Fund Finance Insights

Private debt: what’s the big deal?

6 minute read time

Having grown after the global financial crisis, private debt funds look set to stay. But will they find universal appeal if conditions change?

 
  • Low interest rates have enabled private debt funds to offer higher yields than other investment-grade debt securities
  • One factor driving demand for private debt is the rise of ESG investment and corporate strategies, which are actively encouraged by investors, business leaders, politicians and regulators
  • There are risks involved, however, as private debt is not immune to market volatility and national or international economics

Today’s private debt markets developed after the global financial crisis of 2007 and beyond, growing to fill the gap left when traditional lenders stepped away from riskier lending. The era of low interest rates has enabled private debt funds, , to offer higher yields than other investment-grade debt securities. Institutional investors have found private debt can be a useful diversifier, in part because it can offer relatively low-risk/low-volatility exposure to a wide range of underlying businesses and to private equity, and also because it brings a diversification and illiquidity premium benefit from public market allocations.

The result is many types of private debt fund. Some specialise in different classes of debt, from senior to mezzanine, including distressed debt and venture debt (based on lending to companies backed by venture capital). There are debt funds focused on specific sectors, like infrastructure, real estate and renewable energy.

Market growth continued throughout the Covid-19 pandemic as new opportunities arose. A Preqin survey of private debt investors found that 68% felt returns had met their expectations during 2020. Preqin has also forecast that private debt will grow by 11.4% per year to reach $1.46trn by the end of 2025, up from $848bn at the end of 2020.

“The European private debt market has become a fundamental part of the landscape, especially in the private equity-backed space,” says Andrew Roberts, Senior Director at RBS International. “It supports a lot of underlying businesses.”

The broad appeal

Craig Reeves, Director of fund management group Prestige Funds, says the search for yield is an important factor in private debt market growth. He notes that the global stock of negative yielding bonds hit an all-time high towards the end of 2020, and that negative eurozone yield spreads and 10-year German Bund yields both fell to records low during 2021.

“You even had European junk bonds turning negative,” he says. “If you’re a European financial institution where historically 50% of your portfolio used to be in bonds, you’re scratching your head. So we’ve seen more interest in private debt, because it gets you a yield that is not correlated [to risk] and not so volatile as traditional bonds and equities.”

Another factor driving demand for private debt is the rise of environmental, social and governance (ESG) investment and corporate strategies, which are now actively encouraged by business leaders, politicians and regulators. “Investors now not only need a positive yield, but it has to be a sustainable yield,” says Reeves. Growing numbers of private debt providers have increased their focus on ESG.

The range of specialist private debt funds, designed for investors with particular strategies and goals, also continues to grow. “We’ve seen the development of more niche areas,” says Dominic de Mariveles, Business Development Director at private equity and private debt provider Crestbridge. “I’m involved with venture debt, something that wasn’t really seen as a market three or four years ago, whereas now it’s seen as normal practice.”

Horses for courses

Venture debt has become more attractive to many start-up businesses during the pandemic: it offers a flexible route to funding that does not dilute ownership, but provides some access to expertise. It may be used alongside – as well as instead of – venture capital, and it can give investors attractive returns.

“Some asset classes are more competitive than they’ve ever been. Funds have more dry powder to burn, so you have more money chasing deals. But I suspect that it’s something the market will work through and that there will be an equilibrium”

Andrew Roberts, Senior Director, RBS International

“There’s a shift in Europe towards venture capital that probably makes the venture debt space more bulletproof,” says de Mariveles. “But private debt is also expanding into other areas, like social housing. Really, it could grow into any area of the market that isn’t using debt.”

Reeves believes the pandemic has served to strengthen the profile and attractiveness of private debt. “Interest in our space is much greater than it was in December 2019,” he says. “There’s probably more liquidity that’s going to come in; potentially there will be more players in the market.”

Of course, there are risks. Private debt is not immune to market volatility and national or international economics. “If inflation moves the dial and interest rates change, will underlying businesses find it hard to service their obligations?” asks Roberts. “If risk-free rates start to move up, will the illiquidity premium change?”

Crestbridge’s de Mariveles adds: “I think in the medium term there is a cloud on the horizon with global inflation increasing. If bank rates start to increase, you’d have a credit crunch and a debt crunch. The boom we’re seeing today might not be sustainable if we see the Federal Reserve starting to raise rates, or quantitative easing being turned off. If that happens, borrowers may think maybe now’s not the time to be carrying more debt.”

Roberts thinks regulatory changes could also represent a risk. “If regulators put leverage restrictions on companies, or stopped pension funds investing in certain asset classes, that would be a problem,” he says.

Reeves would be particularly concerned if a regulator made it harder to launch a new private debt fund. “I’m all for regulation: I think having the cowboys kicked out of the industry makes sense,” he says. “But these are not retail funds. It’s all professional investors’ money – pension funds, insurance companies, private banks. Having professional investor funds doing the riskier stuff makes sense to me. [New regulation] would need to be very carefully thought out.”

Looking ahead

Meanwhile, dry powder has been increasing across all private markets in recent months, increasing the risk that more competition and the sheer amount of capital chasing deals will reduce returns from private debt.

“Some asset classes are more competitive than they’ve ever been,” says Roberts. “Funds have more dry powder to burn, so you have more money chasing deals. But I suspect that it’s something the market will work through and that there will be an equilibrium.”

At present, he suggests, private debt in its various forms is performing important functions for businesses and investors. “It enables private equity to raise finance in ways that would not be possible otherwise,” he says. “If the private debt market disappeared, private equity wouldn’t work in the same way and many businesses couldn’t get equivalent finance in the bank market.”

“The market is still growing fast and maturing fast. It’s here to stay. There’s going to be plenty of activity and plenty of capital chasing opportunities. There are uncertainties – but look at what the sector has already been through over the last 10 years. Overall, the future’s bright.”

By David Adams