In Europe, the proportion of private debt financing – as opposed to public debt financing via the bond market – provided by banks has fallen from around 80% in 2008 to 25% today. In the USA, the decline has been even greater, since the figure there is now only 8%. As a result, new players have taken over banks’ role in financing companies, via private debt funds.
There are now three sources of financing for non-investment-grade companies, each of which provides opportunities for investors: i) high-yield bonds (i.e. public debt), ii) bank loans (syndicated loans by groups of banks, which then resell the debt to investors) and iii) private debt, previously known as “direct lending”. Private debt is the segment that has the greatest connection with and proximity to private equity. A private equity fund buys a company through a leveraged buyout (LBO): it raises 40% of the financing through equity and seeks the other 60% through debt from private debt funds. This 40/60 ratio may change depending on the investee company’s business model and the structure of the debt. The quality and stability of a private debt fund’s deal flow depending on how close the fund is to private-equity sponsors. A close relationship allows a fund to identify new transactions and offer customised financing solutions.
In the current context – with interest rates rising, monetary policies returning to normal and markets expecting higher inflation – the main advantage of private debt is that it is floating-rate, with interest traditionally charged at Libor plus a credit margin. In other words, private debt is not exposed to rising interest rates and automatically benefits from any increase in short rates while providing protection against inflation, since Libor rates historically show close correlation with inflation. Floating-rate debt is currently a vital component of a balanced bond allocation.
The private debt market also gives access to different tranches of financing: senior (senior first lien) and subordinated (senior second lien and mezzanine). The yields on offer vary depending on the seniority of the debt, i.e. where the investor ranks in the order of repayment in the event that the company is liquidated.
Over a market cycle, yields on private debt range between 4-6% over Libor for senior first lien debt (the highest-ranking type), 6-10% over Libor for senior second lien debt (which ranks second) and 10-12% over Libor for mezzanine debt, which is the lowest-ranking type, although investors in mezzanine debt still rank higher than private equity investors.
Today, valuations remain attractive. Senior debt in USD and EUR is showing margins of around 4%: although that is at the lower end of the range seen since 2009, it is higher than the 2006-2007 level of around 2.5%. In addition, LBO structures are more solid than before. The private equity contribution has risen to 40% on average today, as opposed to 30% before the 2008 crisis. In other words, LBOs are less leveraged and offering more attractive yields. A diversified private debt portfolio, consisting of 70% senior and 30% subordinated floating-rate debt, would generate a USD yield of around 7.5%. By comparison, high-yield bonds are yielding around 6% in USD, but with duration – a measure of sensitivity to interest rates – of around four years.
Given its liquidity profile, private debt complements a traditional bond allocation well on a long-term view. It combines floating-rate exposure with a yield of around 7% in USD. In addition, private debt is the ideal foil for private-equity investments: the debt portion provides recurrent income while the equity portion provides capital appreciation.
Senior Investment Specialist