Private Debt: Alternative Corporate Financing and Exciting Asset Class

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Companies are constantly on the lookout for efficient financing options to maintain their growth trajectory. In doing so, they often encounter challenges with traditional sources of financing. Private debt provides suitable financing solutions for emerging companies.

The asset class also strikes a chord with many investors who are looking for promising return opportunities and want to further diversify their portfolios. Having long been the preserve of institutional investors, this credit marketplace is increasingly opening up to private investors.

In this article, you will get an overview of private debt, what added value this asset class offers and how this form of investment differs from other investment classes. Furthermore, different types of private debt are explained and which risks have to be considered for this private market investment.

The most important facts in brief

• Private debt is an internationally growing asset class in a non-public market.
• Corporate financing as a private market investment promises high returns.
• Studies predict double-digit growth in Switzerland as well.
• Everon enables private investors to invest in a market that was long reserved for institutional investors.
• Investors should understand the distinction from other financial instruments before investing.

Private Debt: Definition and Explanation of a Private Markets Asset Class

The term private debt describes the extension of corporate credit to companies by non-public institutions such as banks or investors. In contrast to public debt, where companies issue bonds on the public markets or receive loans from banks, companies receive debt capital from private lenders. Private debt has gained in importance in recent years and is used by both institutional investors and wealthy private investors.

Compared to traditional bank loans, private debt often offers more flexible terms and tailored loan arrangements. This enables companies to take advantage of alternative financing solutions, especially when they have difficulty obtaining loans from traditional banks.

Private debt investors, in turn, can diversify their portfolios and achieve attractive returns by investing in corporate lending.

Differentiation from other financial instruments

Private debt differs from other financial instruments available to retail investors in several key ways.

Some important differences and distinctions are explained below, based on some common investment products:

• Public Bonds: Unlike public bonds, which are issued by corporations or government institutions in public markets, private debt is a non-publicly traded security. Private debt investors invest directly in loans to companies and receive interest payments in return and possibly also a share in the company’s profits (mezzanine).
• Stocks: Private debt contrasts with stocks, which represent ownership interests in a company. While equity holders benefit from price increases and dividend payments, private debt investors receive fixed interest payments and are usually not entitled to company shares.
• Private Equity: Private debt also differs from private equity, in which investors invest equity in companies. Private debt investors, on the other hand, provide debt financing and are creditors of the company. They have priority over equity investors in the event of insolvency or restructuring.

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Private debt: a rapidly growing asset class worldwide

Over the past decade, the private debt market has expanded rapidly due to long-lasting low interest rates and high investor demand. The success of private debt is a result of the special market conditions following the global financial crisis. Private debt opens up liquidity opportunities for expanding private companies as well as higher return opportunities for investors compared to public debt instruments. Private debt is therefore often already regarded as an asset class in its own right , having originally been considered a subcategory of private equity. This is also due to the fact that private debt investments are often used to finance leveraged buyouts, i.e. leveraged takeovers of companies.

The international private debt market is one of the fastest growing private markets and is now the third largest private market after private equity and real estate. On average over the last ten years, the private debt market has grown by 13.5 percent annually. This compares with growth of 11.5 percent for private equity and venture capital and 9.1 percent for real estate over the same period. According to forecasts by the British information service Preqin, the private debt market is expected to continue expanding and even reach assets of USD 2.7 trillion by 2026.

Private debt: market size in Switzerland

The market for private financing solutions is also growing in Switzerland, not least due to the general economic conditions. However, as it is a non-public market, statistics are often based on estimates. However, the Lucerne University of Applied Sciences and Arts has already proven the growing importance of corporate financing with private debt in a study in 2019.

The key findings from the study:

• The Swiss private debt market volume is around three billion Swiss francs.
• The global growth of private debt will continue.
• Although banks will remain the main lenders, alternative forms of financing such as private debt are growing.
• Analogous to the growth rates of private equity, double-digit growth rates are expected to continue.
• Investor interest in private debt is strong and will remain strong.

Banks are observing the development and will participate in platforms.

An interesting investment opportunity is now also opening up for private investors

For many years, private debt was reserved almost exclusively for institutional investors. But in recent years, the private market for corporate loans has become increasingly democratized. Triggered by the ongoing low-interest-rate policy, investment opportunities are gaining in importance for private investors as well as the traditional capital markets. For an increasing number of investors, private debt comes at the right time to further diversify their asset structure.

Thanks to innovative asset managers such as Everon, smaller investment sums can now be invested in this attractive asset class in the digital world. Depending on the project, investments as low as 10,000 Swiss francs are possible with Everon. Read more about asset management at Everon if you are interested.

Private debt is primarily suitable for investors with a long-term investment horizon who are not dependent on short-term availability. This requires not only appropriate expertise, but also a certain risk capacity. In return, investors optimize their asset structure and receive an investment with ongoing cash flow. Private debt thereby shows a risk with low correlation to listed securities such as stocks or bonds.

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These opportunities open up for investors

The basic principle of private debt is that private lenders bear the risk of financing a company or a project. As a reward, they receive a decent return that is significantly higher than that of publicly traded investments. Depending on the investment strategy, returns of around 3 to 15 percent per year are achievable for private debt investments, and in some cases even higher. The prerequisite for an effective investment is a well-founded selection as well as control of all selection options. Investors are rewarded for the extra effort with above-average return prospects.

Apart from the usual advantages of alternative asset classes – such as attractive returns, diversification and a low correlation with public markets – private debt brings additional specific benefits:

• Less risk: compared to private equity and real estate, debt is less risky. This is because returns are fixed and investors’ claims in the event of default are prioritized.
• Predictable returns: Returns are predictable and contractually fixed based on an interest rate.
• Close relationship with borrowers: private lenders typically maintain closer relationships with borrowers than standard loans. This results in a more efficient process and often contributes to the success of the business in question.
• Expanded investment opportunities: private debt gives investors access to a variety of economic sectors that would otherwise be inaccessible to them. These include renewable energy, investment in early growth stage companies, and investment in an area otherwise reserved for banks.

These are the risks investors should watch out for

It is important that private investors carefully assess their risk appetite and seek professional advice before investing in private debt. This is the only way they can arrive at a suitable investment approach. Private debt investments involve specific risks for private investors.

The main risks that can occur with private debt investments are:

• Illiquidity: private debt investments are often long-term exposures with limited liquidity. Unlike publicly traded securities, private investors may have difficulty selling their investment early. This is due to the fact that the secondary market in private debt is comparatively underdeveloped.
• Credit risk: Private debt investments carry an increased risk that the debtor will not be able to meet its obligations. This can happen due to payment problems, insolvency or other economic challenges. The risk depends not least on the ranking of the debt instruments in the event of insolvency (senior or subordinate to other claims).
• Concentration: Private debt investments can often be concentrated on specific companies, sectors or regions. This increases risk, as a negative performance in one company or sector can have a significant impact on the entire investment.
• Lack of Information: Unlike publicly traded securities, private debt investments as private market investments often offer less transparency and information about the company, the borrower, or the specific terms of the investment. This can make it difficult for private investors to conduct a comprehensive risk assessment and make appropriate investment decisions.
• Barely regulated: Compared to publicly traded securities such as stocks or bonds, investors cannot rely on government regulation to review investment guidelines. In-depth financial knowledge, especially in the area of credit financing, is required.
• Interest Rate Risk: Private debt investments may be tied to variable interest rates. Although floating rates allow investors to benefit from rising interest rates, they also increase credit risk for borrowers because they can strain their liquidity. Today, most private debt portfolios have a predominance of floating rates, often with an interest rate floor to provide investors with a minimum return.

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Private debt: the complex asset class requires expert knowledge

Private debt is a complex asset class that requires specific expert knowledge. Private investors usually do not have the expertise and access to the necessary information to successfully manage this asset class. Therefore, it is important that experts in the form of professional fund managers or specialized asset managers are involved in the management of the private debt portfolio.

Challenges of the financial markets

Financial markets face many challenges, such as inflation, global economic developments, political conflicts and high debt levels. These factors can have a significant impact on the performance and risk profile of private debt investments. Experts with in-depth knowledge of the markets can correctly interpret these factors and make informed decisions to best position the portfolio.

Market analysis

Analyzing and evaluating private debt investment opportunities requires specific know-how. Selecting suitable borrowers, assessing credit risk, evaluating repayment ability, and negotiating loan agreements require expertise and experience. Private debt experts are able to assess the quality of borrowers and their business models, keeping the goals of capital preservation and return in mind.

Professional asset management

Managing risk and implementing appropriate diversification also play a critical role in managing private debt investments. Professionals can help diversify the portfolio across borrowers, industries, geographies and instruments to spread risk and increase the chances of positive returns. They have access to a broad network of borrowers and can provide a balanced mix of different types of private debt investments, such as senior secured loans or mezzanine capital.

Access to expert research

Involving expert asset managers in the management of the private debt portfolio allows private investors to benefit from their expertise and experience. Experts typically have access to extensive information and resources to effectively manage the portfolio and ensure appropriate risk management.

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Different investment strategies and financing instruments

The majority of private debt investments are in unlisted private debt funds. These funds differ both in terms of their strategy and the debt instruments offered.

The financial instruments are mainly divided into the following areas:

• Loans withsenior collateralization (senior secured loans)
• Loans with subordinated or no collateralization(junior unsecured loans)
• Mezzanine instruments (ranking behind other loans)

Combinations of the various instruments are also conceivable.

The main strategies of private debt funds are described in the following sections.

Direct Lending

In this form of financing, specialized private debt funds grant loans directly to companies. This is done without syndication by a bank. Direct Lending investors enable loans to be structured quickly and flexibly. Among other things, they can waive interest payments for a certain period of time or handle credit ratings more flexibly. Direct lending investors are remunerated for these flexible components with a comparatively higher interest rate.

Distressed debt

As a rule, distressed debt refers to bonds or loans issued by companies that are in financial difficulties. They may be facing insolvency or may already be insolvent. This debt often trades at a price lower than its face value as investors consider the increased risk and uncertainty associated with repaying the debt.

With distressed debt, investors invest in companies that are struggling. However, these have the potential to recover and generate attractive returns once the financial problems are overcome.

Mezzanine capital

Mezzanine capital is a form of financing that combines characteristics of equity and debt. It is ranked between equity and debt in the capital structure.

Mezzanine capital is typically used to supplement a company’s equity and provide additional financing for specific purposes. These include acquisitions, growth investments, capital increases or corporate restructuring. It can also be used in situations where traditional bank loans are unavailable or insufficient.

Compared to traditional equity, mezzanine capital has a higher interest rate, but also involves a higher risk for the investor. Mezzanine capital investors often have the right to share in the profits of the company or to convert their receivables into equity at a later date.

Private debt fund of funds

This strategy is comparable to a traditional fund of funds. Depending on the strategy, the private debt fund of funds invests in several debt funds and thus offers investors greater diversification.

Special Situations

Private debt funds that specialize in so-called “special situations” look for opportunities to provide capital and help companies overcome their specific challenges.

The potential occasions for special situations investments can be many and varied. Examples include companies that are planning an expansion or an acquisition in a certain market segment and require specific financing solutions.

Venture Debt

Venture debt refers to a specific form of financing in which venture capital companies or start-ups raise additional debt to support their growth. Unlike traditional debt financing, venture debt is a form of financing specifically targeted at early stage or growth stage companies. These are typically supported by venture capitalists.