Software designed to help emerging VC and PE firms growFIND OUT MORE
It may not be the largest private capital strategy, but private debt has seen an exciting jump in popularity in the last few years. In 2022, private debt funds raised $200.4 billion, up from $184.8 billion in 2019.
So what is private debt, and what’s behind its growth in the institutional investing space? Let’s break down private debt’s definition, fund structure, recent growth, and more.
Private debt – also known as private credit – is a private capital strategy in which investment managers and institutions invest by making private, non-bank loans to companies. These loans are not available via publicly traded markets, and they generate returns for investment managers and their private debt fund investors via interest payments.
Private debt emerged as a prominent investment strategy in the aftermath of the Global Financial Crisis in 2008. This period marked a significant shift in the lending landscape, with traditional banks tightening their lending standards and reducing exposure to riskier loans. This gap in the market paved the way for private debt funds to become a key player in providing alternative sources of lending. Private debt has now established itself as a distinct asset class, offering a diverse range of lending options and attracting a substantial investor base.
Private debt funds have much in common with other private capital strategies such as private equity and venture capital. For example, it’s a highly illiquid investment with long lockup times for investors’ capital. However, private debt as a strategy is seen as slightly less risky than equity investments, partially due to capital structure and due to the ability to highly customize the risk profile of a private debt investment.
The lifecycle of a private debt fund is quite similar to private equity, but fundamental differences do exist. In the fundraising stage, private debt managers typically target institutions like pension funds, university endowments, or family offices. However, some high-net-worth individual investors are also drawn to the asset class. The average-sized private debt fund in 2022 raised $964 million.
Once fundraising has closed and the fund enters the investment period, the private debt manager seeks out investment opportunities and calls investor capital when it finds the right deals. Rather than buying equity in the portfolio companies they target, private debt funds instead make an investment by setting up a loan.
Just as with a private equity fund, a private debt fund’s lifespan averages around seven to 10 years, and investors can count on the high illiquidity that accompanies such a timeframe. In the final few years of the fund, winddown begins, and the private debt manager will stop seeking new investments while letting their various investment repayment periods run out. At the closing of the fund, final returns are paid out and investors recover the full liquidity of their investment.
Private debt funds adopt a range of investment strategies to cater to various investor needs. These strategies include direct lending, venture debt, and special situations. Each strategy offers unique risk and return profiles, aligning with different investor objectives. The capital for these funds is sourced from various channels, including Collateralized Debt Obligations (CDOs), Business Development Companies (BDCs), and hedge funds. These sources provide the necessary liquidity and financial backing, allowing private debt funds to offer tailored lending solutions to their clients.
The allure of private debt investments lies in their diverse risk/return profiles. Strategies like direct lending generally offer lower risk but also lower returns, making them attractive for conservative investors. On the other hand, ventures like mezzanine debt carry higher risk, potentially leading to higher returns. This variety allows investors to choose strategies that align with their risk tolerance and investment goals. Understanding these profiles is crucial for investors to navigate the private debt landscape effectively and make informed investment decisions.
Debt sits above equity in the private capital structure. This means that if a company were to declare bankruptcy, its debts are paid out before equity, making it less risky of an investment overall. Within each level of debt in the capital structure, there are a variety of debt vehicles and different levels of distress/risk as well as different loan terms based on the borrower’s status.
The term “senior debt” describes loans that are prioritized as first to be repaid in the event of the borrower’s bankruptcy. Since senior debt has the highest priority, it is therefore the lowest risk. As a result, senior debt typically offers lower interest rates, aka a lower return profile for the investor – but also a lower risk profile since the borrower is seen as favorable. Senior debt is most often secured, meaning that it’s tied to certain assets as collateral in the case that the company cannot make repayment.
While still sitting above equity, mezzanine or junior debt describes credit investments that have a higher risk profile than its senior debt counterpart. In the event of the borrower’s bankruptcy, it is paid out after senior debt. Because of this, its higher risk could mean a higher reward for the lender in the form of higher interest rates and more stringent loan terms. Mezzanine financing is increasingly popular with mid-marketing companies in recent years.
Private debt loans can take many forms, but a few of the most common loan structures are as follows.
Part of the reason private debt is experiencing a surge in popularity over the last several years likely can be attributed at least in part to its varying classifications and types. With many options to choose from, there is a private debt niche that works best for every institutional investor.
With the many structures and vehicles of private debt that are available, private debt managers and their investors have many different applications for carrying out their private debt investments. Here are some of the more common private debt scenarios that market participants rely on.
Private debt as an asset class has exploded since 2000. But market factors have shifted significantly over the past few years – thanks to Covid-fueled economic instability, global conflicts, climbing interest rates and beyond. Through all of it, private debt, just like private capital in general, has seen its impressive growth sustain. There are several factors behind its continued growth.
Private debt has become increasingly popular among investors for several compelling reasons. Its reputation as a low-risk investment relative to other alternative asset classes makes it a preferred choice for many. Additionally, private debt offers attractive risk-adjusted returns, especially in low-interest-rate environments. Investors value the portfolio diversification it provides, along with its low correlation to public markets. These characteristics, combined with the potential for predictable and contractual returns, make private debt a lucrative and strategic investment option in the diverse world of private capital.
While the number of private debt deals carried out has shrunk, the average size of deals has grown considerably. The U.S. has seen over $50 billion in unitranche loans sized at $1 billion or larger since September 2019.
Private debt hit its stride as we entered a nearly 15-year period of extremely low interest rates and investors sought investments that would provide the returns they needed at an acceptable risk level. Even as interest rates are climbing again, private debt’s flexibility and differing levels of risk and return by class of debt offers permanent appeal. There’s always a debt strategy that fits the market conditions, whatever they may be.
As rates rise, interest in private debt doesn’t necessarily dissipate since managers can turn to a floating interest rate. While this raises costs for borrowers, it does raise the potential for higher returns for investors.
Private debt first took hold in the U.S., but has been seeing increased adoption in Europe and Asia recently. One-fifth of all private debt deal activity since 2019 has occurred in Europe, and APAC’s private debt AUM has grown 195% over the last five years.
With all the growth the private debt space has seen in the last few decades, exciting developments are on the horizon for this industry. What are some of the key private debt trends to watch for?
Tightened regulations are keeping banks away from leveraged loans, pushing companies of all sizes to private debt as an attractive alternative to bank financing. Between 1994 and 2020, banks saw an 80% drop in loan market participation.
Private debt has encroached on the bank dominated broadly syndicated loan market, with several headline-grabbing $1 billion+ deals throughout 2021. And as deal sizes balloon, fund sizes are growing alongside them, with the average fund size surpassing $1 billion in the first quarter of 2021.
Venture debt emerged as a major alternative source of financing for high-growth startups that have traditionally opted to solely finance through equity VC. More than $20 billion has been loaned to VC-backed companies in the US during each of the past three years.
As the private debt and direct lending industries continue to expand, many fund managers find themselves lacking the proper infrastructure and processes to scale their businesses. Allvue offers an award-winning suite of solutions meant to support a private debt manager at every turn of the investment lifecycle, including the following challenges:
For more on Allvue’s private debt solutions, reach out for a live demo below.
Learn more about how Allvue can help your business break down barriers to information, clear a path to success and reach new heights on the investment landscape. Fill out the form below and we’ll reach out to talk more about how we can help your business.
At Allvue, we’re committed to harnessing technology and expertise to tackle the biggest challenges facing the private capital space. Our Resources hub, offering blog articles, whitepapers, case studies, videos, and more, shares industry best practices and reflects the experience and learnings of top Allvue experts and our partners motivated to see this industry continue to grow and thrive.
Our goal is to provide guidance as well as food for thought for anyone interested in the private equity, venture capital, private debt, and public credit spaces – whether you’re learning the fundamentals or getting ready to raise your fifth fund. Many of our articles contain links to trusted third-party resources to support our takes, and all our content is regularly reviewed and updated to keep current with the fast pace of alternative investment innovation.