Private Debt: Predictable Real Returns

Your Portfolio Mix: The Appeal of Contractual Returns

There’s a place in your investment allocation for a mix of asset classes. Consider the characteristics of equity, investment grade credit, high yield credit, real estate, cash, and other options – but hold a place in the mix for private credit.

Private debt offers predictable, contracwtual cash flows. To consider the balancing role it can play as part of your asset mix, consider the differing characteristics of some other asset classes. Private equity, for example, has historically offered attractive average returns, but low predictability what those returns might be.. The level and timing of the returns, along with cash flows, are among the more difficult to predict, and essentially are only realized through asset sales at an unknown time and value. Among the liquid or traded investment asset classes, publicly-traded equity can be valued or realized, but cash flows are limited to dividends if any. Shareholders know the value today, every day, but we do not know what the public equity market value will be at any specific time in the future. . Net-net? Stock market returns come with  low predictability, and low cash flows. But you knew that…

Publicly-traded debt offers cash flows and additional liquidity, but at a lower return. It also offers no potential upside adjustment, as most bonds are fixed-rate. Not only does private debt offer a liquidity premium,[2] it also offers the additional predictability because the investors are closer to the corporate managers and have more control and visibility over the cash flows. And don’t underestimate the power in stressed times of holding the senior tranche of credit, which is more frequently the case in private debt than in other credit classes.

Good ‘Old-Fashioned’ Credit

Private lending typically follows some of the tried-and-true, fundamental principles of protecting the lender. That is, these products protect you, the investor. In today’s markets, most bonds, bank loans, and other forms of investable corporate debt are bullet loans, with no interim principal payments. With the cash being back-end-loaded, in these structures the banks and investors are reliant upon of the credit quality of the borrowing company at a single point in time. And potentially at the mercy of the financial markets at the due date of the bullet, as well.

A long time ago in a galaxy far, far away,[3] lenders usually required specific financial or other covenants to protect their interests, a practice which competition among banks and underwriters has eroded but which remains in private debt contracts. Even large corporations would issue ‘sinking fund’ bonds in which a portion of the bonds outstanding were retired each year, reducing risk to investors. Bank loans, too, were structured with scheduled principal payments over time, another anachronism which faded away as borrowers began to hold the upper hand. In private debt, not only do we still see covenants, but private debt managers usually monitor the borrower’s operations very closely. Covenants are usually customized to the real-world risks of the borrower, and often allow investors to step in at the first signs of a problem, reducing the likelihood of a late payment.

By definition, private debt is issued by companies which choose not to, or can not, access the public debt markets or attract the interest of banks. Private debt investment companies structure contractual cash flows with more certain streams through the life of the investment. If my bank wants to see a little principal with each of my home mortgage payments (despite mortgages being secured loans), shouldn’t I want a little old-fashioned predictability?

[1] Floating Rate Notes, a small segment within credit, typically have maturities of 2 years to 5 years
[2] One might more appropriately describe this as an illiquidity premium.
[3] If you saw the first run of this movie in theatres, you remember sinking fund loans where borrowers made interim principal repayments for the protection of the lender/investor .. Star Wars, Lucasfilm, 1977.