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.
It’s important to investigate the various types of alternative investments available to you as an investor. Below, you will be able to take a much closer look at the world of private debt.
Table of Contents
- 1 What is Private Debt?
- 2 Investing in Private Debt vs Public Debt
- 3 Investing in Private Debt vs Private Equity
- 4 Benefits of Investing in Private Debt?
- 5 Risks of Investing in Private Debt
- 6 Ways of Investing in Private Debt
- 7 Qualifications for Investing in Private Debt
- 8 What to Consider Before Investing in Private Debt
- 9 How CW O’Conner Helps With Investing in Private Debt
- 10 Download our 2023 Financial Planning Guide
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.*
Investing in Private Debt vs Public Debt
When considering investment options, it’s vital to understand the fundamental differences between private debt and public debt. Both are mechanisms by which entities raise capital. However, each caters to different types of investors, comes with unique risks, and offers varying returns.
Public debt, commonly referred to as government or sovereign debt, represents the obligations of a government. These debts often come in the form of securities, such as bonds or treasury bills, which are sold in public markets. Governments use the funds raised from these securities for various purposes. This might include financing deficits, developing infrastructure, or stimulating economic growth.
Private debt refers to loans or credit extended to private corporations or entities, outside of the traditional banking system and public markets. Unlike public debt, which is issued by governments and often traded on public exchanges with high liquidity, private debt is less regulated, typically more illiquid, and can offer higher returns to compensate for its elevated risk profile.
Choosing between private and public debt largely depends on your investment goals, risk tolerance, and desired returns. If you’re seeking safety and liquidity, public debt might be more appealing. However, if you’re an investor searching for higher yields and are comfortable with higher risks, then private debt may be a more suitable choice
Investing in Private Debt vs Private Equity
In the alternative investment landscape, both private equity and private debt have garnered attention from investors looking for avenues beyond traditional asset categories. While they share some similarities – primarily, they both operate in the private market space – they are inherently distinct in terms of their structure, risks, and potential rewards.
Private equity (PE) involves investing in the equity (or ownership) of companies that are not publicly listed on a stock exchange. The main objective is to acquire a significant stake in a company, influence its management and strategic direction, and eventually exit the investment at a profit. Exits usually occur through a sale to another company, a listing on a public stock exchange, or a sale to another private equity firm.
PE investments can range from venture capital (investing in startups and early-stage companies) to buyouts (acquiring mature, established companies). The goal is to drive company growth and increase its value over time.
Instead of taking an ownership stake, as with private equity, private debt lenders receive interest payments and eventually the return of their loan’s principal. Again, this form of financing caters to companies seeking financing outside of traditional banking systems. With private debt, companies can be given more favorable terms or access to capital they would not otherwise have through conventional channels.
Both private debt and private equity can be appealing to accredited investors and qualified purchasers. However, like with all investments, diversification must be considered. It’s often worth an investor’s time to consult with a financial advisor to balance their portfolio, understand the potential risks and returns of each investment type, and ensure that their financial decisions align with their long-term goals and risk tolerance.
Benefits of Investing in Private Debt?
Private debt offers are generally considered to be less risky than many other types of alternative investments, such as private equity and private real estate. Additionally, private debt provides other key benefits, including:
Steady Income Streams: Private debt typically offers regular interest payments, providing investors with a predictable and consistent income stream.
Diversification: Investing in private debt can serve as a counterbalance to traditional investments like stocks and bonds. This can aid in reducing a portfolio’s overall risk.
Higher Potential Returns: With an illiquidity premium, private debt can provide higher yields compared to similar-duration public bonds.
Seniority in Capital Structure: In the case of a company’s liquidation, debt holders usually get preference over equity holders. This can potentially reduce the risk of capital loss.
Protection Through Covenants: Private debt agreements can come with protective covenants. These offer lenders certain controls or restrictions on borrowers, minimizing risk.
Less Competition: Fewer institutional investors operate in the private debt space compared to the public markets. As a result, private debt can have more favorable lending terms.
Benefit from Regulatory Changes: Post-financial crisis regulations have made it harder for banks to lend to mid-sized entities. This has created more opportunities for private lenders.
Flexible Investment Structures: Investors can tailor lending terms, duration, interest rates, and other factors to fit their risk-return profile.
Inflation Hedge: Interest rates on some private debt can be tied to inflation, protecting the real value of returns.Limited Market Volatility Exposure: As private debt is not traded on public exchanges, it remains insulated from the daily fluctuations of the public markets.
Risks of Investing in Private Debt
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 the company’s governance practices
- 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 the prospects of the business and the quality of its balance sheet.
Ways of Investing in Private Debt
Diversifying your investment portfolio with alternative investments can potentially yield higher returns, especially when venturing into the realm of private debt. Below, you can review a list of ways to invest in this often lucrative yet intricate asset class:
Direct Loans to Companies: The most straightforward way to invest in private debt is by providing direct loans to private entities. Typically, this involves lending to mid-sized companies that may not have easy access to traditional bank financing. Such an investment requires a deep understanding of the borrower’s business model, financial health, and the industry in which they operate.
Mortgage Debt: Another avenue for private debt investment is through private mortgages. Unlike traditional mortgages sourced from banks, private mortgage lending is often sought by borrowers for its speed and flexibility. Investors can either lend directly to borrowers or invest in a fund specializing in private mortgages.
Infrastructure Debt: Infrastructure debt provides financing for substantial projects like bridges, roads, and power plants. The long-term nature of these projects, coupled with their significance for public welfare, can make infrastructure debt a stable and attractive investment.
Project Financing Infrastructure Debt: Growing in popularity, project financing allows large-scale projects to secure funding without the obligation appearing directly on the company’s balance sheet. This off-balance-sheet financing means the debt isn’t directly tied to the company’s broader financial health, providing a measure of insulation for investors against potential corporate downturns.
Syndicated Loans: Rather than a single lender providing a large loan to a borrower, syndicated loans involve a group of investors collectively financing a loan, often coordinated by a lead bank. This shared approach reduces individual risk and allows investors to participate in larger deals they might otherwise not access independently.
Private Debt Funds: For those who wish to avoid the intricacies of direct lending, private debt funds offer an alternative. These funds pool resources from multiple investors to invest in a diversified portfolio of private loans. Managed by professionals, they can provide an easier entry point for newcomers to private debt investment.
Qualifications for Investing in Private Debt
Investing in private debt can be complex and may require a variety of certain qualifications. Generally speaking, the following are some of the common qualifications for investing in private debt:
Accredited Investor or Qualified Purchaser Status: Many private debt investments are open only to accredited investors or qualified purchasers. To qualify as an accredited investor, you will need a net worth of $1 million or more, either individually or jointly with a spouse (not counting the value of your primary residence), or an annual income of $200,000 (or $300,000 combined with a spouse) over the past two years with the anticipation of earning the same amount (or greater) in the present year. To be considered a qualified purchaser, you will need to have an investment portfolio worth $5 million or more.
Minimum Investment Amount: Private debt investments often have higher minimum investment amounts than publicly traded securities. The minimums can vary widely but are often in the range of tens to hundreds of thousands of dollars or even more.
Duration Commitment: Private debt often involves longer investment horizons than public securities. Investors may need to be prepared to have their capital locked up for multiple years.
What to Consider Before Investing in Private Debt
Investing in private debt requires a thorough understanding of the risks involved and a keen eye for due diligence. Consider the following before getting involved:
Research: Before investing in private debt, examine potential borrowers’ financial health and business models. Understand market conditions that may influence your investment. Being well-informed is essential before putting any of your assets at risk.
Diversification: Like with any other investment, you don’t want to put all your eggs in one basket. Diversifying within the private debt sphere can help mitigate risks.
Expert Counsel: Private debt can be intricate. Enlist the expertise of financial advisors or firms specializing in this area. Their insights can help shape your strategy and avoid pitfalls.
Liquidity Needs: Private debt investments can tie up your money for extended periods. Ensure you’re financially comfortable with this level of commitment and understand the challenges of converting these investments into cash swiftly.
How CW O’Conner Helps With Investing in Private Debt
At C.W. O’Conner, we believe in fostering relationships built on trust, transparency, and aligned understandings. Investing in alternative investments like private debt requires a specialized approach, and our team is committed to ensuring that you’re equipped with the knowledge and tools to make informed decisions.
With years of experience and a keen understanding of the financial landscape, our team is uniquely positioned to guide you through the complexities of these investments. We take the time to understand your individual goals, your investment horizon, and your tolerance for risk, ensuring that every recommendation we make aligns with your overall financial plan.
Reaching out to us is the first step in embarking on a tailored investment journey. By choosing to connect with us, you’re not just sending an email or making a call; you’re initiating an ongoing dialogue about your financial future. Whether you have questions, concerns, or simply wish to understand more about private debt and other alternative investments, our team is here to offer our insights and expertise.
The opinions and analysis expressed herein are based on C.W. O’Conner Wealth Advisors, Inc. research and professional experience and are expressed as of the date of this report. Please consult with your advisor, attorney and accountant, as appropriate, regarding specific advice.
Editor’s Note: This article was originally published in November of 2022. It has been updated to provide more information to visitors.