Key Arguments for Private Debt

Key Arguments for Private Debt

September 22, 2021

2021 continues to show a unique investment environment dominated by very low to even negative interest rates, highly compressed risk premiums and record-high stock markets.

The financial crisis 2007/2008 and the objective of governments to avoid low growth or a recession at any price, has led to an abundance of liquidity in the financial system. The system’s failure to put this money to work in the economy effectively has created asset inflation.

Various factors such as regulation, politized investment guidelines, the systemization of risk avoidance and the principal-agent paradox resulted in the inefficient allocation of money. Asset classes perceived as less risky and which are traditionally better understood by less sophisticated investors, have become mispriced and their risk premiums distorted (most prominently government bonds and real estate).

An effective path to improving investment portfolios has always been to broaden the investment universe and look for new alternatives. These alternatives, as an investment, come with benefits and associated, often very specific, risks (alternative risks). As any risk factor is also a source of return, being able to open and access new sources of return, i.e. mastering new risks, will benefit investors by improving the risk/return profile of their portfolio.
In this regard, private debt is a truly interesting and attractive asset class on the rise. While being an important asset class in the U.S. for years, its positive contribution to the portfolios of almost any investor is only being discovered in Europe and Switzerland in the most recent years.

Private debt is somehow the interest and credit-related twin of private equity. Both have a history of being highly intertwined and a big part of private debt exposure is related to private equity business.

However, there are more and more private debt independent niches developing. These private credit niche markets are primarily developing because of the retreat of banks from certain sectors of the traditional credit business and their reluctance to enter into new credit businesses as a result of the regulation (Basel II, etc.) and the new dominance of risk management and compliance in banking.

As credit banks reduce their exposure and volume on their books and pull back from specific market segments, opportunities arise for investors to step in and profit.

Private debt, not associated with private equity, is an interesting segment of the credit market for various reasons, being: a multitude of different traditional and alternative risk factors with highly individual pricing (low standardization), attractive returns due to less pressure on risk premiums and in various time frames (short-, mid-, long-term), strong diversification potential and varying liquidity parameters.

Two key arguments speak for private debt investments: a higher return due to an illiquidity and complexity premium, as well as constant cash flow from stable payouts.