Private Debt
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Introduction
Fixed-income instruments such as loans and bonds are not only the most common source of capital for public issuers, but also play an important role in private markets
The source of debt financing in private markets has evolved from being largely the domain of banks, bank syndicates, and public markets to non-bank sources of lending known as private debt, which have experienced rapid growth.
According to Preqin, an alternative investment data company, private debt capital raised has more than doubled over the past decade, led by a sharp increase in direct lending, and is expected to reach USD2.2 trillion in global assets under management by 2027.
Debt financing used in private market strategies differs from the non-callable, unsecured fixed-coupon bonds commonly used by mature public corporations and sovereign issuers. Lenders and borrowers in private corporate, real estate, or infrastructure debt transactions often incorporate characteristics such as equity-like features (to attract lenders when cash flows are less stable),, or prepayment features to give borrowers flexibility over situations such as company restructuring or managing a project development life cycle. This may involve prepayable variable-rate debt with lower effective duration than fixed-rate bonds of similar maturity, or fixed-rate bonds with explicit call or conversion features. Non-bank private debt funds offer distinct strategies such as venture debt and direct lending to small and medium-sized companies. They also offer funds devoted to event-driven or special situations, such as distressed debt, which are covered in a separate learning module.
In this learning module, we discuss how and why debt financing is used in private markets, from startups to growth companies and buyout situations, as well as real estate and infrastructure financing. We also investigate the similarities and differences in debt instruments offered by banks and non-bank sources, as well as mezzanine debt and unitranche debt. Next, we examine the role these debt instruments play in a private company’s debt profile, applying fixed-income risk and return measures introduced earlier in the curriculum to estimate their value. Differences in debt features, underlying uses, and borrower profiles offer the potential for higher return and diversification with less correlation to traditional public fixed-income securities. Private debt also offers investors exposure to private market strategies with more predictable cash flows than equity. Investors must weigh these possible benefits against the unique risks of private debt when considering their role in an investor’s portfolio.
Learning Outcomes
The candidate should be able to:
- discuss the use of debt financing in private market strategies over the investment life cycle;
- discuss the use of leveraged loans, high-yield bonds, and convertible bonds in private market strategies;
- contrast the use of mezzanine debt and unitranche debt in privatemarket strategies;
- analyze private debt profiles and calculate and interpret financialratios used to value private debt investments;
- discuss the risk and return among private debt investments as well as versus other private market investments as part of a strategic asset allocation.
Summary
- Debt financing used in private markets includes venture debt for startups and mezzanine debt for growth and mature companies. Leveraged loans and high-yield bonds are commonly used for larger buyout equity situations, while direct lending is more prevalent for small and medium-sized firms.
- Leveraged loans involve senior secured, floating-rate debt prepayable by the issuer. This compares to high-yield bonds which are fixedrate, subordinated debt instruments with a fixed-price call feature. Convertible bonds combine features of debt with equity by allowing investors to exchange debt for shares at a predetermined price.
- Subordinated mezzanine debt and unitranche debt are less liquid compared to most other private forms of debt. Both offer more flexible terms to lenders. Subordinated mezzanine debt often incorporates equity-like features. Unitranche debt facilities combine senior and subordinated debt.
- Private issuer debt profiles seek to ensure sufficient operating flexibility with adequate borrower protections, including covenants and other contingencies. In addition to fixed-income risk and return measures, private debt valuation involves a larger credit component than investment grade debt, increased complexity due to the use of security and subordination, and a high degree of illiquidity.
- Differences in private debt characteristics, such as contingency features, higher yield spreads due to credit, and liquidity and its use in private market strategies, contribute to the potential for higher return and diversification from traditional fixed-income exposures.
2 PL Credit
If you are a CFA Institute member don’t forget to record Professional Learning (PL) credit from reading this article.