Curated by: Rubric Advisors
Investing & Markets
Primer on Private Debt
Private debt provides customized loans to companies outside traditional banking and public markets, offering higher yields with floating rates but carrying significant credit risk from leveraged borrowers.
Primer on Private Debt
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What is Private Debt?
- Debt not financed by banks or issued in public markets
- Provided by private lenders who underwrite and structure customized loans
- Most commonly provides debt to private equity-owned companies (direct lending)
- Banks limited this lending after financial crisis to mid-size borrowers
- Offers higher yields but carries significantly more risk than bank loans
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Full Guide
What is Private Debt?
- Debt not financed by banks or issued in public markets
- Provided by private lenders who underwrite and structure customized loans
- Most commonly provides debt to private equity-owned companies (direct lending)
- Banks limited this lending after financial crisis to mid-size borrowers
- Offers higher yields but carries significantly more risk than bank loans
Private Debt Categories
- Direct lending: Senior debt with priority claim on cash flows and assets
- Mezzanine: Junior debt with higher rates and often equity participation through warrants
- Distressed: Debt of troubled borrowers acquired by turnaround specialists
- Categories differ by amount of equity participation and expected returns
Direct Lending Investment Appeal
- Floating rate structure provides protection against rising interest rates
- Senior position and covenants offer downside protection in capital structure
- Higher yields than safer fixed income assets to compensate for credit risk
- Call protection fees compensate for early repayment risk from refinancing
- Lower observable volatility due to illiquid nature and infrequent marking
Expected Returns and Risks
- High single digit returns from credit spread minus losses and fees
- Credit risk from highly leveraged middle market company borrowers
- Liquidity risk as loans cannot be easily traded without discount
- Performance closely tied to economic cycle and private equity success
Credit Cycle Impact
- During booms, lenders compete and offer tight spreads with favorable terms
- Downturns see spreads rise quickly in anticipation of increasing defaults
- Defaults often concentrate in sectors that expanded rapidly with debt
- Recovery depends on business quality, covenants, and lender workout expertise
Manager Selection Factors
- Track record of performance and ability to manage credit losses
- Origination capability through established relationships and reputation in market
- Adequate staffing and expertise to handle portfolio workouts effectively
- Capital discipline especially important at end of credit cycles
Key Takeaways
- Private debt offers higher yields than public fixed income with floating rate protection
- Credit cycle timing significantly impacts returns through spreads and default rates
- Manager selection critical given substantial market growth and increased competition
- Understand credit risk from leveraged borrowers despite senior loan protections
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