The risks and opportunities of private debt
INA global economy increasingly fuelled by credit, the market for private debt has emerged as a new frontier for yield-hungry investors. The close bilateral relationships that are a feature of this market offer unique opportunities for both borrowers and lenders.
But the growing investor base and the broad distribution of private loans across lending platforms make it difficult to assess the level of risk and, more importantly, who ultimately holds it.
The worldwide market for private debt — specifically direct lending — has grown tenfold in the past decade. At the start of this year, funds primarily involved in direct lending held assets of US$412 billion, including nearly US$150 billion in reserves for further investment, according to financial data provider Preqin. This rapid expansion in private debt — which broadly includes special situations, distressed debt, and mezzanine debt, in addition to direct lending — is likely to continue.
Private debt’s track record of steady performance and attractive returns over the past decade – with credit spreads that are typically wider than those for broadly syndicated loans – has understandably attracted institutional investors with fixedincome allocations, such as insurers, pension providers, endowments and sovereign wealth funds.
But private debt is still a littleknown corner of finance, with less transparency and liquidity than the markets for speculative-grade bonds and syndicated loans. And reliable data remain relatively scarce. An expansion of the investor base could lead to heightened risks if it leads to higher volatility. Nonetheless, the appeal of private debt to lenders and borrowers alike is pushing this relatively obscure market into the spotlight.
To be sure, there are advantages to be found in private debt. Borrowers benefit because direct lending is inherently relationship-driven. With fewer lenders involved in each transaction, borrowers tend to work more closely with them. Deals can be done more quickly and with more pricing certainty than when a large group of lenders is involved.
From creditors’ perspectives, private debt is one area of the loan market where covenants are still common. For example, a significant portion of the companies for which S&P Global Ratings conducts credit estimates have financial-maintenance covenants, which require borrowers to maintain leverage ratios or other indicators of creditworthiness. It bears noting, though, that the presence of covenants appears to contribute to more frequent selective defaults.
With fewer lenders, the process of working out a debt structure in the event of a default tends to be faster and less costly for private borrowers. Simpler debt structures, such as so-called unitranche deals, remove the complexity of competing debt classes that can slow a restructuring. Thanks to these factors, recovery rates for private debt often are higher on average than those for broadly syndicated loans.
But there are pitfalls alongside the advantages. For investors seeking a hasty exit, illiquidity is a key risk, as private debt instruments typically are not traded in a secondary market — although this may change over time if the market volume and number of participants continue to grow.
This opacity limits market discovery, and lenders must often be willing and able to hold the debt to maturity. At the same time, private debt funds geared towards individual investors may pose a risk if they are vulnerable to cascading redemptions, which could compel asset sales.
Moreover, borrowers in this market tend to be smaller, with weaker credit profiles than speculative-grade companies. Based on the sample of borrowers for which we have credit estimates, these issuers of private debt are even more highly concentrated in the lowest rating levels than speculative-grade ratings broadly.
Near the end of last year, close to 90 per cent of credit estimates for these borrowers were ‘b-’ or lower, including nearly 20 per cent that were ‘ccc+’ or below. At the time, 42 per cent of speculative-grade nonfinancial companies in the United States were rated ‘B-’ or lower, with about 17 per cent rated ‘CCC+’ or lower.
Aggressive growth in private debt has led to a decline in the quality of underwriting in recent years. In loan documentation, the definition of earnings before interest, taxes, depreciation and amortisation, or EBITDA, is becoming longer and less straightforward, and more like the definitions used in broadly syndicated deals. And, as in the syndicated-loan market, EBITDA add-backs — reclassifying expenses to improve profits — are increasing.
Finally, by definition, less information is available on private debt. And the close relationship between lenders and borrowers, along with the smaller pool of lenders in a deal, means that fewer people are aware of a transaction’s details. As a result, less is known about the aggregate size and composition of the overall market for private debt.
The distribution of private loans within lending platforms involving business development corporations, private credit funds, and collateralised loan obligations makes it difficult to track the level of risk — and who could be left holding the bag.
In loan documentation, the definition of EBITDA is becoming longer and less straightforward