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The Private Debt Win-Win

You’ve heard of private equity, but what about private debt? Most people have heard of private equity, but only a select group of investors are familiar with private debt. Of course, private equity is the investment of capital in a private company in exchange for an ownership interest to participate with that company in its growth and profits. Venture capital is a form of private equity but involves investments in companies in the startup phase with high growth potential.

In contrast to private equity, private debt is not an equity but a debt investment in private companies.

Companies raising capital through private debt typically issue promissory notes or term certificates paying fixed interest rates over fixed terms to investors in exchange for investment capital. Private debt investors are lenders/creditors, not limited partners of the issuing companies, and the issuing companies are borrowers/debtors, not general partners.

What’s in it for investors and for issuing companies with private debt?

For companies raising capital, private debt is a quicker and more flexible avenue for raising debt capital than conventional bank lenders. This speed and flexibility come at a premium in the form of higher interest rates, but for many funds looking to acquire assets and do deals quickly, private debt affords them this luxury. As for investors, their benefit is higher returns than any other fixed-income opportunities available on the open market.

After a record-breaking 2021, we saw the public markets reel in 2022 in the face of multiple economic threats, including inflation, recession fears, war, high energy prices, supply constraints, and political conflict. For 2022, the S&P 500 was down 19.44%, and as for crypto, Bitcoin was down 65%, representing the crypto market as a whole.

Ultra-wealthy investors saw the downturn in 2022 well before the general investing public saw it. The ultra-wealthy saw all the free-flowing stimulus money being pumped into the stock and crypto markets. They rightly anticipated that this money would dry up and the markets would correct themselves. They were right. So while the average investor piled into meme stocks and crypto, smart investors were already allocating away from these traditional and popular markets.

Here’s what they were doing in 2020:

“Ultra-Rich Families With Cash on Hand Pile Into Private Debt.” Bloomberg (May 4, 2020)

 

So why private debt, and why now?

The one obvious appeal of private debt is the opportunity to reap high-risk-adjusted returns. According to the CFA (Chartered Financial Analyst) Institute, the average monthly return from private debt according to its private credit index was 1.53% a month. That translates to an 18.36% annual return.

But what about risk? Smart investors have found that the most effective tool for reducing risk is entrust capital to seasoned experts. Because private companies are more transparent than their public counterparts, investors can get to know their potential borrower companies well before committing capital.

Savvy investors are also adept at negotiating protections for their capital, including security (i.e., collateral) to back up their investments.

Perhaps one of the most valuable appeals of private debt is the protection it offers in the face of inflation, which explains its current popularity. So while wages struggle to keep up with the depleting effects of buying power of inflation, fixed-income asset-paying rates that outpace inflation are an ideal antidote to this predicament. Ideal for preserving capital, private debt also offers peace of mind in the face of economic turmoil – providing a consistent income stream in the face of potential job loss or reduction.

Private debt is also insulated from broader market volatility due to its private and illiquid nature. Private debt affords investors access to higher and more reliable income streams, but investors must be willing to give up liquidity. Private debt typically involves minimum terms of 18-24 months and is not transferable during this lockup period.

​Some may view this illiquidity as a drawback. Still, this illiquidity insulates these assets and returns from market volatility since investors are protected from themselves by preventing the types of runs seen in the public markets.

 

The ultra-wealthy have been pouring trillions of dollars into private debt for years to take advantage of high-risk-adjusted returns insulated against broader market volatility while providing a hedge against inflation.

​​In the current market, with conventional lenders tightening borrowing standards, private companies are seeking alternative sources for financing that offer quick and flexible access to capital from investors willing to surrender liquidity in exchange for fixed returns higher than any other public offerings.

Fortunately, private debt investments are no longer exclusive to the ultra-wealthy and well-connected. Thanks to recent changes by the SEC, private debt, along with many other private alternative investments, are accessible and available to more qualified investors than ever.

MIKE AYALA

MIKE AYALA

Mike Ayala has owned and operated mobile home parks since 2007, and has been active in construction and management since he was 15 years old. He graduated from the Associated Builders and Contractors 4-year project management program at age 22 and then became a licensed instructor. He is also the host of the Investing for Freedom podcast.