Executive summary
What is private debt?
- Private debt is a form of debt financing offered by non-bank lenders that is not issued or traded within the traditional public markets. Although private debt includes real estate and infrastructure debt, this paper focuses primarily on corporate private debt.
Why did it emerge?
- The role of banks as the principal provider of debt has been declining for a long period of time and has accelerated since the Global Financial Crisis (GFC ). The banks’ inherent asset-liability mismatch and changes in the regulatory environment are the key reasons for this development.
What are the main strategies?
- Direct lending, mezzanine, opportunistic/distressed credit and specialty finance, with direct lending being the main strategy within private debt, accounting for roughly 45% of the market.
How big is the PD market?
- According to Preqin, the estimated assets under management (AUM) globally in 2023 reached nearly $1.7 trillion.
What are the main return drivers in direct lending?
- Direct lending’s returns are primarily driven by cash coupons—contractual cash flows based on a floating reference rate and a spread providing stable income and robust returns.
What is the main risk in direct lending?
- Direct lending’s main risk is the credit risk.
What are other special topics that investors should pay attention to?
- Investors should pay special attention to how the investment strategy is implemented: Deployment speed, deployment level, diversification and transparency are among the factors that investors should account for when considering a private debt allocation.
Private debt defined
Private debt is a form of debt financing offered by non-bank lenders—including, for instance, large GPs already active in the private equity market—that is not issued or traded by traditional public markets. Small and midsize companies often turn to private lenders because they either cannot or choose not to use public markets for debt financing and choose not to obtain financing from banks. Depending on the sub-strategy within private debt, the debt will sit at a different position in the company’s capital structure but will remain above common equity.
Private debt first emerged in the ’90s, mainly in the form of mezzanine debt as an alternative to high-yield bonds, and since the early 2000s as an alternative to conventional bank loans and public market offerings. The increase in banking regulations and reduction of available capital for lending following the GFC accelerated banking disintermediation. This, together with the strong growth in private equity markets, provided strong foundations for the growth of the private debt markets.
Most private debt managers lend to middle-market companies with EBITDA between $5 million and $75 million. This market can be further separated into three parts:
- Lower middle-market: companies with EBITDA below $15 million.
- Core (mid-) middle-market: companies with EBITDA in the range of $15 million to $40 million.
- Upper middle-market: companies with EBITDA above $40 million.
The main characteristics that set private debt apart from public debt and make it attractive are:
- For borrowers, it provides flexible terms and customized financial solutions as well as higher certainty of execution, typically in a tighter time frame if needed. Moreover, thanks to the private nature of the asset class, firms do not have to disclose their books to the public/competitors.
- Lenders are attracted to the potential for higher risk-adjusted returns at lower volatility than those typically available from standard fixed-income investments. Furthermore, lenders typically have greater control over the lending terms and can more efficiently negotiate with the borrower if there is underperformance, which can lead to higher recovery rates in case of a payment default.
Because private debt investments are illiquid credit investments, investors should understand two types of risks when allocating capital to the asset class: liquidity and credit risks.
From an investor’s perspective, private debt provides higher risk-adjusted returns at lower volatility compared with public debt. Over the past few years, the private debt landscape has broadened to offer various sub-strategies and implementation options, each with different risk and return profiles. As a result, the investor base in private debt is diverse, including institutions like pension funds and insurance companies, as well as private individuals and investment funds.
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