Definition of the private debt, how it works, fund performance, investment strategies: understand everything before investing with Private Corner, an independent and innovative asset management company whose ambition is to institutionalise access to private equity.
Private debt, along with private equity, real estate and infrastructure, constitutes unlisted assets, also known as private assets, referring to investments in companies, assets or strategies that are not traded on public stock markets.
Private debt, private equity and infrastructure funds: contact us to find out more about our comprehensive range of investments in unlisted assets.
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Definition and origin
Private debt, or private lending or private financing, is a type of financing that is not provided by traditional financial institutions such as banks. Instead, the funds come from private investors or specialised investment funds.
The risk/return profile of this type of financing is intermediate between equity and traditional bank debt financing.
This form of financing emerged from the 2008 crisis as an attractive alternative for companies that cannot or do not want to access traditional bank financing or public capital markets.
Types of debt instruments
As with private equity investment, there are many types of private debt instruments, ranging from senior loans to mezzanine loans, distressed debt and even hybrid securities. Here are a few of them.
Senior loans
Senior debt is a financing instrument commonly used in corporate financing transactions. It is considered the safest form of debt for investors, as it has priority over other forms of debt in the event of the borrower's bankruptcy.
Definition of senior private debt
Senior debt is a form of debt that has priority over other forms of debt in the event of the borrower's bankruptcy. It is generally secured by the company's assets or by a personal guarantee from the borrower. Senior debt is generally repaid first in the event of the company's liquidation, before other creditors and shareholders.
Senior private debt offers several advantages for the borrower, including:
Lower interest rates: senior debt generally carries a lower interest rate than other forms of debt, as it is considered less risky for investors.
Flexibility: senior debt can be structured in different ways to meet the specific needs of the borrower, such as deferred repayments or interest-only payments.
No dilution: unlike issuing shares, senior debt does not dilute the existing shareholders' stake in the company.
Investing in senior private debt also has advantages for the investor, including:
Priority repayment: in the event of the borrower's bankruptcy, senior debt is repaid first, before other creditors and shareholders.
Higher interest rates than government bonds: senior debt generally offers a higher interest rate than government bonds, making it an attractive investment for investors seeking higher returns.
Lower risk: senior debt is considered less risky than other forms of private debt due to its priority repayment status.
Required collateral: Senior debt is typically secured by the company's assets or by a personal guarantee from the borrower, which may limit the borrower's ability to raise additional funds in the future.
Financial covenants: Senior debt agreements may include financial covenants, such as maximum debt ratios, which limit the borrower's financial flexibility.
Mandatory repayment: Unlike subordinated debt, senior debt must be repaid at maturity, which can create cash flow constraints for the borrower.
In conclusion, senior debt is a commonly used private debt strategy in corporate financing transactions. Borrowers can benefit from lower interest rates and greater flexibility, while investors benefit from priority repayment in the event of the borrower's bankruptcy.
Junior or mezzanine loans
Mezzanine debt is a form of hybrid financing that combines characteristics of debt and equity. It is often used in leveraged buyouts (LBOs) and real estate investment projects.
Definition of mezzanine debt
Mezzanine debt is a form of subordinated private debt that sits between senior debt and equity in a company's capital structure. It is typically unsecured and not repayable before senior debt in the event of the borrower's bankruptcy. However, it offers higher interest rates and therefore a higher potential return than senior debt due to its higher risk. Mezzanine debt may also include stock purchase options or warrants, allowing the investor to potentially benefit from an ownership stake in the company.
Key points for the borrower
Flexible financing: mezzanine debt can be used to finance a variety of needs, such as acquisitions, buyouts, capital investments and real estate projects.
Long-term capital: mezzanine debt is generally repayable over a longer period than senior debt, allowing the borrower to benefit from long-term capital.
Reduced pressure on cash flow: Interest payments on mezzanine debt can be deferred or capitalised, reducing pressure on the borrower's cash flow.
For the investor
Investing in private mezzanine debt also has advantages for the investor, including:
High returns: mezzanine debt offers higher returns than senior debt due to its higher risk.
Profit sharing: mezzanine debt may include stock options or warrants, allowing the investor to benefit from a stake in the company and its future profits.
Diversification of the investment portfolio with unlisted assets: mezzanine debt allows investors to diversify their portfolio by investing in companies that are not listed on the stock market.
Keep in mind
Although investing in private mezzanine debt has many advantages, it also has disadvantages, including:
Higher risk: Mezzanine debt is riskier than senior debt due to its subordinate position in the company's capital structure.
Higher cost: Mezzanine debt is more expensive than senior debt due to its higher risk.
Potential dilution: Stock options or warrants associated with mezzanine debt can dilute the ownership stake of existing shareholders in the company.
Financial restrictions: Mezzanine debt agreements may include financial restrictions, such as maximum debt ratios, which limit the borrower's financial flexibility.
In conclusion, mezzanine debt is a form of hybrid financing that combines characteristics of debt and equity. Borrowers can benefit from flexible long-term financing, while investors can benefit from high returns and a share in the company's future profits. However, mezzanine debt also has disadvantages, such as higher risk, higher cost and financial restrictions.
Unitranche debt
Unitranche private debt is a financing instrument that combines senior debt and subordinated debt into a single tranche of debt. It is typically used in leveraged buyout (LBO) and acquisition financing transactions. Unitranche debt is becoming increasingly popular with borrowers and investors due to its advantages and flexibility.
Definition of unitranche debt
Unitranche debt is a form of debt that combines the characteristics of senior debt and subordinated debt into a single tranche. It is typically structured as a single loan with a single interest rate and a single maturity. Unitranche debt is usually provided by a single lender or a group of lenders acting as a syndicate.
Unitranche debt for the borrower
Investing in this form of private debt offers several advantages for the borrower, including:
Simplification of the financing structure: Unitranche debt simplifies the financing structure by combining senior debt and subordinated debt into a single tranche of debt. This reduces the complexity and transaction costs associated with setting up multiple tranches of debt.
Flexibility: Unitranche debt offers greater flexibility in terms of repayment structure and financial covenants. Borrowers can negotiate more flexible terms with lenders, allowing them to better meet their specific needs.
Time savings: Unitranche debt saves time in the fundraising process, as it requires less negotiation and legal documentation than traditional financing structures.
For investors
Investing in unitranche debt also has advantages for investors, including:
Higher returns: Unitranche debt generally offers higher returns than senior debt due to the higher risk associated with combining senior and subordinated debt.
Portfolio diversification with unlisted assets: unitranche private debt allows investors to diversify their portfolios by investing in medium-sized companies that are not listed on the stock market.
Stronger negotiating position: Unitranche debt lenders generally have a stronger negotiating position than senior debt lenders, as they are able to negotiate more favourable terms due to the higher risk associated with their investment.
Keep in mind
Although unitranche debt has many advantages, it also has disadvantages, including:
Higher cost: Unitranche debt is generally more expensive than senior debt due to the higher risk associated with combining senior and subordinated debt.
Higher credit risk: Unitranche debt is generally considered riskier than senior debt because it combines senior and subordinated debt into a single tranche of debt.
Lack of liquidity: Unitranche debt is generally less liquid than publicly traded corporate bonds, which can make it more difficult to sell the investment when needed.
In conclusion, unitranche debt is an increasingly popular financing instrument for borrowers and investors seeking to diversify their investment portfolios with unlisted assets. It offers greater flexibility and a simplified financing structure for borrowers, as well as higher returns and portfolio diversification for investors.
Bridge loans
In a private equity transaction, a bridge (or bridge loan) is temporary financing used to bridge the gap between the acquisition of a company and the implementation of permanent financing. This type of financing is often used in leveraged buy-outs (LBOs) or management buy-outs (MBOs) when the time needed to finalise the financing arrangement is longer than the time needed to complete the acquisition.
The bridge loan is generally set up for a period of a few months to a maximum of one year, giving time to finalise the definitive financial package. It allows the buyer to quickly obtain the funds necessary to acquire the company, while giving investors and lenders time to finalise the negotiations and legal documents necessary to put in place permanent financing.
Simplification of the financing structure: Unitranche debt simplifies the financing structure by combining senior debt and subordinated debt into a single tranche of debt. This reduces the complexity and transaction costs associated with setting up multiple tranches of debt.
Flexibility: Unitranche debt offers greater flexibility in terms of repayment structure and financial covenants. Borrowers can negotiate more flexible terms with lenders, allowing them to better meet their specific needs.
Time savings: Unitranche debt saves time in the fundraising process, as it requires less negotiation and legal documentation than traditional financing structures.
For investors
Investing in unitranche debt also has advantages for investors, including:
Higher returns: Unitranche debt generally offers higher returns than senior debt due to the higher risk associated with combining senior and subordinated debt.
Portfolio diversification with unlisted assets: unitranche private debt allows investors to diversify their portfolios by investing in medium-sized companies that are not listed on the stock market.
Stronger negotiating position: Unitranche debt lenders generally have a stronger negotiating position than senior debt lenders, as they are able to negotiate more favourable terms due to the higher risk associated with their investment.
Keep in mind
Although unitranche debt has many advantages, it also has disadvantages, including:
Higher cost: Unitranche debt is generally more expensive than senior debt due to the higher risk associated with combining senior and subordinated debt.
Higher credit risk: Unitranche debt is generally considered riskier than senior debt because it combines senior and subordinated debt into a single tranche of debt.
Lack of liquidity: Unitranche debt is generally less liquid than publicly traded corporate bonds, which can make it more difficult to sell the investment when needed.
In conclusion, unitranche debt is an increasingly popular financing instrument for borrowers and investors seeking to diversify their investment portfolios with unlisted assets. It offers greater flexibility and a simplified financing structure for borrowers, as well as higher returns and portfolio diversification for investors.
Bridge loans
In a private equity transaction, a bridge (or bridge loan) is temporary financing used to bridge the gap between the acquisition of a company and the implementation of permanent financing. This type of financing is often used in leveraged buy-outs (LBOs) or management buy-outs (MBOs) when the time needed to finalise the financing arrangement is longer than the time needed to complete the acquisition.
The bridge loan is generally set up for a period of a few months to a maximum of one year, giving time to finalise the definitive financial package. It allows the buyer to quickly obtain the funds necessary to acquire the company, while giving investors and lenders time to finalise the negotiations and legal documents necessary to put in place permanent financing.
Bridge financing is generally structured as a short-term loan with a higher interest rate than permanent financing. This rate reflects the higher risk associated with this type of temporary financing. The bridge loan can be repaid early as soon as permanent financing is in place.
Bridge financing can be provided by various types of investors, such as private debt funds, banks or private equity firms. Private equity funds may also use their own funds to finance the bridge, pending the establishment of permanent financing.
In summary, a bridge loan is temporary financing used in private equity transactions to bridge the gap between the acquisition of a company and the arrangement of permanent financing. It allows the acquirer to quickly obtain the funds necessary for the acquisition, while giving investors and lenders time to finalise the definitive financing package. Bridge financing is generally structured as a short-term loan with a higher interest rate than permanent financing.
Summary by risk level
Senior debt: this is the safest form of private debt for creditors, as it has priority for repayment in the event of the company's bankruptcy. It is often secured by the company's assets.
Mezzanine debt: this debt is a hybrid between debt and equity, and therefore carries an intermediate level of risk. It is often used to finance specific projects or acquisitions, and generally carries a higher interest rate than senior or junior debt.
Unitranche debt: this debt combines the characteristics of senior debt and mezzanine debt in a single tranche of debt. It is often used in leveraged buy-out (LBO) transactions and carries a higher level of risk than senior debt, but less than mezzanine debt.
Equity: This is the riskiest form of financing for investors, as they are the last to be repaid in the event of the company's bankruptcy. However, it also offers a higher potential return than other private debt strategies, as investors own part of the company and can benefit from its growth.
History of private debt funds: from their emergence to their current appeal
Debt funds are investment vehicles that focus on financing corporate debt. They have evolved over time in response to economic and regulatory changes.
Emergence of debt funds
Private debt funds emerged in the 1980s in the United States in response to the deregulation of the banking market. Banks began selling leveraged loans to institutional investors, such as pension funds and insurance companies, thereby creating a secondary market for these loans. Debt funds were created to purchase these loans and provide attractive returns to investors.
Rise to prominence during the financial crisis
The 2008 financial crisis led to a contraction in traditional bank lending, creating a void in the debt financing market. Debt funds saw an opportunity to fill this void by providing alternative financing to companies. Institutional investors also sought to diversify their portfolios by investing in unlisted assets, such as debt funds.
Post-crisis financial regulation also promoted the growth of debt funds. The new Basel III rules imposed higher capital requirements on banks, limiting their ability to lend to businesses. Debt funds were thus able to position themselves as an alternative source of financing for businesses.
Interest in the current period
Debt funds have continued to grow in popularity in the current period due to several factors. First, historically low interest rates in recent years have made bond yields less attractive, prompting investors to seek higher returns in other assets, such as debt funds.
The COVID-19 pandemic has created investment opportunities in debt funds, as many companies have needed additional financing to cope with the crisis. Debt funds have been able to provide short-term financing to help companies through this difficult period.
Finally, the current environment is marked by the repercussions of the fastest rise in interest rates in forty years, which is beginning to impact the real economy, and by regulatory tightening and strict financial discipline, which are restricting banks' ability to release capital. Companies have continued to seek alternative sources of financing. Debt funds have thus been able to offer tailor-made financing solutions to businesses, while offering attractive returns to investors.
Debt funds have evolved over time in response to economic and regulatory changes. They first appeared in the United States in the 1980s and rose to prominence during the 2008 financial crisis. Debt funds continue to grow in popularity today. They offer attractive investment opportunities for institutional investors and high net worth individuals.
Percentage of deals financed by credit funds vs. European banks (1)
(1) European Banking Federation
Focus on the Capital Solutions strategy
The Capital Solutions strategy is a private debt management approach used by certain major international managers such as CVC Capital Partners and Arcmont Asset Management.
The Capital Solutions Credit strategy is a private debt management approach that aims to provide tailor-made financing solutions to companies seeking capital.
This strategy is implemented by managers who use their expertise to structure complex transactions and respond to companies whose specific financing needs cannot be met by traditional financing channels, such as banks or bond markets. These companies may have needs arising, for example, from an economic slowdown, sector slowdown or market slowdown.
These managers build highly diversified portfolios, usually alongside sponsor managers. With this strategy, managers generally combine hybrid financing with various debt instruments in their portfolios, with a majority of primary transactions but also equity capital. These funds also target secondary transactions or complex situations.
The benefits of the strategy
The Credit Capital Solutions strategy offers several advantages for companies and investors.
For companies
Flexibility and customisation: managers using this approach are able to offer tailor-made financing solutions adapted to the specific needs of companies. This flexibility allows companies to benefit from more advantageous financing terms than those offered by traditional financing channels.
Speed of execution: private debt managers are generally able to make investment decisions quickly, allowing companies to benefit from rapid access to the capital they need.
Expertise and support: Private debt managers who use the Crédit Capital Solutions strategy have in-depth expertise in debt and corporate markets. They are able to support companies in structuring and implementing their financing projects, providing advice and operational support.
For investors
Short investment period
Three-level diversification: targeted companies, global geographical exposure, multi-sector allocation
Deals sponsored alongside leading global managers
Rapid income distribution
Attractive returns for investors with a high target IRR objective.
Like any investment strategy in unlisted assets, the private debt strategy offered by Crédit Capital Solutions involves risks: credit risk, liquidity risk, interest rate risk.
Illustration of an LBO transaction carried out by a private equity fund with the involvement of a debt fund
In an LBO (leveraged buyout) transaction, a private equity fund will acquire a company using leverage, i.e. by financing part of the acquisition with debt. To do this, it will create a holding company that will acquire the target company's securities and will call on a private debt fund to finance part of the transaction. Here are the key steps in such a transaction:
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Step 1: Identifying the target and negotiating the purchase price**
The private equity fund identifies a target company and negotiates with the current shareholders the purchase price of their shares. Once the purchase price has been agreed, the fund creates a holding company dedicated to the acquisition of the target company.
Step 2: Structuring the debt
The private equity fund will call on a private debt fund to finance part of the transaction. The private debt fund will then structure the debt according to the target company's risk profile and its ability to repay the debt. The debt will generally consist of a senior tranche (less risky and less remunerative) and a junior tranche (more risky and more remunerative).
Step 3: Capital contribution
The private equity fund will contribute the capital necessary to acquire the target company. This capital may come from the private equity fund's investors or from third-party investors.
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Step 4: Creation of the holding company**
The private equity fund will create a holding company dedicated to the acquisition of the target company. This holding company will be owned by the fund and any co-investors.
Step 5: Acquisition of the target company
The holding company will then purchase the target company's shares from the current shareholders. The purchase price will be financed by debt raised from the private debt fund and capital contributed by the private equity fund.
Step 6: Management of the company
The private equity fund will then take control of the target company and put in place a new governance structure. It will also implement a business development strategy to increase the company's value.
Step 7: Debt repayment
The target company will repay the debt raised from the private debt fund from its cash flow. The private debt fund will receive interest on the debt and will be repaid in priority over the holding company's shareholders.
Step 8: Sale of the company
Once the target company has reached a certain value, the private equity fund will sell its shares to a new buyer. This sale may take the form of a sale to another private equity fund, an initial public offering or a sale to an industrial buyer. The shareholders of the holding company, including the private equity fund, will then realise a capital gain on their initial investment.
Impact on investors
For private equity fund investors, the LBO transaction allows them to benefit from leverage that will amplify their return. They will also benefit from the capital gain realised on the sale of the company. However, they take on a greater risk than private debt fund investors, who are repaid first in the event of the company's default.
For private debt fund investors, an LBO transaction allows them to earn interest on the debt and enjoy a certain degree of security thanks to priority repayment in the event of the company defaulting. However, their return will be lower than that of private equity fund investors if the transaction is successful.
How a private debt fund works
The operation of a private debt fund can be explained from the perspective of both the fund itself and the investor.
From the perspective of the private debt fund
Fundraising: the private debt fund raises capital from institutional and private investors, such as insurance companies, pension funds, family offices, high net worth individuals, etc.
Investment: The fund then invests the capital raised in debt instruments issued by companies, projects or assets, depending on its investment strategy. Debt instruments can include senior loans, mezzanine loans, subordinated loans, bonds, structured securities, etc.
Active management: The private debt fund actively manages its debt portfolio by monitoring credit risks, negotiating loan terms, conducting financial analyses, tracking company performance and making investment decisions.
Repayment and distribution: When loans mature or are repaid early, the fund repays investors based on their share in the fund. Profits made by the fund are distributed to investors in the form of dividends or share redemptions.
From the investor's perspective:
Subscription: the investor subscribes to shares in the private debt fund based on their investment capacity and risk appetite. The investor must comply with the eligibility conditions set by the fund, such as the minimum investment amount, the lock-up period, etc.
Remuneration: the investor receives remuneration in the form of interest and performance from the debt portfolio.
Risks: the investor takes on credit, interest rate, liquidity and market risks by investing in a private debt fund. The risks depend on the fund's investment strategy and the quality of the debt instruments selected.
Exit: Investors can exit the fund by selling their shares to another investor. The exit may be subject to lock-up periods, notice periods and fees.
In summary, a private debt fund allows investors to invest in debt instruments issued by companies or assets in exchange for remuneration in the form of interest. The fund actively manages its debt portfolio to maximise returns and minimise risk, while investors assume credit, interest rate, liquidity and market risks. Subscription, remuneration, risks and exit depend on the conditions set by the fund and the chosen investment strategy.
FAQs
How do private debt funds generate returns for investors?
These unlisted asset funds earn returns primarily through interest payments made by borrowers on loans provided by the fund.
What types of companies do private debt funds lend to?
They typically lend to medium-sized companies in various industries. These companies often seek capital for growth, acquisitions, or refinancing existing debt.
How does private debt compare to public debt?
Private debt offers higher potential returns and more customised loan terms but comes with higher risk and lower liquidity. Public debt, such as government or corporate bonds, is generally more liquid and has lower risk but also lower returns.
Can individual investors access private debt funds?
Yes, individual investors can invest in these types of investment funds, but access may be limited to sophisticated or professional investors due to the higher risks and longer investment horizons associated with these funds.
Is private debt affected by stock market fluctuations?
It is generally less correlated with stock market fluctuations, making it an attractive option for investors seeking to diversify their portfolios and reduce exposure to market volatility.
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