The risks and opportunities of private debt

In a global economy increasingly fueled by credit, the private debt has emerged as a new frontier for yield-hungry investors. The close bilateral relations that characterize this market offer unique opportunities for both borrowers and lenders. But the growing investor base and the wide spread of private lending across lending platforms make it difficult to assess the level of risk and – more importantly – who ultimately holds them.

The global private debt market – especially direct loans – has grown tenfold in the last decade. At the start of this year, the funds mainly involved in direct lending held $ 412 billion in assets, including nearly $ 150 billion in reserves for other investments, according to financial data provider Preqin. This rapid expansion of private debt (which includes special situations, distressed debt, and mezzanine debt, in addition to direct loans) is expected to continue. Private debt’s track record of stable performance and attractive yields over the past decade – with credit spreads typically wider than those of largely syndicated loans – naturally attracted institutional investors with bond allocations (such as insurers, pension funds, endowment funds and sovereign wealth funds).

But private debt remains a still unrecognized corner of finance, with less transparency and liquidity than the markets for speculative-grade bonds and syndicated loans. And reliable data remains relatively scarce. An expansion of the investor base could lead to increased risks if it results in higher volatility. Nonetheless, the attractiveness of private debt to both lenders and borrowers brings this relatively obscure market to the fore.

Of course, there are advantages to be found in private debt. Borrowers benefit because direct loans are inherently relationship-oriented. With fewer lenders involved in each transaction, borrowers tend to work more closely with them. Transactions can be closed faster and with greater price certainty than when a large group of lenders are involved.

From a creditors’ perspective, private debt is an area of ​​the loan market where alliances are still common. For example, a significant portion of the companies for which S&P Global Ratings performs credit ratings have financial maintenance covenants, which require borrowers to maintain leverage ratios or other indicators of creditworthiness. It should be noted, however, that the presence of covenants seems to contribute to more frequent selective defaults.

With fewer lenders, the process of developing a default debt structure tends to be faster and cheaper for private borrowers. Simpler debt structures, such as unitranche transactions, remove the complexity of competing debt categories that can slow down restructuring. As a result of these factors, private debt collection rates are often higher on average than those for heavily syndicated loans.

But there are pitfalls alongside the benefits. For investors seeking a rushed exit, illiquidity is a major risk, as private debt securities typically do not trade in a secondary market (although this can change over time if the volume of the market and the number of participants. continue to grow). This opacity limits market discovery and often lenders must be willing and able to hold debt until maturity. At the same time, private debt funds aimed at individual investors may present a risk if they are vulnerable to cascading redemptions, which could force the sale of assets.

Additionally, borrowers in this market tend to be smaller, with weaker credit profiles than speculative companies. Based on the sample of borrowers for which we have credit estimates, these private debt issuers are even more concentrated in the lower rating levels than speculative ratings in general. By the end of last year, almost 90% of credit ratings for these borrowers were “b-” or lower, of which nearly 20% were “ccc +” or lower. At the time, 42% of speculative grade non-financial companies in the United States were rated “B-” or less, with around 17% rated “CCC +” or less.

The aggressive growth of private debt has led to a decline in the quality of underwriting in recent years. In loan documentation, the definition of earnings before interest, taxes, depreciation, and amortization (EBITDA) becomes longer and less straightforward, more like the definitions used in heavily syndicated transactions. And, as in the syndicated loan market, additions to EBITDA – reclassification of expenses to improve profits – are on the rise.

Finally, by definition, less information is available on private debt. And the close relationship between lenders and borrowers – as well as the smaller group of lenders in a transaction – means fewer people are aware of the details of a transaction. As a result, less is known about the overall size and composition of the overall private debt market. Distributing private loans within lending platforms involving business development companies, private credit funds, and secured loan bonds makes it difficult to track the level of risk – and who might stay in charge.

Evan Gunter is a director at S&P Global Ratings. Abby Latour is Editorial Manager at Leveraged Commentary & Date, an S&P Global Market Intelligence offering. Copyright: Project union, 2021, and posted here with permission.

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