English
Private debt –debt financing that takes place outside of public markets and outside the banking system – is a highly diverse asset class that offers alternative financing solutions.
Private debt can be highly customizable, with debt that can be structured in a variety of ways – ranging from good old-fashioned lending with interest to deals that combine debt and equity – depending on the lender, borrower and their needs.
Today, we look at four of the most prominent private debt transactions, their key features, benefits, and disadvantages.
Read more about: Understanding Private Debt & How It Differs From Public Debt
- Key features: This is a loan provided by private creditors to companies for a set duration at an agreed upon interest rate and collateral. As with any typical loan,
direct lending comes with senior debt status – when lenders are given priority of repayment in the event of a default or bankruptcy. Covenants – restrictions that lenders put to limit the actions of the borrower – can be used by lenders to mitigate risk.
- Users and use cases: Borrowers are typically mid-market companies looking to fund growth, acquisitions, or refinancing. Lenders are your typical private debt players, including asset managers, insurance companies, and private credit funds seeking steady income.
- Benefits and risks to investors: A direct loan provides them with steady cashflows at typically higher yield than the bond market.
These loans are also secured by assets and collateral reducing the default risk. These loans, however, are usually medium to long-term and are illiquid, making it more difficult for a lender to exit the loan than with public markets.
The lender is also at a higher risk of default if the borrower’s financial position should worsen.
- Benefits and risks to borrowers: Borrowers get faster access to funding than through a typical bank. It also allows them the flexibility to structure the financing in a way that is beneficial to them and not as restrictive as banking loans.
Borrowers can expect to pay a higher risk premium in a direct lending transaction than through a typical bank loan. Borrowers can also be subject to restrictions under debt covenants.
- Key features: Combines debt and equity by giving the lender the right to convert debt to equity in case of a default, usually through a warrant. Mezzanine debt holders are subordinate to standard lenders in the event of a default.
- Users and use cases: Borrowers tend to be companies looking to pursue a leveraged buyout or other types of acquisitions, or those looking for growth capital. Lenders are typically hedge funds, private equity firms, and other asset managers looking for higher yields and equity upside.
- Benefits and risks to investors: The investor gets a higher yield owing to their subordinate position in the debt seniority, as well as potential equity through the warrants. When it comes to risks, their subordinate position in the debt stack makes the impact of default much higher for them.
- Benefits and risks to borrowers: Borrowers who are in a good financial position will get access to speedy, and typically, non-dilutive capital. However, should the borrower not be able to make payments on the loan,
investors can exercise their warrants and hold significant equity in the company. Interest payments on these loans are also usually higher than standard ones.
- Key features: Similar to mezzanine financing and used typically to fund startups, venture debt sees VCs lend to startups with equity stakes in the company as collateral, giving founders capital without necessarily giving up equity. These are also governed by warrants.
- Users and use cases: Borrowers are usually growth stage startups looking to fund extending their runway and scaling operations. Lenders are typically venture capital firms looking for equity upside in a growth-stage and scalable startup.
- Benefits and risks to investors: Benefits include access to growth startups with a potentially massive equity exit down the road, as well as the steady income from interest payments.
Startups, however, are highly risky investments, with 90% of startups expected to fail in their first five years. With the shares being the collateral, there is little recourse for the lender to recoup any losses.
- Benefits and risks to borrowers: Venture debt gives founders access to capital without having to significantly dilute their ownership stakes. On the flipside, high interest rates and repayment obligations may increase cash flow problems, hinder growth, and risk the founders losing significant equity if default occurs.
Read more about: Venture Debt Vs. Venture Capital
- Key features: These are typically loans given to companies facing financial difficulties. These companies are bought cheap and then restructured in a manner similar to private equity.
- Users and use cases: Borrowers are usually companies facing financial and operational challenges.
Investors are typically distressed asset firms and other asset managers that are looking to buy the debt at a discount and profit from the recovery or the restructuring.
- Benefits and risks to investors: Distressed debt can provide an investor with the opportunity to invest in an undervalued company, and if the turnaround is success the returns can be in the multiples.
However, companies in financial distress are at a high risk of default. And because they are in distress, it can be complicated to assess valuations.
- Benefits and risks to borrowers: Distressed debt is the solution of last resort to the companies that need them and could be a crucial lifeline to save a foundering business. That said, borrowers can expect to pay higher interest rates and potentially lose control to creditors.
Disclamer:
This post is for educational purposes only, and the Firm does not directly or indirectly provide these services.
