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Private debt, or private credit, is one of the fastest-growing asset classes for investors. This should come as no surprise given that private credit strategies yield an average of over 8.1 percent internal rate of return (IRR). The high returns generated by private debt investing might explain why the total volume of private credit has tripled from $200B to over $600B since 2007.
The private debt sector has skyrocketed in value due to regulatory tightening in the banking industry in the fallout of the late-2000s financial crisis. In the void left by bank lending, more and more non-bank lenders are issuing private debt that isn’t traded on public markets.
Today, private debt is an excellent vehicle for portfolio diversification that often exceeds returns generated by fixed-income indexes. However, investors should also note the risks inherent to loans, whether backed by a bank or a private issuer. To help you cut through the noise, we’ve gone over the fundamentals of private debt investing, including its various risks and benefits below.
Private Debt 101: What Is It?
We’re often asked, “what is private debt investing?” Private credit is a specialized asset class that reduces exposure to variable interest rates and allows investors to capitalize on higher yields. The downside, however, is that private debt loans tend to have longer terms, which negatively affects investors’ liquidity.
Following the most recent global financial crisis, a widespread financing void arose in which banks and their regulators made it more difficult to get approved for a loan. Enter private debt, which functions as a loan but lacks the same regulatory constraints as banks. In other words, private debt is any form of lending that is not issued by a bank or state-owned lender.
Private Debt vs. Bank Loans
The difference between private debt and bank loans is that the latter tend to have lower fees and interest rates than private lenders. This is because banks receive funding from depositors, who are their retail customers, in savings and checking accounts. Therefore, banks have a lot of funding available to convert into loans for which they pay very little interest.
Commercial banks also have the benefit of drawing from federal funds. Central banks loan to commercial and retail banks at a relatively cheap interest rate (currently 1.50-1.75%).
Now, compare institutional banks to private lenders. The latter do not have access to low-interest federal funds, nor do they have millions of depositors from whose funds they can draw. Instead, private debt lenders must acquire funding from investors who are seeking a profit, or from commercial banks who lend to them for a premium.
The Benefits of Private Debt Investing
Private debt funds have recently caught the eye of institutional investors looking to diversify their portfolio, return a higher yield, and take advantage of market dislocation. Traditionally, private debt investing was the domain of banks. However, institutional investors are now increasingly considering private debt investment strategies given their uniquely high yields.
There are a host of advantages associated with private debt investing, including the following:
- High returns: Average compensation for mature loans is 4-6 percent above the basic benchmark interest rates used between banks, with some lower-ranking loans reaching as high as 12 percent returns
- Excellent cash flow: Private debt investing provides regular income due to fixed interest payments and principal repayments.
- Lower interest rate sensitivity: Private debt is immune to long-term federal rates due to their shorter duration and floating interest.
- Increased diversification: Private debt is an alternative asset class that’s largely untethered to the performance of the traditional stock indexes—essentially, they have equity-like returns but the volatility of bonds.
Disadvantages of Private Debt Investing
Private debt investing is held back by several risks and systemic disadvantages that should be considered and weighed against its benefits. A few of the main drawbacks of private debt investing worth considering are:
- High management fees: Usually, private debt investment managers charge a higher fixed percentage fee than other funds, in addition to a fee based on fund performance.
- Illiquidity: Private debt investing generates reliable positive cash flow, but short-term sales are usually not feasible.
- Unpredictability: Private debt loan performance is still not reliably understood in the long-term. It remains uncertain how well they historically perform under financial crises.
- Capital requirements: Generally, the capital requirements for institutional investors looking to invest in private debt loans are higher than bank loans due to their comparatively low credit ratings.
- Variable returns: How well a private debt investment performs largely depends on the manager’s ability to choose a loan that will not default.
Private Debt: A Rising Star
Before 2008, private debt was considered a peripheral asset to the average institutional investor. Those days are long gone. Since then, years of quantitative easing programs in the US and abroad have inflated traditional stocks and bonds, sparking institutional interest in assets offering higher yields. Plus, new regulatory accords and capital requirements (Basel III) caused banks to tighten their belt and give rise to a credit crunch, causing investment funds to look elsewhere.
Today, more global institutional investors than not are investing in private debt. Offering a combination of low volatility and high returns, private debt is a rewarding alternative to stocks and other equities while providing immunity to systemic risk. In other words, private debt is the perfect surrogate for stocks that would otherwise expose investors to greater volatility.
Although the US private debt market cooled toward the end of 2019 (raising just over $22B in Q3), private debt investing remains one of the highest-performing alternative investment vehicles for institutional investors seeking a risk-adjusted strategy.