Are Private Credit Debt Funds the new hot space for investors?

Are Private Credit Debt Funds the new hot space for investors?

Private Debt and Credit funds have thrived on low interest rates in past years, but could increasing rates affect their growth going forward? Some say that they will continue to thrive and grow because floating rates can mitigate rising rates and that coupled with the Credit Fund’s ability to have more control in how the documentation is crafted gives the lender greater protection. Private Credit Funds have consistent income and attractive risk adjusted returns which have outperformed other sectors in recent years.

?Private Debt funds, also referred to as Private Credit funds generally invest by making private, non-bank loans to companies.? While a Private Credit fund is illiquid similar to a Private Equity fund, the Private Credit fund manager has the ability to customize the risk profile of the private debt investment and the structure of the investment.? This type of strategy is generally suitable as a long term investment for individuals or institutions that that do not need liquidity, therefore there are restrictions embodied in state laws requiring a certain net worth or limiting the percentage that can be invested.? Most are structured as closed end funds similar to Private Equity Funds and Venture Capital funds. ?

Investments can be comprised of loans, bonds and other credit and related instruments that are issued in private offerings or issued by private companies.? Some examples of investment instruments are leveraged buy-outs, collateralized loan obligations, venture debt that are privately originated and privately negotiated investments, predominantly through direct lending.

Investments are generally based on availability in the market, the investment targets can be U.S. or non U.S. private companies in the middle market or upper middle market for senior secured loans. There can also be selective second lien and subordinated loans (including loans that rank senior only to a borrower’s equity securities and ranks junior to all of such borrower’s other indebtedness in priority of payment) of private companies. You may see a Private Credit fund invest in liquid credit instruments, such as secured floating rate syndicated loans, securitized products and corporate bonds.? You may see a portfolio that includes equity interests such as preferred equity, debt investments accompanied by equity-related securities (including warrants) as well as common equity investments, which generally could be obtained as part of providing a broader financing solution.

These types of investment strategies are desirable because debt sits above equity in the private capital structure. This means that if a company were to declare bankruptcy, its debts are paid out before equity, making it less risky of an investment overall. Within each level of debt in the capital structure, there are a variety of debt vehicles and different levels of distress/risk as well as different loan terms based on the borrower’s status.

The lifespan of an average Private Credit fund spans 5 to 10 years.? Private debt loans can take many forms, but a few of the most common loan structures are discussed below in slightly more detail.

Leveraged buyouts (LBO) – A leveraged buyout involves the acquisition of a company with borrowed money. The acquiree’s assets are then designated as collateral for the loan. Some of the largest leveraged buyout deals include H.J. Heinz in 2015, Hilton Worldwide in 2007, and R.J.R. Nabisco in 1988.

Collateralized loan obligations (CLOs) – CLOs describe a collection of separate loans that are pooled together and packaged into a security for purchase to investors by CLO managers. The loans are often poorly rated, but investors can benefit from the diversification across the full pool of the loans.

Venture debt – Venture debt describes loans made to small, early-stage businesses, usually in tandem with equity arrangements. Often, venture loans are constructed with specific benefits to the portfolio company in mind, such as by protecting the equity ratio as the company grows or by helping the young company establish a credit track record.?

Real estate debt – A real estate debt fund is typically set up by a private debt manager and backed by their investors. The fund then makes loans to real estate developers for the purpose of building or purchasing real estate properties. The property itself serves as collateral to a senior debt asset.

Infrastructure debt – An infrastructure debt fund is set up with the intention of loaning money to finance the building of essential societal and economic needs, such as roads, bridges, airports, power plants and beyond. Infrastructure debt is seen as a relatively stable and lower-risk form of private debt, with lower default rates than corporate debt

Term loan – A term loan provides a borrower with a one-time lump sum of cash up front attached to certain borrowing terms, including a set repayment schedule and either a fixed or floating interest rate.

Revolving credit facility – A revolving credit facility allows the borrower to borrow up to a set limit and pay back that money on a continuous basis.

Convertible debt – A convertible debt arrangement stipulates that the money the borrower receives from the lender will be repaid in the form equity. Hence the name, the investment is ultimately converted from debt to equity.

The term “senior debt” describes loans that are prioritized as first to be repaid in the event of the borrower’s bankruptcy. Since senior debt has the highest priority, it is therefore the lowest risk. As a result, senior debt typically offers lower interest rates, aka a lower return profile for the investor – but also a lower risk profile since the borrower is seen as favorable. Senior debt is most often secured, meaning that it’s tied to certain assets as collateral in the case that the company cannot make repayment.? While still sitting above equity, mezzanine or junior debt describes credit investments that have a higher risk profile than its senior debt counterpart. In the event of the borrower’s bankruptcy, it is paid out after senior debt. Because of this, its higher risk could mean a higher reward for the lender in the form of higher interest rates and more stringent loan terms. Mezzanine financing is increasingly popular with mid-marketing companies in recent years.

Sourcing deals is a very important part of the investment process. ?Private Debt or Credit funds frequently rely on and work with Private Equity Funds or PE Sponsors, so they do go hand in hand. Maintaining a sponsor relationship with Private Equity sponsors for a constant stream of deal flow is almost as important as the ability to self originate a deal.? Private Debt funds generally spend a substantial amount of time and resources on pre-investment due diligence and screening.? Some have reported spending on average 100 hours conducting due diligence per deal which is similar to the amount of time that Venture Capital Firms spend vetting deals. Some funds have the resources to do all of this in-house, but normally there are also other third parties involved such as accountants, lawyers and other consultants. ?

Finally when evaluating deals, the target company’s track records and stable cash flow are key, as well the overall industry, management team and competitive position. ?Also, a good Private Equity partner who engages in operational and governance oversight can mitigate the private credit fund’s concerns over mismanagement and overall risk in the investment. ?

So, is this the next hot spot? Will this strategy do well in a recession environment? Perhaps, perhaps, perhaps ....