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Investors’ demand for stable investment returns with a low correlation to public markets has accelerated the growth of the private debt sector since the beginning of the COVID’19 pandemic. With over $1.25 trillion in total assets as of Q2 2022, private debt is currently the third-largest alternative asset class after real estate and private equity. The sector is expected to witness one of the highest growth rates among private capital assets over the next five years, as market conditions make private debt investments increasingly more attractive to investors of all types.
According to Preqin's forecasts for the private debt sector based on 2010 - 2021 data, private debt assets under management (AUM) are expected to approach $2.69 trillion by 2026, surpassing real estate by 2023.
This forecast is driven by an expected CAGR of 17.4% for 2021 - 2026, compared to the 12.8% achieved since 2010. Since the publication of this forecast, market conditions have shifted to indicate an even faster growth rate in the private debt sector.
The key underlying drivers of growth for private debt investments over the past decade in Asia are:
Since late 2019, public and equity markets have experienced increased and persistent volatility, driven by ongoing global supply chain and geopolitical crises. Meanwhile, the low interest rate environment has resulted in low yields from public fixed income products. The stability, low market correlation, and higher yields of private debt assets have rendered this asset class a haven for investors seeking stability in their returns.
As a result of the fast-growing middle class in Asia over the past two decades, stricter regulations on bank lending following the Global Financial Crisis, and low supply of non-bank capital, there exists a fundamental gap between the supply and demand of credit in the region. According to the IFC, there is a US$500 billion opportunity for lenders of private debt in Southeast Asia alone.
A growing number of new opportunities and strategies have become available to credit investors across Asia, as a result of the increase in consumer spending and the subsequent rise of fast-growing start-ups in the region. The technology sector in Southeast Asia has especially become a target for Private Equity and Venture Capital firms from North America, Europe, and North Asia, creating a credit-positive environment for lenders in the sector.
Though all private debt investments refer to loans given to unlisted companies, numerous strategies with distinct risk, fee, maturity, and repayment profiles can be followed by private debt investors. These strategies include but are not limited to:
Refers to working with non-banking creditors to primarily finance working and expansion capital directly to companies without using an intermediary. The return potential and risk profile here significantly vary in proportion to the type of repayment, tenor, seniority, and security of the loan, as well as the financial condition of the borrowing company.
Typically refers to subordinated hybrid credit instruments with embedded equity instruments. These loans are at higher risk than other kinds of debt instruments due to their subordination. In response to the increased risk, mezzanine debt investments often offer higher returns to investors. Mezzanine debt instruments are mostly used by established companies to finance specific projects and are commonly used in acquisitions and buyouts.
Ordinarily refers to loans given to venture-backed, high-growth companies that include warrants over the company’s equity. Founders of the borrowing start-ups regularly use the proceeds from their venture debt raises to further extend their cash runways and as an alternative source of non-dilutive capital. Other common use cases of venture debt include performance insurance, as well as CAPEX and inventory financing.
Consists of loans made to distressed companies facing bankruptcy, insolvency, or other unfavourable financial conditions. Due to the borrower's financial situation, there is a higher risk involved, but higher interest rates at origination or discounts during the purchase of distressed debt also result in higher returns.
Refers to loans intended for specific purposes, such as financing mergers and acquisitions (M&As) or acquiring an underperforming business. These loans often carry upside return characteristics of equity investments when underlying assets are discounted due to lack of liquidity, market disruption, business cyclicality, or an unsustainable capital structure. The risk profile for special situations loans is primarily driven by the specific circumstances that motivate the investment.
Subject to the specific strategy and instrument used, private debt investments can provide investors with major benefits over other assets. These include, but are not limited to:
Debt instruments have a more senior position on the capital stack than equity, allowing for the first claim on the borrowing company’s assets in cases of defaults. Depending on the security and subordination of the instrument, borrower defaults can lead to partial or full recovery of both the principal and accrued interest.
Returns on performing credit lines are predictable and steady over time, as the returns are typically derived from regular interest payments and related fees. For passive and income investors, these regular payments can also provide steady cash flows over the lifetime of each loan.
Private debt returns are largely independent of public market performance since they are based on interest payments and other fees determined through bilateral contracts. However, the borrowing company's ability to repay loans even for private debt may be hampered by public market downturns, introducing a small statistical correlation. These downturns can reduce the availability of equity funds or increase interest rates for additional debt funding.
Private debt investments are originated and structured through negotiations between the lender and borrower, requiring a direct and close relationship between the two parties. This allows lenders to negotiate for numerous clauses to protect and monitor their investments in a more controlled environment, including covenants the borrower is required to meet to avoid an event of default, security packages, reporting requirements, and the rights of the lender.
Private debt, as an asset class, shows low correlation to public markets and equity investments while producing reliable yields for investors. This makes private debt investments an attractive option for investors looking to diversify their portfolios against market volatility or for hedges against inflation.
As with every type of investment, private debt also comes with its challenges. Barriers to entry include significant roadblocks in debt origination and challenges in credit risk assessment for investors inexperienced in the asset class. Partnering with investment advisors can help mitigate the risks and avoid barriers, while also optimising returns to capitalise on this growing market:
Private debt origination is challenging, frequently requiring extensive networks to find potential borrowers who match lender preferences for risk and return.
Maintaining appropriate returns against risk requires thorough evaluation. Due to scarce insights on traditional credit scores and other data points in the private markets, investors need to rely on risk models to assess potential opportunities, in order to ensure that their investments fit their appetite for risk and returns. Though private debt returns show low volatility against public markets, the risk for these investments is not inherently lower. Therefore, it is critical for credit risk models to accurately identify vulnerabilities and sources of risk in private debt opportunities, such that investors can avoid underperforming positions or potential losses of their principal.
These models need to be precise, providing investors with accurate representations of the risk underlying each potential debt investment, in order to inform both pricing models and investment decisions. For these models to reliably provide actionable and relevant insights, deep expertise in the focus markets, types of borrowers, and local regulations, as well as strong tech capabilities for automation need to feed into their development. This typically requires significant input from advisors, finance professionals, software developers, and other subject-matter experts.
To achieve high risk-adjusted returns, appropriate structuring of loan agreements is essential. Building in the right mixture of covenants, conditions, reporting requirements, and security structures, among others, are key to ensuring successful repayments from borrowers and adequate coverage in case of borrower defaults. Drafting contracts that ensure investor returns even in cases of undesirable eventualities requires in-depth market knowledge and significant expertise in legal structuring.
As a result of these caveats, investors can best gain exposure to private debt assets through investment firms and funds, whose expertise in legal structuring, networks for origination, and existing risk management and monitoring processes can ensure high risk-adjusted returns for investors.
Meanwhile, pre-existing standards on loan agreements, reporting requirements, and recovery processes in cases of borrower defaults can ensure the highest levels of downside protection.
At Helicap, investors can gain exposure to high-quality debt investment opportunities through our co-investment platform, curated by an experienced team of specialised private debt professionals and powered by our proprietary credit risk analytics engine.
Learn more about our unique technology here.