Private debt – a cul de sac or a two-way street?

Private debt was one of the few asset classes to generate positive returns through the bond market meltdown in 2022, benefiting from its floating rate profile and a relatively stable environment for corporate defaults. As private debt managers continue to deliver attractive returns with low volatility, there is a growing perception that the asset class is a ‘one way’ bet, delivering high income with minimal downside risk.

Interest in the private debt sector started with domestic managers providing loans to traditional corporate borrowers and real estate developers. It has since expanded to include offshore managers setting up funds, feeding into global loan portfolios. Today, private debt funds are a cornerstone of most defensive portfolios and an important complement to publicly traded bonds.

However, private debt is unique. Consistent headline returns can hide the risks that lie beneath the surface. Paradoxically, two managers could end up delivering similar return outcomes, but with varying risk profiles and default sensitivities. As the ancient philosopher, Seneca famously quoted “fallaces sunt rerum species” - appearance can be deceptive.

As the impact of higher interest rates and declining consumer spending continues to impact corporate profitability, we are approaching an inflexion point. The spotlight will be placed on private debt managers and the robustness of their lending processes. Investors may soon learn that private debt returns are in fact, a ‘two-way street’!

What is private debt?

Private debt is relatively simple; a lender provides a loan to a company, property developer or private equity (PE) sponsor to finance its operations, construction project or merger and acquisition (M&A) activity. Alternatively, loans can refinance existing debt or optimise a company’s debt/equity mix.

When a loan is funded, the lender receives an original issue discount (OID), which is an upfront fee where the loan amount is slightly below the par value that is repaid at maturity (e.g. 1% to 2%). Over the life of the loan, the borrower makes interest repayments, typically expressed as a spread above the Bank Bill Swap Rate (BBSW) and at maturity, repays the loan. Depending on the borrower’s risk profile, seniority level and tenor, the spread over BBSW can range between 4% p.a. to 8% per annum.

Types of private debt

Private debt encompasses a wide range of lending purposes, each with its own risk/return profile and specialisation requirements:

Type	Description
Corporate lending - bilateral	A loan where a borrower and lender(s) transact directly, and agree on negotiated terms, conditions and covenants. This can include senior secured, 2^nd lien and unitranche financing (detailed below).
Corporate lending - syndicated	A corporate appoints a lead arranger to syndicate the financing of a loan to multiple lenders. They negotiate the terms and invite other syndicate members to participate.
PE sponsor-backed lending	Financing provided to a Private Equity (PE) sponsor for the acquisition of a leveraged buyout (LBO) target.
Real estate (RE)	Funding for land acquisitions, pre-construction, early works and project construction.

Navigating the private debt universe

Navigating the private debt universe can be a minefield for advisers given the different lending types and associated risks. Managers employ a range of strategies, some specialising in senior secured lending while others invest in junior or mezzanine loans or a combination of both.

The ability to compare performance across managers is difficult given the private, bilateral nature of corporate lending and the differences between individual loans, covenants and security packages. A manager with an impeccable track record of no ‘technical’ defaults may pass the first review, but this may not reveal the number of loan restructures, payment deferrals or covenant relief provided to borrowers.

In stable environments, returns from private debt are predictable, delivering consistent monthly returns with limited capital volatility. However, in challenging environments, the type of lending, quality of underwriting, level of covenant protections and security packages quickly separates good managers from those with relaxed standards.

The current challenges in the healthcare sector illustrate how excessive debt, rising borrowing costs, and declining revenues, can lead to debt restructures to protect equity investments. Despite a long history of low corporate defaults, future outcomes can be unpredictable. Monitoring trends in borrower leverage, interest coverage, covenant waivers and those borrowers converting from paying cash interest to capitalising interest (PIK interest) is crucial to identifying future problems.

Selecting the right private debt fund

Including a private debt fund in a client’s portfolio is complex it involves identifying the expected risk/return, performance in negative equity environments, and alignment to the client’s growth or defensive allocation. The reliability of cash distributions and regular access to capital are key considerations. What if a manager were to freeze redemptions, would this create asset allocation imbalances and broader liquidity challenges?

Fees and costs have always been a murky topic, with many funds not subject to the RG97 fee disclosure regime. The payment or collection of fees across managers varies significantly, including the types of fees charged and the beneficiary of those fees. Managers may retain a portion of the borrower-paid margins or penalty interest.

In many instances, the costs of a private debt fund exceed 2% p.a., subject to the type of lending and a manager’s approach to sharing lending fees with investors. This remains a key focus area for Zenith and an area where we are yet to gain complete comfort (apart from a small number of institutional quality managers that we have on our Approved Product List (APL)), noting that the universe has yet to achieve uniformity in terms of disclosure practices.

The two-way street

The growth of the private debt sector has been positive for the adviser market, providing access to funds that generate attractive risk-adjusted returns, with structural protection and with minimal mark-to-market volatility. Despite this, we can’t lose sight of the fact that private debt is an illiquid, sub-investment grade asset class with default risk. A thorough understanding of the lending process and how managers protect capital is crucial. The smallest detail around a security package or a covenant can ultimately save an investor from losses in a default scenario.

If higher interest rates persist for a couple more years, the pressure will be on borrowers and ultimately private debt managers, and it could be a matter of time before investors learn a painful lesson that private debt returns are in fact, a ‘two-way’ street.