Private debt, also known as private credit, refers to debt provided by non-bank lenders. There are multiple types of private debt products, ranging from direct residential loans to arranged corporate bonds. This article focuses on direct corporate loans within the context of private debt, which share similar characteristics with those provided by banks but offer several additional benefits to investors.

The recent popularity of private debt globally, and in Australia, is attributed to higher benchmark interest rates set by central banks worldwide. Following the Global Financial Crisis (GFC), benchmark interest rates were reduced and kept relatively low to aid economic recovery. During the Covid-19 period, unprecedented levels of public stimulus programs were introduced to sustain economies. This included record-low benchmark interest rates, such as the 0-0.25% federal funds rate in the US and the 0.1% cash rate target in Australia.

Global markets experienced loose monetary and fiscal policies, pent-up demand post Covid-19 lockdowns, and geopolitical tensions like the Russo-Ukrainian war. These factors altered supply and demand dynamics, contributing to the highest levels of inflation in recent memory. To combat inflation, benchmark interest rates were raised sharply, with the US federal funds rate currently at 5.25-5.50% and the Reserve Bank of Australia’s (RBA) cash rate target at 4.35%. These successive increases in benchmark interest rates have drawn investors to fixed income, with private debt gaining attention due to its relatively high risk-adjusted returns.

In Australia, another reason for the rising popularity of private debt is the scaling back of small and medium-sized enterprises (SME) lending by the local Big4 banks due to regulatory requirements.

Key benefits of private debt are further described as follows:

Attractive Returns:

Private debt generates higher interest income from borrowers, especially SMEs that are underserved by traditional banks. Additionally, investors can earn a higher internal rate of return (IRR) through upfront loan establishment fees and several other one-off fees paid by borrowers.

Inflation Protection:

Private debt loans may feature fixed or floating interest rates. Floating rates typically consist of a base rate tied to a benchmark interest rate, along with a margin that may be fixed or variable, potentially with a floor, depending on loan characteristics.

Structural Protection and Capital Reservation:

Private debt transactions are often negotiated directly between borrowers and lenders, allowing for greater customisation and flexibility in covenants, terms, and conditions of loans that favour lenders.

Borrowers, and sometimes their corporate or individual sponsors, often pledge security (or collateral) such as real estate, specialised equipment, future cash flows, and guarantees.

Another pertinent concept related to capital preservation is the loan-to-value ratio (LVR). For example, an LVR of 70% means that even if the underlying security’s value declines by up to 30%, the lender can still recover all capital, providing a 30% buffer. Typically, LVRs are kept below 100%; otherwise, lenders would require additional protection, such as guarantees from sponsors.

Protection also derives from the loan’s seniority within the borrower’s capital structure, with senior secured loans having priority over the borrower’s assets and cash flows compared to junior loans. Equity, by definition, ranks lowest in the capital structure during a liquidity event. In Australia, the recovery process in an insolvency event is generally simpler compared to the US.

Diversification benefits:

Private debt offers exposure to companies that are typically inaccessible through traditional debt markets, often including businesses in their growth stages owned by established families. Additionally, private debt tends to show lower correlation with equity markets, thereby providing diversification benefits. Geographical diversification can also be achieved by global investors through Australian private debt investments.

Overall, Australian private debt presents a compelling investment opportunity with various benefits, offering high and stable risk-adjusted returns to investors. The primary challenge for investors entering this asset class is selecting the right private debt strategy and finding an investment manager with specialised skills, relationships, and experience in navigating the complexities of direct lending. An experienced private debt investment manager can originate loans with high-quality borrowers and sponsors, maximize returns for investors, and ensure favourable loan structuring and legal documentation.

Author: Claire Vuong, Director at a private debt specialist funds and investment manager based in Sydney, Australia.