Fixed Income investors have heard the same story repeatedly over the past few years: there is no juice in traditional fixed income products, and investors will have to look elsewhere to earn any meaningful yield. We see an opportunity for our clients in private debt, as the risk premium of over 5% above comparable high yield bonds nicely compensates for the illiquidity of this asset class, which is arguably the most common barrier to investing. However, we find that most of our clients hold over 85% of their family portfolio in highly liquid securities (i.e. with less than a week of liquidity). The expansive monetary policies of central banks, coupled with some distortions formed by the 2008-2009 financial crisis, have created a great opportunity to lend to middle market private companies.
Brief Overview of Private Debt
Private debt is often utilized by small and mid-sized companies looking for capital or financing. These firms are known as “middle-market” companies- broadly defined as those firms with EBIDTA of $15mm to $100mm and capital needs of $50mm to $500mm. [1] Because of their size, these middle-market firms have limited access to liquid capital markets, which have high minimum issuance sizes. The average issue size per bond in the iBoxx High Yield Corporate Bond index is currently $855 mm.[2]
There are different types of private debt securities- the most typical are in the form of senior loans (first and second lien); unsecured and subordinated debt; and hybrid instruments (combining senior and subordinated debt). The two principal sources of private debt deals are private companies and private equity sponsors. Private companies may look for funding to make acquisitions, to refinance or for growth capital. Private equity sponsors also look to the private debt markets when a transaction such as leveraged buyout or add-on acquisition occurs, or a company needs refinancing.[3]
Investors in private debt earn returns from two factors: 1) contractual return components and 2) equity upside. The contractual return component is the base of the return stream (consisting of high coupons typically 10-15%), plus up-front commitment fees and sometimes premiums relating to early redemptions. Equity upside can be a source of return in some private debt deals. A private debt investor will usually have the opportunity to make equity co-investments in a deal to enhance returns; or sometimes have warrants which potentially benefit from capital appreciation. Private debt investments are positioned higher in the capital structure than equity, giving investors a priority on cash flows of the company.
To understand the risk/return profile of private debt investments it can be helpful to compare this asset type with high yield bonds and private equity (see Table 1 below). While private debt is illiquid when compared to high yield bonds, when compared to private equity we see two main differences: 1) Private debt has a shorter investment period (usually 3-5 years); and 2) Private debt generates attractive cash flows (today we expect around a 9% current yield).
TABLE 1
Current Opportunity in Private Debt
We like the attractive yields and risk profile of private debt. Private debt is a highly specialized market. Thus, it requires managers with a strong track records as well as a solid network to gain access to deals. We believe the best way for our clients to invest in private debt is through a high quality third party manager. Over the past few months, we have been looking into different managers in the space, focusing on these core qualities:
- Track record through multiple credit cycles. We’re looking for managers with a long track record through different market cycles. There are many funds which boast a 0% default rate- but have only been investing since 2009, a period of low defaults across the board. We want to see a team that has proven itself to invest in difficult market and credit environments.
- Access to private equity sponsors/ deal flow. We want to work with managers who have direct access to private equity sponsor and deals. This access is important because it ensures the manager is seeing the best deals first- and has first choice in participating. Managers with good access also avoid paying fees to a middle man – which would otherwise be absorbed by the investors in the fund.
- Strong investment process/ due diligence process. We want to see a proven track record as well as a strong investment process. We like to see highly experienced teams with the right firm infrastructure to allow for in-depth due diligences.
- Alignment of interests. We are always looking for a meaningful alignment of interests when we invest, in this case a capital commitment to the fund from the fund senior managers and or the firm.
- Dividend Distributions. In line with our investment philosophy, we look for managers that pay distributions of around 75% of their gross yields. That means at least 9% current yields with expected gross returns of 13% to 17% per annum.
Report by Ignacio Pakciarz, CEO and Ilina Dutt, Research Analyst, BigSur Partners. You may access the full report through this link.
[1]Rocaton Insights, “Opportunities in Private Middle Market Lending”, January 2013
[2]iShares, data as of January 31, 2014
[3]ICG, “Introduction to Private Debt,” January 2014
