Private Debt are external funds that are provided outside of the traditional banking sector. Those loans are issued privately and are not listed at any stock exchange. In addition, they usually don’t have any rating. However, these loans are nothing but a “traditional” loan. The US has a privately organized loan market for decades while in Europe the loan market is still dominated by banks. Between 1999 and 2012, banks provided 65% of the credit volume on average in Europe, while banks in the US only provided 21% on average between 2002 and 2012.
Private Debt is becoming more and more popular in Europe since a couple of years. This is closely related to the new Basel III regulations. “Traditional banks” face tougher regulations for their capital ratios, liquidity and leverage requirements. Hence, banks have to increase their Tier 1 capital or sell their non-core assets. Data shows a trend to de-leveraging that materializes in bad banks, which came up after the financial crisis.
European banks decrease their exposures in the credit market, creating attractive opportunities for institutional investors. The pressure on banks to shorten their balance sheets leads to significant discounts, especially in the area of non-performing loans and non-core assets. Thus, there are interesting secondary options with a good risk-return structure. Through the discount on loans or leasing objects, investors can get attractive returns since interest and repayment is still payed on the nominal value, the “pull-to-par” effect. In addition, there are possibilities in the field of syndicated loans. As banks don’t pull out of the credit business entirely but face capital restrictions, institutional investors can participate as co-investors for new loans. By doing so, institutional investors act like banks in the field of direct lending and refinancing of loans.
Despite its illiquidity, Private Debt provides an interesting addition in the Fixed-Income portfolio. Through special arrangements in the contracts it has a lower default rate and a higher recovery rate than traditional corporate bonds. These special arrangements are called “covenants”. In contrast to a traditional bank loan, a manager of a Private Debt fund is actively advising and monitoring a company during the time of the investment. In addition there are several clauses that prohibit certain behavior of the company manager. These things result in a better performance of Private Debt loans. As an equivalent to a loan, it generates periodic interest payments. In addition, there are also other contract terms like arrangement fees and “PIKs” (Payment-in-Kind) that increase the profit. A PIK is a one-time only interest payment at the end of the life of a loan on the entire duration. Moreover, the fee structure is very attractive, since returns are mainly driven by “beta”. As typical for bonds, there exists a variety of different maturities. With a median net IRR of 9%-13% during the vintage years 2011-2012, Private debt had an attractive rate of return, according to a Preqin report.