Private debt explained, and why it continues to attract investors

29 September 2022
Private debt is an enormously popular alternative investment asset, trailing only private equity and venture capital in volume. Financial analysts predict private debt assets under management will reach US$2.6 trillion by 2026.

Given its track record and upward trajectory, we asked two Vistra experts to explain the basics of private debt, why institutional investors find it compelling and what to expect in the future. This article presents their answers, which have been edited for length and clarity.

Navita Yadav is managing director and global head of capital markets for Vistra and is responsible for loan market solutions. Gulsey Torenli is director and head of product and onboarding for private equity in North America and the global business owner for private equity.

What is private debt and what are some examples of it?

Navita: Private debt, which is sometimes called private credit, involves loans made by private companies rather than commercial banks. Here, “private” refers to institutional and individual investors, who effectively act as a lender. The borrower is typically a company in need of cash to achieve specific goals, such as developing real estate, building infrastructure or improving operations.

Private debt can include direct lending, mezzanine funds, distressed debt and special situations. As banks continue to tighten financing, cash-strapped borrowers have increasingly flocked to private debt funding. Borrowers include small and medium-sized enterprises that don’t have ready access to bank financing and businesses that need funds quickly.

How do private debt funds differ from or complement private equity and venture capital funds?

Navita: Unlike private equity funds, investors don’t use private debt funds to own shares in a company. As with most loans, borrowers pay lenders back with interest over time, according to specified terms.

As we pointed out in an article on private debt trends, private equity funds often have a small portion of debt in their portfolio as a way to diversify assets. Increasingly, we’re seeing private equity funds transition to being high-volume debt providers or managers of a book of loans.

What are some of the advantages of private debt funding?

Gulsey: Traditional equity and fixed income markets don’t necessarily deliver returns as attractive as private debt. And as Navita mentioned, banks are increasing loan requirements, which often favours large corporations.

Navita: Compared to traditional asset classes in the public market, investors appreciate private debt’s broader options and flexibility. Private debt includes private debt funds, hedge funds, high-yield bonds, collateralised loan obligations (CLOs) and more. When looking at private debt compared to private equity or venture capital, private debt is often considered less risky and more reliable.

Another benefit of private debt is that deals are privately negotiated. Sometimes arrangements can be open-ended, while private equity funding is typically closed-ended.

How are current economic realities, including rising interest rates, influencing the growth of private debt funding?

Navita: Despite a brief decline at the height of the pandemic, private debt has offered steady returns for more than a decade.

Historically, private debt has proven to be resilient during tough economic times when interest rates are rising due to inflation and other factors. Because private debt loans tend to have a floating rate, they may have lower risks and involve a shorter duration compared to traditional fixed-rate loans.

Gulsey: Some private debt deals also involve financial covenants, which can prohibit certain actions by borrowers that might increase risks for lenders. Other terms might include a senior secured structure — meaning senior debt has priority over junior — or call protection, which places buy-back restrictions on the issuer. Essentially, investors can establish from the outset that loans pay high margins and have built-in risk protections.

Is loan administration for private debt funds different than for other funds, and if so, how?

Navita: Loan administration has become an integral part of private debt offerings. We have also seen more demand for this service in private equity and venture capital transactions. Requirements vary depending on how the fund is structured and reporting obligations.

In a private equity deal, because the fund has an ownership stake in a company, the loan administrator must be directly involved in the investment. Generally, that’s not the case with private debt funding. Therefore, it’s critical for private debt loan agreements to be carefully crafted.

Private debt funds can include asset-backed loans or loans that are highly structured with paying collateral. Loan administrators must ensure they have the right safeguards and processes in place to handle complex loan terms and potential defaults or delinquent payments. Outsourcing the loan administration is one way that managers look to improve efficiency throughout the life of the investment.

Gulsey: Investors want to ensure that fund managers perform extensive due diligence, oversee credit quality and focus on downside protections. It’s also important that the loan administration and fund administration teams align the reporting for the underlying loans, which in turn will be presented on the private equity fund’s financial statements.

How is technology changing or expected to change the private debt market and private debt fund administration?

Gulsey: Private equity debt fund managers expect to be able to sync technology platforms for loan and fund administration, which minimises manual errors. In addition, they look for loan administrators that can provide a secure platform that offers dashboards that investors can view.

Navita: The operational infrastructure for administering loans is complex, and technology is critical to helping managers ensure accuracy, scalability and replication. Relying on manual processing in an environment of constantly changing rules and regulations is challenging and complicated. For that reason, we are seeing even large private fund houses considering outsourcing. The time, costs and efforts required to administer funds can be a distraction, taking the focus away from an asset manager’s core business. Hence, we are seeing a growing appetite for automation and increased adoption of new technologies in private debt.

What are some private debt trends you’re seeing, and what do you feel is in store for this market?

Navita: In the immediate term, we may see rising interest rate commotion in the private debt market. However, given that private debt is mostly floating rates, the asset class is largely protected from interest-rate and inflation risks. I also believe that direct lending strategies will continue to be in vogue given the tightening liquidity scenario. Private credit financing of private equity will gain momentum. All told, I think we will see investors remain enthusiastic about the asset class.

Gulsey: More competition among private debt lenders is also resulting in larger loans becoming available. I think J.P. Morgan rightly pointed out that companies that have evolved into middle-market enterprises over the last couple of years are now looking to finance their growth. Private debt, as opposed to syndicated loans, can help them do it faster.