, they are backed by some form of collateral, such as the company’s assets.

    Because of this lower risk, returns – in the form of the interest paid – are lower and the asset class is preferred by banks and other traditional lenders, who may, in some circumstances, dictate the degree to which the issuer takes on additional debt of any type.

  • Subordinated debt

    Also known as junior debt, this type of loan is not secured against any kind of collateral. Because, therefore, it is ranked lower than senior debt, holders can only be repaid once all senior debt holders have first been made whole.

    This additional risk is reflected in a higher rate of interest that can make such loans attractive to private debt funds.

  • Unitranche debt

    An “unitranche” refers to a loan that combines both senior and subordinated debt, thereby simplifying both the borrower’s capital structure and the lender’s risk management. Most commonly, it is encountered in leveraged buy-outs and pays an interest rate somewhere between that of secured and unsecured loans.

Private Debt In The 21st Century

It has been noted already that the growth of private debt has accelerated in the current millennium. This was especially true after the GFC, during which period assets under management have grown fourfold to more than USD 1 trillion.

Global private debt AUM forecast by 2027
Source: Investment & Pensions Europe

The outlook remains strongly positive. According to Investment & Pensions Europe, private debt was virtually unaffected by the 2022 setbacks in equity and bond markets. Following a period when it was feared that declining loan quality endangered the entire sector, private-debt managers are experiencing a resurgence of interest from institutional investors, especially pension funds, and assets under management are expected to top USD 2 trillion within the next five years.

The demand is being spurred by rising volatility in public debt, making it more difficult for companies to issue listed bonds, while banks, despite the higher interest rates now available, remain unwilling to lend to many types of businesses.

Simultaneously, the market upheavals of the past year have led to tighter standards for private loan terms. Consequently, the risk-return profile of the asset class has improved, claim specialists such as Paolo Malaguti, head of Credit-Vision.

Performance Of Private Debt

While private debt is unlikely to generate the same elevated returns available in private equity (PE), it has a lower risk profile and, therefore, a more consistent pattern of returns. On that basis, it is an effective private-market complement to PE for investment portfolios.

Private debt risk to returns analysis
Source: Mercer

The chart above compares returns in US private debt with those in listed high-yield and leveraged loans. Clearly, the private market has not only produced better long-term investment returns than either of those, but has done so with much lower deviation and, therefore, less risk.

A similar picture emerges from comparing private returns with those from private debt/credit. The chart, below, shows how an investment of a single US dollar would have fared over the four years to the end of 2021.

Comparison of growth of USD 1 investment in private equity, private credit, private real estate & public equities
Source: Hamilton Lane

Private credit trailed the field in terms of its absolute performance, but note how much less volatile it has been. Moreover, it proved almost as defensive as private real estate during worldwide downturns such as that which occurred during the 2020 coronavirus pandemic.

How To Invest In Private Debt

Private debt has, therefore, a record of moderate but reliable returns. That makes it a good counterbalance to private equity in a private markets portfolio. How can you invest?

Funds might be ideal. Managed by professionals and diversified to reduce risk, they are rendered acceptably transparent by periodic management reports. However, as with private equity, they have high minimum investment requirements, usually CHF 1’000’000, equivalent, and almost never less than CHF 100’000.

Funds-of-funds, meanwhile, carry additional fees to those charged by the funds in which they invest. They also have similarly exclusionary minimum investment levels.

Listed private credit funds look promising and you can deal in their shares every day. However, they have two valuations. The net asset value (NAV) represents a fund’s investments, plus any cash held, while the share price is the market value.

These two can diverge. A share price discount (or premium) to the NAV of about 5% is fairly common, but a discount of 20%, even 40%, is far from unusual. In 2022, the Financial Times recorded these worst cases in the UK market (where listed closed-end funds are known as investment trusts).

Top five biggest negative movers in 2022
Source: Financial Times

Moonshot offers a worthy alternative. With a minimum investment of just CHF 25’000, you can access a well-diversified private debt portfolio, as well as numerous lucrative private projects in real estate, infrastructure, and other credit opportunities usually available only to professional investors and the ultra-wealthy.

Don’t miss out and join our network to find out how you can invest alongside them.

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