All services Fund and Asset Managers Private and Institutional Asset Owners Debt, Capital Markets and Corporate
Close
Close
Close

Demystifying private debt funds: a guide for investors

13 Mar 2024

By Joanne McEnteggart, Global Head of Debt, Capital Markets and Corporate, and Justin Partington, Global Head of Fund and Asset Managers

Private debt is the hottest alternative asset class, growing at 10% CAGR over the past decade and forecast to swell to $3.5 trillion by 2028. Institutional investors are clamouring to put their money in private debt, with Preqin forecasting 2023 to be the fourth consecutive year that the asset class has gathered more than $200bn of institutional commitments.

In today’s economic landscape, fundraising from retail sources is on the rise, particularly as private debt continues to yield favourable returns despite the challenges within the macro environment. Private debt stands out as a promising avenue for High-Net-Worth Individuals (HNWI) retail funds due to its liquidity benefits. Moreover, the democratisation of private markets through retail platforms further enhances accessibility to private debt opportunities. This convergence of factors not only underscores the attractiveness of private debt for retail investors but also signifies a broader trend toward diversification and democratisation within the investment landscape.

Private debt offers a wide range of opportunities across asset classes and debt seniority, each with its own returns profile, risks and nuances that need to be considered. Investors new to the asset class must get their heads around PIK notes, bullet repayments, equity warrants, and a host of other relatively technical financial terms that describe the differences between private debt strategies. In this guide, we aim to spell out what each strategy does and provide investors with an understanding of the asset class that’s set to dominate alternatives the next decade.

What is private debt?

At the highest level, private debt investments are credit extended by non-bank lenders, typically to small and medium-sized private companies. The sector really took off as a result of the Great Financial Crisis when banks’ tightened lending criteria opened the door to alternative lenders. It has recently taken centre stage as near-zero interest rates ended and banks further curtailed lending.

Private debt assets offer a reliable income stream, comparatively high liquidity and high risk-adjusted, contract-based returns. With interest rates at their current levels, the returns from private debt, which typically extends loans with floating rate coupons, are approaching equity-like returns of 10% or more, even for senior secured debt. In addition, private debt funds provide more reliable distributions and liquidity that other alternative investments.

However, the asset class offers spectrum of strategies that each approach lending differently, and here we outline these and why investors might consider each in turn.

Direct lending

Direct lending makes up the majority of private debt AUM, accounting for just under half of private debt capital raised in the first half of 2023, according to Preqin. It involves non-bank lenders extending credit, typically senior secured debt with a floating rate coupon of five to six per cent above base rate, to mid-sized companies. Historically, direct lending has been used to provide leverage in sponsor-backed deals, with private equity firms and their portfolio companies appreciating the speed and certainty that comes with dealing with one lender rather than a consortium of banks and the more flexible covenants that non-bank lenders can provide.

These factors, along with regulatory pressures restricting banks’ lending from their balance sheet, have made direct lending a significant alternative source of debt capital for non-private equity-backed companies, and high levels of dry powder in direct lending funds mean managers are looking beyond sponsor-backed firms to broaden their investment universe.

To investors, direct lending may now seem like a goldilocks asset class. It is insulated from interest rate and inflation shocks, yields upwards of 10% (currently) with historically minimal default rates and, in comparison with other alternative asset classes, is relatively liquid. There are also broad secular changes that mean these factors are likely to continue. Regulators are taking even more notice of banks’ risk-taking after three failures in 2023 and further retrenchment from the lending business is likely, further increasing opportunities for non-bank lenders.

Mezzanine debt

Mezzanine debt sits between senior debt and equity in the capital structure and is one of the highest-risk forms of debt. These instruments offer higher returns than direct lending due to its lower seniority, and equity warrants that give lenders the right to convert debt to equity should the borrower fail to meet its obligations provide downside protection.

Demand for mezzanine financing on the part of borrowers is strong because of companies’ greater difficulty in obtaining senior loans and bank lending. Borrowers can view mezzanine debt as a cheaper form of equity as the cost of capital is lower than issuing equity and it also means that existing shareholders aren’t diluted.

Distressed debt

Distressed debt involves investments in the existing debt of a financially distressed company that is trading at a discount to its par value due to the company being in or near default or with otherwise compromised creditworthiness. This may be due to cash flow shortfalls, covenant violations, or debt overload, and the debt is considered distressed if it can’t be serviced or refinanced using conventional approaches. Distressed debt managers acquire these securities, then generate returns by restructuring the capital structure or positioning itself as a senior debt holder in the company’s bankruptcy.

The strategy is currently having its moment in the sun. Preqin research last June found that it was the most sought-after strategy among US LPs, with 35% of investors looking to allocate to distressed debt funds in the coming 12 months.

Special situations

Similar to distressed debt, special situations investors typically target companies that are experiencing difficulties. Unlike distressed debt, however, special situations investors target companies where economic fundamentals are generally sound but are facing temporary challenges. Typical special situations could be prospective mergers or spinoffs, shareholder activism, possible bankruptcy or litigation, and other events with unpredictable consequences. Such funds often aim to take control of target companies and profit from turning the company around and exiting.

Across asset classes

So far, we’ve covered how the spectrum of private debt instruments work with investments in the debt of companies. The same investment structures exist in other asset classes and offer investors a further range of risk-reward opportunities.

Infrastructure lends itself to debt investments, with individual projects financed by lenders and servicing the debt from income it generates. Stable, inflation-hedged cash flows mean lenders can extend long-term credit and reduce risks through covenant protection. Returns from brownfield projects, being mature and in operation, are lower than greenfield, where lenders charge higher rates to compensate for taking on development risk.

In real estate, private debt invests in loans to a developer or owners of assets. Managers tend to specialise in strategies, for example residential construction, student accommodation or social housing in addition to commercial assets or retail developments. Each presents a different risk profile which, along with the stage of development, dictates the interest rates lenders offer.

Venture debt is higher risk, extending credit to venture capital-backed companies that are typically pre-profit and potentially pre-revenue. Borrowers take on debt to fund growth without diluting ownership stakes and are charged high rates commensurate with the level of risk lenders take on.

An additional niche but rapidly growing area of private debt is NAV financing, in which specialised lenders extend loans to a private equity fund holding a diversified portfolio of companies. This flexible capital might be used to fund add-on acquisitions or accelerate liquidity to investors without the complexities involved in running a secondaries process.

What can investors expect in 2024?

The outlook for the private debt market very positive. Banks retreating from lending means the opportunity set for non-bank lenders is rapidly expanding and a track record of stable, inflation-beating returns means investor appetite will continue to grow.

As private debt becomes a more significant part of the alternative investment universe, you need the right supporting partner to fully realise emerging opportunities. IQ-EQ’s Global Private Debt and Credit Desk team has an unrivalled combination of experience, global reach and technology at our fingertips. Get in touch today.

Working with IQ-EQ has been seamless – you and your team understand our business, advise us appropriately, and handle your side of our collective partnership so that we can focus on making good investment decisions. Evan Gibson SVP, Merchants Capital

Get in touch with us today

We’re ready to listen.

Make an enquiry

Interested in joining our team?

We are always on the lookout for passionate people that possess IQ and EQ to join our growing team.

View job vacancies