Private Debt

Private Debt

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The uptake of private debt is a relatively new trend in alternative investments. The recent rise in private debt AUM was born out of the Global Financial Crisis as banks, the more traditional lenders, shied from riskier loans and private, or direct, lenders filled the void. Private debt funds bring several advantages to the table for investors, particularly higher yields than traditional investment-grade debt securities. Additionally, the breadth of offerings from their underlying loans offers investors a diverse spectrum of industry exposures and risk/return profiles. The size of the private debt market is expected to cross the $1tn threshold in 2020 or 2021.

Private debt, or private credit, is the investment of capital to acquire the debt of private companies (as opposed to acquiring equity). The term private debt is when debt from private companies is acquired by another source. Banks do participate in private debt, but to a lesser extent since the GFC due to de-risking, which is why direct lenders now also participate as a source of debt acquisition. Private debt is not traded or issued in an open market. Lending private debt can be to both listed or unlisted companies, as well to real assets such as infrastructure and real estate .

Assets under management in private debt has now surpassed $812bn, with the number of active investors in the industry currently more than 4,000.

Sources of private debt include:

Bank lending Private debt funds Collateralized loan obligations (CLOs) High-yield bonds Business development companies (BDCs) Hedge funds

Debt owed to an unsecured creditor, which in the event of liquidation, can only be paid after the claims of secured creditors have been met.

Debt owed to a secured creditor, which must be paid first in the event of liquidation. This is therefore less risky than investment in subordinated debt.

They fail to repay debt and/or interest to loan distributors. This includes missing one or more scheduled payments or the inability to complete any payments at all.

In this lesson, we explored how private debt became its own asset class after the Global Financial Crisis. From the different sources of debt to the capital structure and strategies, you now know the ways investors can allocate to private debt, and why they choose to do so.

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The private debt market has grown tenfold in the past decade with assets under management of funds primarily involved in direct lending surging to $412 billion at end-2020—spurred in part by investors’ search for higher yield.
Borrowers in this market tend to be smaller (averaging $30 million in EBITDA) and more highly leveraged than issuers in the broadly syndicated leveraged loan market—most are unrated.
Transparency and illiquidity are key risks of the growing private debt market; lenders typically lend with the intention of holding the debt to maturity, as private debt loans are often less liquid than broadly syndicated loans.
Despite these risks, private debt appears to have weathered 2020 well, as lenders quickly stepped in with amendments and capital infusions that enabled borrowers to avert bankruptcy, often in exchange for equity.
Private debt has emerged as a new frontier for credit investors in their search for yield, and for borrowers and lenders seeking closer bilateral relationships. The market has grown tenfold in the past decade. The growing investor base, a lack of available data, and the distribution of debt across lending platforms make it hard to know how much risk is in this market—and who holds it.
Listen to a synopsis of this research, read by one of our lead authors.
Assets under management of funds primarily involved in direct lending surged to $412 billion at end-2020—including nearly $150 billion in “dry powder” available to buy additional private debt assets—according to financial-data provider Preqin (see chart 1). This came as institutional investors with a fixed-income allocation (e.g., insurers, pensions, endowments, and sovereign wealth funds) have increasingly waded directly or indirectly into the market. More recently, private debt funds have been marketed as an alternative asset and are increasingly accessible to individual investors through new classes and funds. This expansion of the investor base could lead to heightened risk in the market if it leads to volatile flows of money into and out of the market.
Chart 1: The Market For Corporate Private Debt Has Grown 4x Over The Past Decade
However, as its importance grows, market data is relatively scarce and private debt (also known as direct lending) remains a lesser known corner of finance—with less transparency and liquidity than in the markets for speculative-grade bonds and syndicated loans. While the private debt market is active in both the U.S. and Europe, this report offers a primarily U.S. perspective on the market. While many private-equity-owned issuers are publicly rated and/or funded in the broadly syndicated market, this report focuses on those that rely on private debt from direct lenders. For the purposes of this article we have defined the private debt market as the direct lending market, but acknowledge that a broader definition of private debt could also encompass distressed debt, special situation, and mezzanine debt.
Who Are The Players And What’s The Appeal?
As private debt matured, more lenders emerged. Institutional investors were attracted by the prospect of higher yields relative to other fixed-income assets, higher allocations, quicker execution and expectations for consistent risk-adjusted returns. This increased supply lured borrowers and attracted more private equity sponsors, who were looking for another option to syndicated loans to fund small- to mid-market deals.
This created a business opportunity for private debt providers, including specialty finance companies, business development companies (or BDCs, which were created in the U.S. by an act of Congress in 1980 to provide capital to small and medium-sized borrowers), private debt funds managed by asset managers, collateralized loan obligations (CLOs), mutual funds, insurance companies, and banks. Many of the largest lenders in the private debt market have platforms that encompass several vehicles that hold private debt, enabling private loan deals to grow ever larger.
With more private debt lenders and larger loans available, a growing share of middle-market funding appears to be coming from the private debt market as opposed to broadly syndicated loans. While the number of middle market private equity transactions has remained relatively stable in recent years, the number of broadly syndicated loans in the middle market space has fallen sharply (see chart 2). Assuming private equity sponsors still rely on debt financing to complete acquisitions, one explanation is that middle market private equity sponsors and companies are increasingly turning to private debt markets instead of broadly syndicated markets.
In general, the private market has grown since the Dodd-Frank Act of 2010, given the cost and requirements of being a public company. From the lender’s perspective, leveraged lending guidelines in the wake of the global financial crisis of 2007-2008 led banks to reduce their exposures to risky credits, which provided opportunities for nonbank financial institutions to expand their footprints in the private debt market. Where these guidelines recommended limits of 6x leverage for broadly syndicated loans, leverage levels in private deals may go higher. While these regulatory changes have contributed to the growth of the private debt market over the past decade, regulators in the U.S. are showing growing interest in this asset class as it has grown in size and is reaching a broader base of investors.
More recently, growth in the private debt asset class has been spurred by investors seeking relative value. For example, within BDC portfolios, the nonsyndicated portion of the portfolio had an average spread that was 100 basis points (bps) wider than the broadly syndicated portion in early 2020—although this premium has been shrinking in recent years.
Borrowers in the private debt market tend to be small to middle-market companies, ranging from $3 million-$100 million in EBITDA. This market is split between the traditional middle market companies (with upwards of $50 million in EBITDA) and the lower middle market (with under $50 million and averaging $15 million-$25 million EBITDA).
While borrowers in the private debt market tend to go without a public rating, S&P Global Ratings assigns credit estimates to nearly 1,400 issuers of private market debt held by middle-market CLOs. A credit estimate is a point-in-time, confidential indication of our likely rating on an unrated entity or instrument, and from this data we can make some broad observations on the market of private borrowers. The average EBITDA for companies on which we have a credit estimate is about $30 million, and the most represented sectors are technology and health care—similar to the rated universe of broadly syndicated loans.
Among private market issuers for which we have credit estimates, more than 90% are private equity sponsor-backed, and these entities tend to be highly leveraged. From 2017-2019, more than 75% of credit estimates had a score of ‘b-’. By contrast, obligors rated ‘B-’ accounted for around 20% of broadly syndicated CLO pools in same period.
One of the central differences between the private debt market and the broadly syndicated loan market is the number of lenders involved in a transaction. Since private debt deals aren’t syndicated, borrowers work more directly with lenders. On the front end, this allows for quicker turnaround (about two months from inception to execution), and borrowers also know the pricing through their direct negotiation with the lender, instead of submitting to the syndicate market’s shifting conditions. Unlike in the broadly syndicated loan market, covenants are still written into most private loan agreements. For firms that face liquidity needs and are otherwise unable to access the public capital markets, private debt has a reputation as “bear market capital” available during periods of market stress—but at a price.
In 2020, many middle-market companies were at risk of breaching financial maintenance covenants with financial positions under pressure. Many private lenders quickly stepped-in with amendments that helped borrowers meet immediate liquidity needs. These amendments included agreements such as capital infusions, switching cash interest owed to payment-in-kind, and postponing amortization schedules that we viewed as distressed exchanges. While these transactions contributed to the elevated number of selective defaults of middle market companies during the year, they also helped to avert payment defaults, in exchange for increased equity stakes to the lender.
In the second quarter of 2020, private loan defaults in the U.S. peaked at 8.1%, according to the Proskauer Private Credit Default Index. Our universe of credit estimates showed a similar default rate of 8.4% (including selective defaults) in June 2020. Excluding selective defaults, the credit estimate default rate was lower than that of the broadly syndicated S&P Global Ratings/LSTA Leveraged Loan Index, which also excludes selective defaults. (see chart 3).
Asset managers—especially alternative asset managers—are central to the private debt market through their lending platforms. It’s not unusual for asset managers to operate lending platforms that include multiple lending vehicles, BDCs, private debt funds, middle-market CLOs, and mutual funds, thus enabling them to gradually offer ever-larger loans. Loans originated by a BDC in the lending platform may be distributed to the private debt funds, or middle-market CLOs that are managed by the same institution. With exemptive relief from the SEC, the asset manager may co-invest alongside the BDC and the private debt vehicle in the same deal, resulting in larger pieces of the deal for the same asset manager. Through its lending platform, an asset manager can allocate a loan across several of its managed vehicles, which are frequently enhanced by leverage.
Recently, we’ve seen further pairings between alternative asset managers and insurers, where the insurance company can provide a source of perpetual capital for the lending platform. Alternative asset managers place illiquid credit assets in the buy-and-hold portfolios of insurers to earn the illiquidity premium. For example, asset manager Apollo Global Management Inc. manages substantially all of annuity provider Athene Holding Ltd.’s assets, and these assets represent a significant share (around 40%) of Apollo’s assets under management. Earlier this year, Apollo announced its plan to merge with Athene.
While private debt funds have been targeted mostly toward institutional investors, several large asset managers have recently taken steps to open classes of private debt funds to accredited individual investors. As private debt has traditionally been
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