Private Debt Investments

Private debt has rapidly grown into a significant alternative investment class, providing financing solutions to companies outside traditional banking and public capital markets. This growth has been particularly pronounced since the banking reforms following the Global Financial Crisis (GFC), which made it harder for banks to service small and middle-market companies.

Definition and Characteristics

Private debt refers to loans provided by non-bank lenders that are not traded on public markets. It primarily involves financing the debt of small- and medium-sized enterprises (SMEs) that seek alternative sources of capital beyond traditional banks or public markets.

Key characteristics of private debt include:

• Higher Yields: Returns are generated from charging a pre-agreed interest rate, which is typically higher than yields obtained from safer investments like government bonds or public company debt, compensating for the illiquidity and higher risk.

• Customization and Flexibility: Private debt agreements are often structured in a personalized way, tailored to the specific needs of each company. This flexibility allows companies to obtain capital under more favorable conditions and enables lenders to establish protection clauses and guarantees.

• Security: Private debt often offers security to investors through negotiated guarantees. In the event of company liquidation, debt is always paid before equity, providing a layer of protection for investors.

• Fixed Term: Unlike some other private capital strategies, private debt investment contracts typically have a fixed term.

• Illiquidity: Similar to other private market alternatives, private debt is highly illiquid, with a limited secondary market for early sale. Investors must be prepared to commit capital for multiple years, typically 5-10 years.

• Accessibility for Borrowers: Private debt is an attractive financing source for companies that may not meet the stringent requirements of traditional lenders or lack sufficient credit history to access public markets.

Types of Private Debt

The private debt market is diverse, comprising several sub-strategies categorized by the type of borrower, loan, or collateral:

• Direct Lending: This is the largest and most common strategy, involving private debt investors directly offering capital to borrowers, typically in the form of senior secured loans to small or midsize companies. Direct lending offers borrowers flexible terms and faster access to capital. Its floating interest rates (at a premium to risk-free rates) can protect investors from inflation and duration risk.

• Mezzanine Debt: A hybrid form of financing that combines elements of debt and equity. It is typically unsecured and subordinated to senior secured debt but ranks above equity in the capital structure. Mezzanine loans offer higher return potential for assuming greater risk and may include equity participation options like warrants or conversion rights.

• Distressed Debt: This strategy involves investing in the debt of companies facing financial distress or bankruptcy. It is a high-risk, potentially high-return strategy that often requires specialized legal and operational expertise, with investors actively involved in restructuring and reviving the company.

• Venture Debt: Private funding provided to start-ups or early-stage firms that may generate small or negative cash flow. Companies seek venture debt, often as a line of credit or term loan, to obtain additional financing without further diluting shareholder ownership.

• Unitranche Debt: A combined or hybrid loan structure blending different tranches of unsecured and secured debts into a single loan with a single, blended interest rate. It is ranked between senior and subordinated debts.

• Specialty Financing: A broad category encompassing loans made to consumers or asset-based finance strategies that target assets (e.g., real estate, infrastructure, equipment, receivables) rather than operating companies.

How to Invest

The investment thesis for private debt is to capitalize on the growing demand for capital from companies underserved by traditional bank lending and public markets, while generating competitive yields for investors. Investors can access private debt either directly by lending to a specific operating company or indirectly by purchasing an interest in a fund that pools contributions to invest in a set of operating companies.

A common vehicle for investing in private debt, particularly for retail and institutional investors, is through Business Development Companies (BDCs). Most BDCs elect to be treated as a regulated investment company (RIC), providing for pass-through tax treatment of net income, similar to REITs. BDCs typically provide financing solutions to U.S. middle-market businesses, primarily through senior secured, floating-rate loans. They are required to invest a significant portion of their assets (no less than 70%) in private U.S. companies or small public U.S. companies. BDCs offer enhanced disclosures and are valued by independent valuation agents, providing some transparency. Funds like the BlackRock Private Credit Fund (BDEBT) are examples of non-traded BDCs that provide access to directly-originated, senior-secured corporate debt investments.

Risks in Private Debt Investment

Despite its advantages, private debt carries specific risks:

• Illiquidity Risk: The lack of a robust secondary market means investors are committed for the long term, making it difficult to exit positions quickly.

• Credit Risk: The primary risk is that the borrower may default on their obligations, requiring thorough assessment of the company's financial health and ability to generate revenue.

• Valuation Challenges: Private credit operates in a more opaque environment than public credit. Detailed financial information may not be publicly accessible, and valuations often rely on third-party assessments, which can be subjective and lead to discrepancies. Regulators are increasing scrutiny on valuation policies.

• Regulatory Scrutiny: The private credit industry is facing growing regulatory attention, with concerns raised about its opaque nature, potential liquidity mismatches, and overleveraged portfolios. While some SEC efforts to increase disclosure have been challenged, regulators are expected to continue focusing on conflicts of interest and valuation practices.

• Conflicts of Interest: Conflicts can arise from deal sourcing arrangements (e.g., bank partnerships), or when a firm manages funds across multiple layers of a company's capital structure (e.g., both debt and equity stakes), potentially leading to misaligned priorities.

• Economic or Credit Cycle Risks: Private debt is susceptible to broader economic downturns, which can increase default rates.

• Operational Risks: These depend on the management of the loan, including oversight of covenants and company criteria.

• Payment-in-Kind (PIK) Arrangements: While deferring payments, PIK arrangements increase a borrower's debt burden over time, raising the risk of default, especially for struggling companies.

Historical Performance vs. Traditional Credit and Diversification Benefits

Private debt has experienced significant growth, with assets under management (AUM) reaching approximately $1.2 trillion, representing about 9% of all corporate borrowing. This growth has been driven by its ability to offer distinct advantages compared to public credit.

Private credit typically offers higher yields to compensate for its illiquidity and higher risk profile. For example, while investment-grade corporate bonds may yield 3–6%, private credit strategies often deliver 8–12% or more in annual returns. Over the past decade, private credit has outperformed high yield bonds by approximately 150 basis points. While private credit may involve companies with weaker fundamentals (e.g., weaker interest coverage, higher leverage, slimmer EBITDA margins) compared to public markets, investors have historically been rewarded for this additional risk.

Private debt plays a vital role in enhancing portfolio diversification. It offers unique investment opportunities in areas underserved by conventional financial institutions, providing exposure to privately originated credits with attractive returns and low correlations to public markets. This low correlation provides an additional layer of protection against market turbulence, especially as traditional asset classes like stocks and bonds show increasing correlation.

Furthermore, private credit, particularly floating rate direct lending strategies, has demonstrated durability through various market cycles and can serve as a hedge against inflation and interest rate uncertainty. The floating rate nature of these loans means interest payments adjust upwards with prevailing rates, allowing private credit to benefit from rising interest rates and even outperform traditional fixed income in recessionary periods that may follow. Private credit investments facilitated through Business Development Companies (BDCs) can also offer potential tax advantages, as BDCs are often exempt from federal tax on distributed income at the corporate entity level, protecting shareholders from double taxation.

Industry Associations and Data Providers

Key data providers and research organizations in the private debt space include Cambridge Associates, which provides industry-standard benchmarks for private investments, including private credit. Preqin is another prominent source of data on private capital AUM