The risks and opportunities of private debt

In a global economy increasingly fueled 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 makes it difficult to assess the level of risk and – more importantly – who ultimately holds it.

he 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 $412 billion – including nearly $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 fixed-income allocations (such as insurers, pension providers, endowments, and sovereign wealth funds). But private debt is still a little-known 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. Private debt includes any debt held by or extended to privately held companies. It comes in many forms, but most commonly involves non-bank institutions making loans to private companies or buying those loans on the secondary market.