With interest rates at historic lows, asset classes such as commercial real estate debt, infrastructure debt and corporate debt are increasingly attractive. But this is not just because of their potentially higher yields. In this article, we compare private debt with public debt (i.e. bond markets). We highlight some of the benefits of private debt investments and the main features distinguishing them from public debt.
Access to unique drivers
One advantage of private debt is that it allows us to invest in markets that are otherwise inaccessible.
One advantage of private debt is that it allows us to invest in markets that are otherwise inaccessible. Private infrastructure debt for example, can provide access to areas such as renewable energy. In the UK and Europe, renewable energy projects are generally backed by government subsidies. These subsidies safeguard a project against fluctuating electricity prices. Importantly, the company can use payments for the energy it provides to create a stable cashflow for investors.
Of course, some publicly traded utility companies also own renewable energy projects. However, their businesses are so broad that investing in these firms also exposes investors to fluctuating energy prices and changes in retail pricing. By including renewable projects in the portfolio, investors can potentially gain exposure to drivers that are more idiosyncratic and less closely linked with the economic cycle. In this way, investors can seek to diversify the sources of return from their portfolios. Investment returns from a renewable project are influenced, not by changes in electricity pricing, but by environmental factors and project-specific technology risks. For example, solar projects are affected by the reliability of sunshine forecasts and the efficiency of technologies still under development.
Access to smaller issuers
Commercial real estate debt in the private market tends to comprise one or a few assets in different regions of the UK. Underlying market drivers vary depending on the property sector and location. A prime office in London has very different set of economic drivers to an industrial park in north England. Commercial real estate debt lets us invest in small or rare issuers with unique assets. Typically, these companies don’t seek public bond market funding.
Investors in private debt can have far greater influence over the negotiation and structuring of the debt. Private debt investments are usually tailored to the specific needs of the asset or company being financed. Additionally, they nearly always have some form of financial covenant. This might be a level of debt or profitability that, if breached, would alert the investors and allow them to intervene to avert trouble.
Debt structures and recovery values
Around 95% of public bond market issuance is unsecured (i.e. not backed by assets that could be sold to repay the investor in the event of default). In the private debt markets, almost all issues are secured, thereby reducing the risk for investors.
Because private debt is secured, in the event of default, recovery values for private assets are generally much higher than those on the public market. Chart 1 shows that a private corporate debt instrument has a recovery value of around 80% (80 pence recovered for every pound invested). For an unsecured public corporate bond, the recovery value is around 50%.
Chart 1: Recovery levels for public debt (grey bars) versus private debt (blue bars)
Flexibility in negotiation
A bond issue can be sold to numerous market participants. Private deals involve far fewer parties – usually the borrower and one or a small group of investors. This allows considerable scope in negotiation. So, if an investor has a certain requirement – such as cash outflows that need to be met in 20 years’ time – they can work with the borrower to accommodate the needs of both parties.
Most public bonds are rated by one or more of the rating agencies, giving investors an idea of the quality and riskiness of a bond. Most private debt has no such quality-rating. The onus is on the investor or their asset manager to undertake a ratings analysis as part of the credit assessment. However, it also means fewer investors can participate in the debt, so there’s less competition. Moreover, it encourages a more prudent approach to risk management that relies on robust analysis of the debt. This contrasts with public bond markets, which tend to be heavily reliant on agency ratings.
Compensation for illiquidity
Public bonds are usually traded actively, so market prices are readily available. By contrast, private assets don’t tend to trade regularly and so there are no readily observable market prices for them. Instead, they are valued at ‘amortised cost’ or by calculating their ‘fair value’. Private debt and other illiquid assets tend to pay higher yields to compensate investors for being unable to readily exit a position. This potential extra return over comparable public bonds is called the ‘illiquidity premium’.
It’s important that the extra return being offered is high enough to compensate for the asset’s illiquidity. Asset managers with expertise across both the public and private debt markets are best placed to make this assessment.
Private debt investing offers many potential advantages – higher yields, greater security (and therefore higher recovery values), flexibility and influence over the structuring of the asset, and the right to intervene in the event of problems. Private debt investing can also enhance portfolio diversification by providing exposure to idiosyncratic drivers different from those influencing public bond markets.
These benefits come with a caveat. The lack of a readily tradeable market for private assets limits an investor’s ability to quickly shift position. Therefore, it’s imperative to invest only in well-structured assets that are professionally managed and that have undergone a thorough credit assessment.