The Case for Private Debt Part 1: What is Private Debt? - Nicola Wealth

The Case for Private Debt Part 1: What is Private Debt?


When we think of investing in debt, we may think of bonds. A bond is basically an I.O.U. from a government or corporation that comes with a certain rate of interest and maturity date when the borrower must pay back the principal. All the complexity of the bond market arises from the fact these debt obligations can change hands many times in their lifetimes, during which their net present value and yield changes.

But if you strip away the securitization of debt into bonds, there exists another, more basic form of debt investment, what we call private debt. “Private debt is just debt financing that’s provided by non-bank lenders that doesn’t trade in public markets,” says Jurgen van Vuuren, Senior Director & Head of Private Debt for Nicola Wealth. It’s a way for companies to borrow money without going to a bank or issuing bonds.

For investors, it’s a relatively new asset class.

Historically, you could always arrange privately to lend money with interest to another person or organization. But until about 10 years ago financial institutions dominated the business of lending to corporations. Then regulations arose in the wake of the 2008 financial crisis that forced banks in the United States to exit lending in the small and mid-market segment of the economy, leaving corporate borrowers and private equity firms in need of new sources of debt financing.

Private lenders, pension funds and other institutional investors, including Nicola Wealth, stepped in to fill that void. In the United States today there are about US$600 billion in private debt assets under management and over US$1 trillion globally—“a sizable market, though just a fraction of the global bond market,” van Vuuren says. “In Canada, where banks still cover most corporate borrowing needs, it’s much smaller and more fragmented, at around $10 billion. But with less competition, there are good deals to be had by creative lenders.”

Private debt comes in a number of forms.

The largest segment is corporate direct lending, much of it for the purpose of financing private equity buyouts (as a general rule normally half of every private equity deal is financed with debt), but also for growth initiatives, working capital and acquisitions. “Corporate direct lending is the lower risk cash yielding cousin of private equity” says van Vuuren. There is also real estate debt, special situations debt, and venture-type debt financing sought by technology and life-sciences companies. So although the market is small relative to bonds, it’s broad in its exposure to different parts of the economy and covers a range of risk profiles.

In corporate direct lending “the loans are usually to mature profitable companies,” notes van Vuuren. “Loans are often to companies with hundreds of millions of dollars in annual revenue.” The incidence of default is comparable to high yield bonds and after peaking at around 8% on a trailing 12-month basis at the height of the COVID-19 shock defaults have settled back to under 2%.

In the next instalment in this series, we’ll examine why now may be a particularly opportune time for investors to get exposure to this asset class.

 

This material contains the current opinions of the author and such opinions are subject to change without notice. This material is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. All investments contain risk and may gain or lose value. Please speak to your Nicola Wealth advisor for advice based on your unique circumstances. Nicola Wealth is registered as a Portfolio Manager, Exempt Market Dealer and Investment Fund Manager with the required provincial securities commissions.