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Aon Retirement and Investment Blog

What is Private Debt?

Private debt can be broadly defined as any non-publicly traded debt financing of a company and typically references companies in the small- and middle-market segment. The debt of large-market companies is more commonly traded in the public markets. Private debt includes a wide range of investment strategies, which offer investors access to a broad opportunity set that is capable of meeting varying risk/return goals. While private debt may be considered a stand-alone asset class today, many of the underlying investment strategies are not new to institutional investors and have historically been classified under different asset classes such as private equity, hedge funds, and real estate. Investment strategies that fall within the private debt asset class include capital preservation-focused strategies (e.g., direct lending, mezzanine debt and venture debt), capital appreciation-focused strategies (e.g., distressed debt and special situations), as well as opportunistic credit strategies (e.g., non-core loan portfolios, specialty finance, royalties, structured credit, commercial real estate loans, and regulatory capital relief trades).

Direct Lending

Direct lending is defined as the origination of loans by non-bank lenders to small- and middle-market companies in generally below investment grade transactions. Loans are typically floating-rate and senior secured, which is top of the capital structure to provide for downside risk protection. The small- and middle-market companies typically use the loans for leveraged buyouts, acquisitions, dividend recapitalizations or organic growth initiatives. In many cases, the borrower is owned by a private equity sponsor. As of March 31, 2018, direct lending accounts for the largest share of Preqin’s private debt market with approximately $235.4 billion of assets under management.[1]

  • “Direct Lending: An Investment Opportunity Within Private Debt,” March 2018.
  • “Understanding European Direct Lending ”October 2018.

Mezzanine Debt

Mezzanine debt is defined as any subordinated or preferred equity instrument that represents a claim on a company’s assets that is senior only to that of the common equity shares. In the event of default, the mezzanine debt holder will only be repaid after all senior obligations have been satisfied. To compensate for the increased risk of being lower in the capital structure, mezzanine debt holders require a higher return for their investment than more senior debt holders. A typical mezzanine debt position will generate returns from (i) cash interest, (ii) payable in kind (PIK) interest (a form of payment in which the interest payment is not paid in cash, but rather by increasing the principal amount of the loan by the amount of interest earned), and (iii) a small equity stake in the form of attached warrants or a conversion feature similar to a convertible bond. As of March 31, 2018, mezzanine debt accounts for the third largest share of Preqin’s private debt market with approximately $150.7 billion of assets under management.1

Venture Debt

Venture debt is a type of debt financing targeted towards venture-backed companies by specialized banks or non-bank lenders to fund working capital or capital expenses, such as purchasing equipment. Unlike traditional lending, venture debt is available to startups and growth companies that do not have positive cash flows or assets to use as collateral. To compensate for the higher risk of default inherent in these loans, venture debt providers will combine warrants or rights to purchase equity to the loans. As of March 31, 2018, venture debt accounts for the smallest portion of Preqin’s private debt market with approximately $14.6 billion of assets under management. 1[1]

Capital Appreciation-Focused Strategies

Distressed Debt

Distressed debt is a broadly defined category that in its simplest form involves the purchase of securities (e.g., bonds, debentures, notes, mortgages or other asset-backed instruments, equipment leases, trust certificates and commercial paper) from below investment grade companies at a substantial discount to fundamental value. In many instances, a transaction will involve companies that are undergoing, or likely to undergo, a bankruptcy or other situation such as a debt restructuring, reorganization or liquidation outside of bankruptcy proceedings. Underlying investment strategies can vary broadly, and may include (i) distressed and out-of-favor credits, including commercial and corporate loans and asset-backed securities, (ii) residential sub-performing or non-performing loans and securities, (iii) corporate and commercial loans, mezzanine loans and other investments in subordinated levels of the capital structure of issuers, and (iv) publicly traded or privately negotiated equity securities (such as preferred stock, common stock and warrants) of stressed and distressed firms. As of March 31, 2018, distressed debt accounts for the second largest share of Preqin’s private debt market with approximately $224.1 billion of assets under management.1

Special Situations

Special situations is a broad categorization of investment strategies that make debt and equity-like investments, often referred to as “rescue financing,” to companies undergoing operational or financial challenges. These strategies are typically seeking to identify undercapitalized segments of niche markets where their capital can exploit point-in-time opportunities. By their very nature, these strategies are often cyclical and/or tied to periods of distress in the market. As of March 31, 2018, direct lending accounts for the fourth largest share of Preqin’s private debt market with approximately $101.4 billion of assets under management.1

Opportunistic Credit Strategies

Opportunistic credit strategies don’t employ a one-size-fits-all approach. Some gravitate toward investment themes where an asset manager’s in-house expertise gives them a unique advantage. Themes can also change quickly as parts of the market become increasingly competitive, or specific opportunities fail to materialize as anticipated. Aon’s research teams have highlighted several of these strategies over the years, including:

  • “Opportunistic Strategies for Navigating A Changing Credit Landscape,” November 2014.
  • “Commercial Real Estate Debt Overview,” August 2018.
  • “Bank Capital Relief,” October 2018.
The file here illustrates the differences in various characteristics of the strategies explained above.

Eric Denneny is a member of both the global private equity investment committee and the global credit committee, and he is based in Lincolnshire, Illinois.

1 Preqin Pro Market Data research as of March 31, 2018.

[1] Preqin Pro Market Data research as of March 31, 2018.

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