Do You Want to Be a Bank?

7/3/2023

One of the hot areas in the financial markets is private debt, also referred to as private credit. What is private debt, how does it work, and why is it growing?

The two types of traditional investing are owning an asset like a stock which represents a share in a company, or lending money to an entity. The value of stocks can go up and down. By comparison, when we lend money, we expect to earn interest and hope the borrower repays us the full amount of the loan. Private debt is a form of lending.

In the past, companies have gone to traditional lenders like banks to borrow the capital they needed to operate and grow their businesses. Since the Great Recession of 2009, banks have been more cautious lenders, and they have tightened lending guidelines again recently. This has resulted in private debt providing a significant amount of the capital borrowed by companies in the US. Moody’s currently estimates the current outstanding private debt is about $1.3 trillion and will increase to about $2.0 trillion by 2027.

There are two main groups involved in the world of private debt. First, there are investors who are looking for income. This includes pension funds, endowments, and high-net-worth individuals. The second group consists of the asset managers who accept investor capital and do the actual lending. These asset managers range in size from large money management firms, like Blackstone, to smaller niche firms that specialize in specific lending areas.

Who are the borrowers? The answer is many types and sizes of companies ranging from medium-sized companies needing working capital loans to large private equity firms looking to finance transactions. Borrowers like the flexibility and longer-term perspective available in the private debt markets. Recent history with traditional bank lenders has shown that regulatory oversight and changing capital requirements can reduce the availability of bank loans to fund capital needs and thus hinder companies’ ability to operate and grow. The private debt market is more lightly regulated.  This helps private debt managers provide loans that are often viewed as more stable and patient.

The risk in the private debt space is the same as the risk of lending money for any lender. One of the main risks is the impact on borrowers’ ability to repay if there is an economic downturn. Economic conditions have recently been mainly positive for private debt. Even during the Covid pandemic, private debt performed well. But a prolonged recession will test borrowers across the spectrum. Lenders of all types, including private debt funds, will see losses rise if default risks increase.

Is private debt suitable to be a part of an individual’s investment portfolio? The answer depends on several factors, including investor status, the desire for income, possible benefits of diversification, risk tolerance, and the ability to accept some level of illiquidity. Just like any investment, it is critical to understand the risks of a potential allocation to private debt.

Carl Gambrell