PRIVATE DEBT: THE PAST

Macroeconomic trends in recent decades have set the stage for the rising prominence of the private debt market over the last several years.

U.S. Dollar banknotes are seen in this photo illustration. Jose Luis Gonzalez/Reuters


Over the past three decades, the environment for alternative investment has changed considerably, driving the emergence of new capital sources whose effect can be seen on both the supply and the demand sides.

The old saying “investors follow returns, not asset classes" has proven its validity, as witnessed by the growth of total assets under management in the alternative investment industry from USD1 trillion in 1999 to projections of USD13 trillion by 2020.

Before delving into the specifics of the private debt segment, we should lay out three key macro trends that have led to the rise of the alternative investment industry as a whole.

Firstly, there are the record levels of quantitative easing, which have reduced nominal returns for investors, increased pension liabilities, and driven asset prices to extremely high levels.

Secondly, there is the economic rise of non-OECD countries, which created new pools of capital and increased global trade.

Finally, the frailty of social support systems in OECD countries have reduced access to defined benefit plans and increased funding gaps in pension funds.

This broader post-financial crisis scenario has thus lead to the rise of an increasingly popular investment area for both GPs and institutional investors: the private-debt market.

Private debt is primarily offered to small- and medium-sized enterprises by private debt funds, private equity managed debt funds, or hedge fund managed credit funds.

Since 2009, both the number of funds raised and total assets under management doubled their sizes, a testament to the rapid expansion and growth in popularity of this alternative investment solution.

Fairly predictably, the underlying driver behind these numbers lies in the regulations affecting the banking sector as a result of the 2008 crisis. As a matter of fact, of the three forms of debt—mezzanine, distressed, and direct lending, the last has been the fastest growing segment precisely because it has been supplanting traditional bank lending processes.

Regulatory pressures have indeed pushed banks to reduce their leverage and adopt a more capital-light model, syndicating capital risk and offering credit funds with wide opportunities to own it.

According to S&P, the scale of withdrawal by banks from lending markets will lead to a total shortfall, by the end of 2018, of USD700 billion in the EU and UK, with an additional USD500 billion in the US.

Moreover, the proportion of total corporate debt taking the form of bonds and other debt securities is growing steadily, with the scale of net bank disintermediation amounting to roughly USD1 trillion by 2018 in Western economies and another USD2 trillion in China, India, and Australia.

This led to sizeable opportunities for alternative investment funds which have expanded in the credit space, especially in the leverage loan market, where alternative investors have been meeting the demand.

The rapid fall in lending capacity and risk appetite of traditional lenders in the post-crisis years should not overshadow the inherent advantages of the private-debt market, which include the lack of maturity transformation, a low amount of leverage, and attractive, stable spreads compared to sovereign debt, corporate bonds, and high yield securities.

There is also a low correlation with traditional asset classes, providing positive diversification, relatively stable performance across market cycles given a combination of different credit strategies, and highly experienced fund managers with verifiable track records.

In the last eight years, the private debt market has been able to address the gap in the mid-market range as a result of regulations restricting banking activity. Existing industry structures have indeed been shaken, and new and existing customers have been provided with tailored solutions to meet their business needs.

The most affected segment has so far been the mid-market segment, where medium-sized businesses have received extensive capital to spur growth and create jobs to the benefit of broader economies.

However, there is reason to believe 2018 will pose a number of new questions for investors. These will likely see the overall private-debt ecosystem witness a certain degree of change.


This is the first in a series of articles on private debt markets.