The private debt market’s robust growth is largely attributed to tighter regulations imposed on commercial banks. A recent US banking crisis, coupled with stricter Basel IV norms, propels this surge. Additionally, tight monetary policies are leading to a notable spike in fees, particularly in relation to risk. Consequently, a promising asset class has quickly taken shape.
Private debt isn’t a novel concept. Essentially, it’s an evolution of bank-provided financing. When a single bank deems a company loan too substantial, the credit is typically syndicated. Initially, this consortium predominantly comprised commercial banks. But with the utilization of standardized agreements, transferring such loans to institutional investors became relatively straightforward.
Over time, these loans adopted the “leveraged loans” label. While there’s no strict definition, they’re often loans with a credit rating of BB+ or lower and a credit markup of at least 125 basis points. The backing for the loan is usually the company’s cash flows, either as primary or secondary collateral. Unlike high yield bonds, leveraged loans have this right. Typically, a covenant safeguards lenders’ rights, though these provisions can sometimes be relaxed or entirely omitted. For lenders, staying updated on a company’s internal developments is crucial.
Redefining bank credits
Following the Great Financial Crisis, these loans began being referred to as “senior secured loans,” a gentler term. While technically not private debt, they’re classified as such since they’re not publicly traded. True private debt became prominent mainly post the crisis. It differs in that neither banks nor their syndicates play a part in the financing process. These loans commonly cater to medium and small-scale businesses – entities often overlooked by many commercial banks. Additionally, private lenders offer far greater flexibility than traditional banks.
In certain cases, the private entity becomes the ultimate financier, effectively making it distressed debt. There’s also mezzanine financing, allowing shareholders to partake alongside interest payments. Many of these smaller entities struggle to secure loans from commercial banks under identical conditions due to regulatory barriers. Such hurdles arise because these banks, when holding such loans, are mandated to maintain a substantial equity reserve.
Bridging investment gaps
Private debt loans are increasingly repurposed to yield customized returns and risks. There’s always a sizeable investor group solely focused on investment-grade papers (AAA to BBB ratings). Using a Collateralised Loan Obligation (CLO) facilitates this. Notably, the bottom-most equity tier in a CLO often boasts a superior risk-return balance compared to private equity. With private equity, challenges extend beyond choosing stellar parties; it’s crucial to invest funds promptly. Delays often culminate in diminished overall returns.
The total volume of US private debt has escalated to approximately 1.5 trillion dollars this year, outpacing both the high yield and leveraged loan markets. Its growth is propelled by its relatively low volatility. While volatility might be an odd and inadequate risk gauge, it remains pivotal for numerous institutional investors. Another factor is that private debt loans often have variable interest rates, negating interest rate risk for lenders and shifting it onto businesses. In Europe, the private debt market is burgeoning as well, particularly as the era of high yield loans with negative interest rates concludes.
However, the best justification for investing in private debt isn’t volatility or variable rates. It’s that private debt investors have honed their risk management skills, given the sector’s inherent uncertainties. On one side, high compensation offers a buffer. On the other, proficient recovery tactics curtail potential hazards. Experience is invaluable, a trait seldom acquired by investment-grade investors.
Han Dieperink is the chief investment strategist at Auréus Asset Management. He previously served as the chief investment officer at both Rabobank and Schretlen & Co. This article was initially published in Dutch on InvestmentOfficer.nl.