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Private debt investing entails investing in loans to private companies through various vehicles and securities. This type of investment differs greatly from public debt for various reasons. Firstly, public debt investing involves lending money to public companies or governments. Although sometimes public companies issue private debt, known as private placements.
Second, public debt, depending on the borrower, can have a very liquid secondary market compared to private debt. In fact, some private debt instruments have no secondary market whatsoever. However, some investments do allow for an investor to sell their stake before maturity. But the seller will probably have to sell at a large discount.
Private debt investing has become more popular since the global financial crisis of 2008. Banks were imposed stricter regulations when it came to lending. Laws and regulations such as the Dodd-Frank Act and Basel III were implemented after the crisis in the hope of averting future issues. So, companies turned to other non-banking institutions to find funding.
Source: TradingEconomics
Private Debt Investing Definition
Most private debt is organized through private debt funds, or special purpose vehicles, set up to finance the activities of specific projects or business areas. The borrower may be a private or public company, but the debt instruments are not public.
This means there may not necessarily be a secondary market to trade this security. A fund may establish its investment strategy by lending medium-term loans to companies in a specific industry. The investors of the fund are seeking exposure to revenues from that specific industry and are interested in the higher premiums paid on the loans.
Private debt will usually demand a higher interest rate on the loan mainly for the reason that investors may not be able to divest easily if they are able to at all. Investors, therefore, take on the extra risk in exchange for a higher reward.
Private Debt Investing Strategies
For the most part, private debt investing strategies are achieved by investing in a specialized private debt fund or special purpose vehicle. However, some private debt investing strategies involve buying debt issued privately by companies.
This privately issued debt is known as a private placement, where a company usually uses a bank to find investors willing to purchase these securities directly. The main advantage of buying private debt directly is that the investor will only pay a commission at the time of buying.
Whereas, buying into a private debt fund implies that the investor will pay ongoing yearly management fees. Having said that, a fund allows for risk diversification as the fund will invest in various companies and debt issuance which can justify the fee.
Private Debt Funds
Let’s take a look at the different types of investments a private debt fund can make.
How private debt funds invest:
- Direct Lending: This involves making loans to mid-sized companies directly. The loans may involve a revolving credit line facility or second lien loans. These loans may involve financing for a specific project and are usually not longer than medium-term maturities.
- Mezzanine Debt: Is a subordinated type of debt with various levels of seniority. They often also have preferred equity features which increases the risk but also the value. And they are often used in leveraged buyouts.
- Infrastructure Debt: These loans are used to finance new projects or for the maintenance of existing ones. The maturities of these loans tend to be long-term, for example, 30 years, as the useful life of these assets is very long.
- Real Estate Debt: Most often these debt investments are made by lending directly to the real estate developer. Here a fund will usually have enough capital to invest in a multitude of projects and therefore decrease the overall risk of the fund.
- Distressed Debt: Involves investing in the debt of companies that as the name suggests are in financial difficulty. The debt is usually purchased in the secondary market. Although a public company may have issued the debt and it may have even quoted it publicly, the distressed situation means it takes on the vest of private debt.
- Special Situations: Is somewhat similar to distressed debt. However, here the investor may take on debt from a company in an effort to gain control. The fund manager may issue direct origination of distressed debt when he feels there is a dislocation in value.
- Venture Debt: Startups that seek to finance growth and capital expenses may seek loans as a way to avoid diluting their ownership. These loans are usually issued to companies with venture capital backing. The loans also help extend the runaway of the company to allow more time to reach an IPO.
Peer-To-Peer Lending
Although you won’t usually find peer-to-peer lending on any private debt investing list, I feel this is an excellent example. Peer-to-peer lending has all the features of private debt investing. It is illiquid, and it has privately placed loans to a borrower. In return, you can get higher yields than you would on public debt.
There are various peer-to-peer platforms, and as it is a relatively new space there are bound to be some nefarious players. So, always do your research and preferably go for one that has been around for a number of years.
The main fields of peer-to-peer are real estate projects and personal loans. With the real estate project, the platform acts as an accumulator of funds for a developer’s project. While the personal loan field can vary in how you participate in a loan.
Some platforms match lenders and borrowers directly, while others manage the money they receive from lenders and then distribute the cash independently to the borrowers.
How to Get Started in Private Debt Investing
Possibly the easiest way to gain exposure to returns from private debt investing is by allocating cash to a specialized fund. There are many on the market here is a list of some of the biggest in the market by target size:
Your broker or bank should be able to offer these investments if they have the necessary sophistication. Or you may have to open an account specifically for this type of investment at an institution that offers this type of asset.
Ultimately there are also other ways of gaining exposure to private debt such as researching local businesses and real estate developers. However, that can be extremely time-consuming with a steep learning curve. In our opinion, the easiest way is to leave it all in the hands of experts.
People who have the knowledge, know-how, and connections to streamline the process. Also, pooling your money with other investors means you are more likely to have invested in a diversified portfolio of private debt.
Wrapping Up
The alternative investment space offers many types of assets that have a low to no correlation with the returns of traditional assets. Adding securities that have a low correlation to stocks and bonds helps bring down the overall risk level of your investment portfolio.
In addition to private debt investing you may want to consider other alternative assets such as real estate, Bitcoin, or hedge funds. Bear in mind that you should always evaluate as best as possible your risk reward ratios. To that aim and to discuss the appropriateness of an investment for you, always speak to your financial advisor.
Overall, private debt investing is considered a relatively low risk with slightly higher returns than other more liquid fixed-income securities. If you are looking to gain exposure to riskier assets and other alternative investments, you may want to consider doing so in a self-directed IRA.
IRA accounts allow investors to watch their investments grow in a tax-enhanced environment. Many companies offer their services to IRA investors. We have come up with a list of companies and rated them under various aspects. You can read the reviews on the top self-directed IRA companies here.
Gino D'Alessio is a Broker/Dealer with over twenty years experience in various OTC markets such as Bonds, FX and Derivatives. Currently a Financial Markets and Investments Writer & Analyst
