Why private debt?
Investing in the debt of private companies may provide an alternative source of income and diversification at a time when both are difficult to find within traditional markets.
Institutional investors have long turned to private debt strategies for their potential to generate a high level of income and diversify their fixed income portfolios. Their allocations to private debt have grown from about $15 billion to nearly $260 billion in 20 years’ time.¹
Private debt assets under management¹
Many private debt strategies focus on investing in middle market companies, which represent a sizable opportunity. In the U.S. there are nearly 200,000 middle market businesses generating annual revenues ranging from $10 million to $1 billion that together employ about 48 million people.²
Types of private debt strategies
Private debt represents a wide range of investment strategies with varying risk/return profiles. Major private debt strategies include the following:
Direct lending strategies primarily focus on providing loans to private U.S. middle market companies. Regulations following the financial crisis reduced the capacity commercial banks had to lend to many of these businesses. As a result, non-bank lenders such as hedge funds and institutional private debt managers have helped fill that void.
Distressed debt investing refers to acquiring debt securities of companies experiencing some type of financial or operational stress. Distressed debt investors often purchase debt securities at a significant discount to face value, expecting to profit as a company goes through a bankruptcy or restructuring to improve long-term performance.
Mezzanine lending is a hybrid of debt and equity financing. Mezzanine lenders have the right to convert to an equity interest in the company in case of default, generally after senior lenders are paid.
Special situations lenders typically buy debt securities well below par, looking to profit from a positive resolution to any issue(s) affecting the company. Some special situations may include litigation, a merger or acquisition or bankruptcy, among others.
Source of income
Many investors turn to private debt strategies as a source of income to help enhance their traditional fixed income allocations. As an example, middle market loans (direct lending strategies) have historically generated a high degree of income compared to many traditional fixed income investments.³
Opportunity for diversification
Direct lending strategies also historically have had a low correlation to many traditional investments, such as stocks and investment grade bonds. They have been negatively correlated to U.S. Treasuries, a component of many fixed income portfolios.⁴
Correlation of middle market loans with many traditional investments⁴
Many private direct-lending strategies, particularly senior loans made to middle market companies, also typically have floating rates, meaning their interest rates adjust or “float” as market interest rates rise or fall.
Therefore, their value tends to be less impacted by changing interest rates than traditional fixed rate investments such as investment grade and high yield corporate bonds.
Investing in private debt is different than investing in traditional investments, such as stocks and bonds. Private debt strategies are often illiquid and issued by below-investment-grade companies. Investment constraints such as risk tolerance, liquidity needs and investment time horizon should be taken into consideration. It is important to note that investments with higher yields may be accompanied by a higher degree of risk. Investing in private debt involves risk in addition to the normal risks associated with investing, including the risk that a shareholder may receive little or no return on their investment or that a shareholder may lose part or all of their investment. Investing in private debt often includes securities that are rated below investment grade or would be rated below investment grade if they were rated. Below investment grade instruments are particularly susceptible to economic downturns compared to higher rated investments. When building a portfolio that includes private debt investments, financial professionals and their investors should first consider the individual’s financial objectives. Past performance is no guarantee of future results.