The evolution of the Private Debt asset class: focus on private lending

First and foremost, Private Debt is a form of financing for companies that need liquid assets. This form of financing can come across in a variety of forms; it includes any debt owned by or extended to privately held firms, but most generally it consists of non-bank institutions lending to private companies or buying loans on the secondary market. A company might not have the funds available to support its desired expansion and in this case, therefore, debt may be the preferred funding option.

Corporate lending has traditionally been the business of commercial banks, but the 2008 – 2009 Global Financial Crisis (GFC) created an opportunity for non-bank private asset managers to replace bankers as primary lenders with a large number of middle market businesses, primarily in the United States. Indeed, while banks continue to hold a key advantage over asset managers by having lower cost of funds, new regulations made middle market corporate lending more expensive and restrictive for most banks. The aforementioned regulations consisted of increased capital requirements and tighter lending regulations that caused the subsequent weakening of banks’ relationships with their borrowers. The slow economic recovery found many middle market companies seeking debt capital for growth or refinancing. As banks steeply decreased their lending activity, these companies found asset managers, regulated by the SEC, to be willing lenders since they are not subject to the same regulations as the banks. As a direct consequence of the GFC, many asset managers started participating in direct lending and recruited experienced credit professionals from banks that either went bankrupt (e.g. Bear Sterns, Lehman Brothers) or had seen their activities severely limited. Another driver of private lending has been private equity: the proliferation of direct lending by experienced asset managers has provided an alternative and preferred source of funding to private equity sponsors. 

To fill the gap created by the growth of private equity and the restrictions on bank lending, private credit funds have stepped in. According to data from Preqin, the private credit asset class expanded exponentially from $37 billion in 2004 to $261 billion in 2019. In this period, direct lending appeared to be particularly attractive to investors. Firstly, yields of direct lending middle market loans are very attractive, ranging from 6% (least risky senior loans) up to 12% (riskier subordinated loans). Secondly, private credit funds have other advantages such as capital preservation, the portfolio diversification, the downside protection, the cash coupon and the short duration. The capital preservation is based on private credit’s position in the capital structure, which is more senior than publicly issued debt and common equity. The diversified exposure means that private credit funds can give investors access to a wider variety of industries and types of deals than other strategies. More generally, diversification is a key aspect of portfolio building, both across and within asset groups, and has been shown to help increase risk-adjusted returns. The downside protection refers to lower default and higher recovery rates over time as well as the ability to generate current revenue, usually on a quarterly basis, implying cash coupons. Lastly, the short duration refers to the fact that the average life of a direct loan has been approximately three years, much less than its reported maturity. This is due to refinancing for example as a result of the borrower being acquired by another company. This essentially means that direct loans are more liquid. 1/3 of the loans pays off every year resulting in a three-year lifespan effectively. This liquidity profile makes them attractive compared to private equity funds, whose effective life is on average seven to nine years.

From the perspective of private equity funds, this asset can not be avoided since it is a perfect distribution method, because a single loan can fully finance an acquisition. This form of structure can be easily arranged, does not always involve multiple lenders, and is competitive in terms of cost. Unlike collateralized loan obligations (CLOs), these facilities do not need ratings, so lenders face no ratings-based limitations on their lending. 

The private debt arms of both Apollo and Blackstone have reported that they expect growth in the private credit sector and are targeting loans in the billions. However, if equity and credit funds operated by a Private Equity company (e.g. Apollo, Blackstone) invest in the equity and debt of the same company, conflicts of interest may arise. In theory, for example, private credit investors may face the risk of unforeseen losses in the event of debt restructurings that are unduly beneficial to equity holders. 

Cliffwater Direct Lending Index (CDLI) seeks to measure the performance of US middle market corporate loans as represented by the asset-weighted performance of the underlying assets of Business Development Companies (BDCs). As of September 30, 2020, the CDLI (with a yield of 8.76%) represented over $115 billion in direct loan assets covering over 6,000 loans from public and private BDCs managed by the largest direct lending asset managers.

Instead, for the traded, non-investment-grade credit there are two types of measures: the S&P/LSTALeveraged Loan Index measures the performance of broadly syndicated bank loans and is the most common index currently used to benchmark direct loans and other private debt strategies. The most common index used to benchmark high-yield bond portfolios is the Bloomberg Barclays High Yield Bond Index. High-yield bonds are non-investment grade, like direct lending, but they are usually traded actively, not buy-and-hold, and have fixed, non-floating rate coupons.

Source: Private Debt, opportunities in corporate lending, Stephen L. Nesbitt, Wiley 2019

As seen in the graph, with a 14.1% annual return, the Private Equity Index was the highest performing asset class, which was 4.8pp above the Russell 3000 Index return on US public equities. The 4.8pp gap contrasts favourably with the 3% excess return per annum targeted by most institutional investors for private equity over public equity. 

As with any asset class, it is crucial for investors to consider the potential risks of investing in private credit. These include the risk of capital, relative illiquidity and economic cycles. Firstly, there is a risk that committed capital will be lost as with almost any investment. Secondly, while private credit investment represents an excellent complement to other private market strategies, it is not readily tradable, and it could take up to several years to exit or mature. Finally, the effect of economic cycles on the expected output of the underlying investment must be considered.

In conclusion, the advantages private credit has, make it highly attractive as evidenced by its rise in recent years. This trend is likely to continue and thus diving deeper into the mechanics of it is advised to any reader wanting to stay on top of important trends in finance.

Authors:

Ilaria Zerbi

Beatrice Lazzarin

References:

Private Debt, opportunities in corporate lending, Stephen L. Nesbitt, Wiley 2019

https://www.institutionalinvestor.com/article/b1k369v2lg69qt/High-Yield-Was-Oxy-Private-Credit-Is-Fentanyl

https://www.bis.org/publ/qtrpdf/r_qt2003v.htm

https://pe-insights.com/news/2020/10/22/asset-managers-in-300bn-drive-to-build-private-lending-funds/

http://pages.harbourvest.com/rs/509-TRI-465/images/Private_Credit_F_A4.pdf