For some investors, traditional asset categories of stocks, bonds and cash equivalents aren’t enough to ensure a well-diversified portfolio. These individuals may want to consider turning to alternative assets in the private market space.
These are investments that don’t fall into one of the three traditional asset categories. Some of the most common alternative assets are private equity, private debt, private real estate and hedge funds.
For the most part, private market funds have been regulated much less than assets in the public market. That’s because high-net worth investors are considered to be better equipped to sustain potential losses than average investors.
In this series of articles, we are taking an in-depth look at each of these alternative assets to help you decide if they are a wise choice for you. Here, we look at private debt.
What is Private Debt?
As the name implies, private debt is simply the lending of money to a private entity.
These may be public or private companies that need financing to fund growth, optimize their balance sheet, refinance existing debt or perform a strategic acquisition. These companies often don’t have access to financing through traditional banks or debt markets, or they sometimes prefer to work with a lender who can offer more flexible terms and customized lending structures.
Most of these entities are established mid-sized companies with proven business models. They tend to fall in the $10 million to $150 million in annual sales range and outside the coverage of the major rating agencies, so they don’t usually have an official credit rating.
Regulatory reforms enacted after the 2008 financial crisis have made it more difficult for banks to lend to some of these companies, which has led to a rise in private debt as an investment.
The amount of money invested in private debt has skyrocketed over the past two decades. Assets under management in private debt funds have grown from less than $50 billion in 2000 to more than $1 trillion in 2020, according to Preqin.*
Why Invest in Private Debt?
Investors in private debt are generally seeking to obtain better risk-adjusted returns and a higher, more sustainable rate of income in comparison to publicly traded fixed income instruments.
Private debt offers a fixed return via the interest rate paid by the borrower and is generally considered to be less risky than many other types of alternative investments, such as private equity and private real estate.
Loans made via private debt are not frequently traded, which makes this type of investment highly illiquid. In exchange, investors are compensated with an illiquidity premium, or a higher yield than normal to compensate for the illiquidity.
There are several different ways to invest in private debt, including direct loans to companies. Mortgage and infrastructure debt are other options. So-called project financing infrastructure debt has become popular because it allows projects to be funded without having to be included on the company’s balance sheet.
Risks of Private Debt Investing
While private debt may carry less risk than other alternative investments, this doesn’t mean it’s risk-free. The main types of risk associated with private debt are:
- Credit risk – This is the risk that the borrower will not repay the loan’s principal and interest in full. As noted above, the major credit rating agencies generally don’t cover private debt, so it is unrated. One way to gauge credit risk is by considering the 4 C’s of credit analysis:
- Capacity: The ability of a company to service its debt.
- Collateral: The value of a company’s assets that can be liquidated should it default on the debt.
- Covenants: These may include making regular principal and interest payments, maintaining financial ratios and filing audited financial statements.
- Character: These refer to the management team’s track record and company’s governance practices
- Interest rate risk – This is the risk that the prices of fixed income securities decline as interest rates rise. Floating rate payments reduce credit risk by adjusting up or down based on a pre-determined benchmark interest rate, such as LIBOR.
- Fund level leverage – This risk arises when fund managers use leverage (or borrowed money) to gain additional exposure to private debt instruments beyond 100% of the fund’s net asset value
- Valuation practices – These vary among private debt funds, but they can have a big impact on how volatile the prices of funds are. An independent third party should be involved in valuation to help ensure objectivity.
If a business breaches the terms of its credit agreement, the lender and borrower may engage in a workout to restructure the company’s balance sheet, adjust the terms of the loan or inject more equity into the business. Investor recourse depends on prospects of the business and the quality of its balance sheet.
How We Can Help
The team at C.W. O’Conner Wealth Advisors works closely with investors to determine if alternative assets, including private placement debt, are appropriate based on goals, time horizon and risk tolerance. Call us directly at 770-368-9919 or email Cliff at email@example.com or Kevin at firstname.lastname@example.org to learn more.