Public debt vs private debt
Public debt can be invested in and traded on public markets, for example bonds (loans to corporates and governments), and tends to be a relatively low risk/low returning fixed income investment. As the returns are ‘fixed’ they can be less attractive when interest rates rise as their returns lag the market.
The returns from private debt compare favourably to those of public debt. Understandably investors want to be compensated for the illiquidity that features where there is no tradable market for their investment. This means private debt investments tend to pay higher yields. This is known as the ‘illiquidity’ premium. Some private debt investments also vary their yield based on an underlying interest rate. These ‘floating rate’ debt investments aim to provide investors with flexibility in a rising interest rate environment.
Private debt is also more likely to be secured than its public market equivalent e.g. bonds or gilts (asset manager abrdn states that around 95% of public market issuance is unsecured (source abrdn.com)). These factors contribute to private debt’s superior risk-adjusted returns over public debt.
Why invest in private debt?
The private debt asset class offers investors multiple attractive benefits such as: portfolio diversification, reduced volatility, the potential for superior risk-adjusted returns and a way of targeting returns that are less correlated with public markets. We explore each in turn below.
Potential for superior risk-adjusted returns
Offering more flexibility to a borrower than a traditional lender would be willing to provide does not necessarily mean an increase in risk. Indeed, because companies are prepared to pay a higher interest rate, the targeted return is therefore higher, ultimately creating a more attractive risk-adjusted return.
Some direct private debt deals may also include a small equity share in the company: not as much, clearly, as in a full private equity deal, but some degree of ‘equity kicker’ to further enhance returns potential and share in any upside as the company grows.
Target reliable income streams
Investing in debt can provide investors with a predictable stream of income through regular, scheduled, contracted repayments.
Reduced volatility
As investment returns from private debt often take the form of regular repayments, the asset class can be used to reduce the volatility of a portfolio which includes equities, where the timings of returns, through exits and realisations, are less predictable.
Portfolio diversification
Private debt provides opportunities for investors to diversify sources of risk and return for their investment portfolio through a differentiated asset class. Contractual repayments on a loan are unaffected by the market for mergers and acquisitions or other exit routes such as a stock market listing which holders of equity in a private company are targeting. Private debt is commonly used to provide diversification from equities.
Diversified sources of income
Investing in a diverse range of private debt opportunities spreads risk. Diversity of income source can be achieved through investing through multiple companies but also different entry routes to the asset class such as direct investments, co-investments and investments in private debt funds, which may target companies of different sizes, in different sectors and using differentiated private debt strategies.
Diversification from public markets
Investments in private companies, including private debt investments, have not historically been correlated with public markets or traditional fixed-income assets.
Inflation hedge
In an inflationary environment and with rising interest rates, many traditional fixed income debt investments such as gilts or bonds have their returns eroded. Some private debt strategies invest in floating rate loans which means returns are not fixed and can vary against a reference point. These strategies can be used to hedge against increases in inflation and central bank interest rate rises.
What are the investment returns from private debt?
Private debt can offer investors attractive risk-adjusted returns, which are less correlated with the performance of public markets and may provide regular income payments. The range of those potential returns correlates with the type of debt provided and its position in the company’s capital structure which dictates the order capital is returned to investors/lenders in the event of sale or liquidation.
Senior debt, often provided by a bank, is the first in line, making it the lowest risk. Target gross annual returns from a senior debt investment are around 4-7%. This is followed by unitranche debt (8-14%) and then mezzanine debt (15-20%). Equity is higher risk but has higher return prospects as it is last in the capital stack.
How to invest in private debt
Connection Capital offers access to private debt investment opportunities in a variety of ways:
Direct
Sourced and diligenced by our Direct Investment team with a focus on direct lending investments in profitable UK SMEs. Read more.
Co-investment
Single asset transactions we source through third party managers. Read more.
Private debt funds
We source, diligence and enable access to a diverse range of third party managed institutional-grade private debt fund strategies ranging from direct lending to structured credit funds and most things in between. These private debt strategies are highlighted below. You can read more about our approach to Fund selection here.
