There are two ways of investing in privately owned companies: private equity, which is the equivalent of buying shares in listed companies, and private debt, which is the equivalent of buying bonds.
In this article, we will look at the opportunities and drawbacks in private debt.
The first opportunity is in the yields offered by this type of investment. Yields 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 defaults. Over a market cycle, yields on private debt range between 4% and 6% over Libor for senior secured first-lien debt (the highest-ranking type), 6% and 10% over Libor for senior secured second-lien debt (which ranks second) and 10% and 12% over Libor for mezzanine debt, which is the lowest-ranking type, but still higher than equity investors. For Swiss investors, mid-ranking senior second lien debt is currently delivering a gross CHF yield of 5.25% and 9.25%, given that the 3-month CHF Libor is currently -0.75%. The second opportunity lies in the characteristics of this type of debt. Private debt is floating-rate, with yields linked to cash rates (generally 3-month Libor). A company will pay Libor plus a credit margin that reflects its risk profile. This is currently attractive, given the upward trend in the Fed's official rates. Holders of fixed-rate bonds suffer capital losses if interest rates rise, whereas holders of floating-rate debt see coupons increase if Libor rises. However, some caution is required, because US rate hikes still have some adverse consequences for the Swiss market. Since yields bottomed out and started rising again in July 2016, prices of CHF-denominated Swiss government bonds have fallen 4.7% on average.
The main drawback of private debt is its lack of liquidity. Private debt is naturally less liquid than publicly-traded debt: it can be semi-liquid or have little or no liquidity at all, depending on the type of debt. Senior secured first-lien debt will be mainly semi-liquid. Some senior secured second-lien debt will be semi-liquid, while some will show little or no liquidity. Mezzanine debt has little or no liquidity. As a result, investors in private debt funds run the risk of not being able to access their money immediately when they want to sell their investment, particularly in a market downturn.
However, there are investment solutions that enable investors to access private debt in all its diversity, while enjoying enhanced liquidity. These solutions combine comprehensive exposure to private debt – including mezzanine debt, the least liquid type – with exposure to high-yielding and highly liquid instruments. That involves co-ordinating investments in private debt with actively managed positions on CDS indexes. High-yield CDS indexes, for example, have a proven track record of high liquidity in all market conditions, including in 2008. February 2016 is a good recent illustration: the oil price fell to USD 25, there were concerns that Deutsche Bank would fail to pay the coupon on a CoCo, and bad debt in the Italian banking sector was a major issue. The SMI Swiss share index fell 15% between the start of the year and mid-February 2016. However, during that period, trading volumes on US and European high-yield CDS indexes jumped by 62% to USD 21 billion per day. With this combination of publicly traded and private debt, investors can access the private debt market including its mezzanine segment, thereby securing an attractive yield with limited exposure to interest-rate movements as well as enhanced liquidity.
Source: SBIDGT index (Swiss government bonds)
Senior Investment Specialist