Investing in private debt capital offers the opportunity to earn a return through interest payments and possibly increase the enterprise value of the company borrowing the money (depending on the structure of the transaction). Since debt is a lower-risk asset class compared to equity, the returns are historically lower than those from stocks or private equity investments, but they are safer.
Public Credit Market or Private Credit Market
Public debt, or public debt securities, can be invested in and traded on the public capital market, such as through bonds (loans to companies and governments), and are generally relatively low-risk/low-return fixed-income investments. These returns are “fixed,” meaning they can become less attractive in a rising interest rate environment as they tend to lag behind the market.
The returns from private deb – debt securities in private markets – are comparatively better than those from the public market: Investors want to be compensated for the illiquidity that arises when there is no tradable market for their investment, the so-called “illiquidity premium.” For some private debt securities, the return also varies depending on an underlying interest rate. These variable-rate loans are designed to offer investors flexibility in an environment of rising or falling interest rates.
Private debt is also usually better secured than its public market equivalents – abrdn reports that about 95% of issuances in the public market are unsecured. These factors contribute to private debt often having a higher risk-adjusted return than public debt.
Why Invest in Private Debt?
The asset class of private debt offers investors numerous advantages:
Potential for Higher Risk-Adjusted Returns
Offering a borrower more flexibility than a traditional lender would not necessarily increase risk. Since companies are willing to pay a higher interest rate, the targeted return is also higher, ultimately leading to a more attractive risk-adjusted return.
Some direct private debt deals may also include a small equity stake in the company – not as much as a full private equity deal, but some “equity kicker” to further enhance the return potential and participate in any gains as the company grows.
Reliable Income Streams
Investments in debt can offer investors a predictable income stream through regular, scheduled, contractually agreed-upon repayments.
Lower Volatility
As returns from private debt often flow in the form of regular repayments, the asset class can be used to reduce the volatility of a portfolio.
Portfolio Diversification
Private debt offers investors the opportunity to diversify the risk and return sources of their investment portfolio through a differentiated asset class. The contractual repayments of a loan are independent of the mergers and acquisitions (M&A) or equity (stock) market. Private loans are often used to diversify against stocks.
Diversified Income Sources
Investing in a wide range of private debt spreads the risk. Income source diversification can be achieved by investing in various private debt funds that target companies of different sizes and industries and apply differentiated private debt strategies.
Diversification from Public Markets
Investments in private companies, including private debt investments, have historically not been correlated with public markets or traditional fixed-income investments.
Hedge Against Inflation
In an inflationary environment and with rising interest rates, the returns of many traditional fixed-income investments are eroded. Some private investment strategies invest in variable-rate loans, meaning the returns are not fixed and can fluctuate based on a reference point. These strategies can be used to hedge against inflationary increases and central bank interest rate hikes.
The good news in conclusion: These advantages can increasingly be utilised by private investors as well. Since the ELTIF amendment at the beginning of the year, more and more national and international asset managers are offering private debt as an investable asset class. According to the rating agency Scope, a record number of ten new Private Debt ELTIF 2.0 funds were launched in the first nine months of 2024 alone, with only Private Equity having more new launches with twelve.