How To Invest in Private Debt
Private debt may also be called ‘private credit’, ‘alternative credit’, ‘alternative debt’, or even ‘alt-credit’.
The terms refer to debt that’s neither financed by banks (overdrafts, mortgages, and personal loans don’t count) nor traded on a stock market (not listed government and corporate bonds, therefore).
Because there’s no intermediary bank or market between lenders (bank depositors, bond investors) and borrowers, private debt is also called ‘direct lending’.
Private debt finances business
Consumer credit (hire purchase, personal contract hire, credit cards) is generally not counted as private debt. It involves loans by banks or finance firms to individuals for their personal spending.
Private debt, as described here, finances business. Generally, the loans are advanced by non-bank investors. Those may include individuals, mutual funds, and institutional investors.
‘Private’ describes the borrowing instrument, therefore, not the borrower.
Companies may issue private debt whether they are public (listed on a stock market) or private.
Institutional investors, such as pension schemes, insurers, and endowments, have long been investing in private loans. Usually, these financed big infrastructure or property development projects, but were mostly underwritten and managed by banks.
Retail investors were completely unfamiliar with private debt until after the Great Financial Crisis (2007-08).
Then, the banks reined in lending in order to recover from the enormous losses they’d suffered.
Private debt has ballooned
That should have been a temporary response and, once their balance sheets were repaired, the banks could have resumed lending. It’s what banks do.
The regulators thought differently.
They required the banks to set aside much greater amounts of capital against their loans. That reduced the risk of getting caught short by any tsunami of defaults among borrowers.
It also forced banks to reduce lending to more risky debtors such as entrepreneurs, farmers, small businesses, and property developers.
Private debt ballooned to fill those gaps.
Worldwide, it now raises about $100 billion annually, mainly from institutional investors, and has doubled in size over the past eight years.
Financial repression has supported this growth.
By pouring trillions into government bonds, central banks have driven interest rates to record lows.
That was supposed to force companies and consumers to take money off deposit to spend it on, respectively, expanding production and buying stuff.
Yields can be huge
It didn’t work as well as hoped. Economic growth has improved, but remains well below the pace normally seen during a recovery.
Instead of being invested or spent, much of this quantitative easing, as the central banks’ bond-buying programme is called, has been recycled into private debt.
There, yields can be several times what’s available from banks or government bonds.
As the above chart implies, there’s more than one type of private debt.
Most of it is financed directly by big institutions, to which debt issuers make private placements. The institutions each have to invest many tens of millions in a typical placement, so retail investors are shut out.
However, a variety of funds have sprung up to cater for smaller institutions and ‘accredited’ private investors, i.e., those deemed sufficiently rich, experienced, or knowledgeable to afford or understand the risks.
Broadly speaking, these funds invest either for capital preservation or growth.
Some of the latter target specialised activities such as trade or supply-chain finance, farming, clean energy, football transfers, property development, and so forth.
In the capital preservation sector, direct lending dominates. The funds can be very large.
The biggest to date was launched by U.S. manager Ares in July 2018. It raised about $7 billion.
Capital preservation strategies
Direct lending funds typically involve the lowest risk.
They invest in senior debt, which has the first call on the borrowing company’s cash and other assets if the company goes bust.
The funds may use leverage (borrowing) to raise returns, which reflect the funds’ reduced risk profile by being among the lowest in private debt.
Mezzanine funds often work closely with private equity funds, providing them with loan finance for buyouts.
The loans tend to be subordinate to senior debt, so they’re less secure. Added risk arises from the less-certain outcomes of private equity deals, compared with direct lending.
Capital appreciation strategies
Distressed credit funds are pretty much self-explanatory.
They invest in existing loans priced well below repayment value, usually because the borrowers have met financial problems. The funds seek to raise loan values by renegotiating terms, or by pre-empting a turnaround in the borrowers’ businesses.
Specialist funds lend for niche activities, such as those cited above, but also caravan parks, video game development, and film production.
The loans tend to be relatively small (a few million, not tens of millions). Returns may be increased by advisory and other fees, and/ or by taking a cut of the borrowing companies’ profits.
Peer-to-peer lending (P2P) (https://alsanagroup.com/why-peer-to-peer-lending-is-the- future/), also called crowd-lending, is like a matchmaking service for lenders and borrowers.
Anyone can become a lender and in the process earn more interest than they would through a conventional savings account.
Using a P2P website, you can lend as little as £10 to other people and companies, earning interest rates of 5%-10% and above.
Accredited investors can invest in all of these through a variety of UK and EU funds.
However, the strategies are considered to be complicated and esoteric, compared with unit trusts and other retail funds investing in public equities or debt.
Accordingly, most of the funds set a high level of minimum investment.
This could range from £25,000 up to a million or more, but listed funds, such as investment trusts and open-ended investment companies (OEICs) in the UK, are exempt from such restrictions.
With financial repression having reduced deposit returns to near-nil, the prospect of 5% to 11% annual returns from private debt investment seems compelling.
So, what are the risks?
With listed investment trusts and OEICs, the biggest risk is the listing itself.
It’s bad enough when your fund goes south because it made some dodgy loans, but the fund’s shares are likely to sharpen your pain by falling well below the value of what remains in its portfolio.
For all private debt, meanwhile, the risk of borrower default is paramount.
It increases as the economic cycle matures, encouraging over-enthusiasm and, therefore, over-investment.
Given the explosion in private debt since 2008, we may be at that point already. A common measure of over-investment is the level of ‘dry powder’.
That’s money subscribed by investors but not yet invested in any loans.
Just to be clear, the chart shows $250 BILLION in dry powder, much more than double the decade-ago level.
That’s a lot of money that cannot, for the time being, find anything in which to invest. Under pressure from return-hungry investors, it might end up in poor-quality loans.
Whether that opinion matters to you or not, if you do decide to invest in private debt, don’t do it at home. Talk to a professional adviser first.
Paul Connolly
Paul Connolly has been a journalist for more than 20 years, as a reporter and editor for Argus Media, Reuters, The Times, Associated Newspapers and The Guardian. He has covered Islamic Finance for Reuters in the 1990s. Paul has since helped launch three newspapers, as well as reported from Tokyo, Los Angeles and Stockholm.
