Should Investors Consider Adding Private Debt to Their Portfolio?
A good investment portfolio is diversified, balancing both risk and reward. Investors often include a mix of stocks, bonds, and other asset classes in their portfolios to create this balance. However, in recent years, there has been growing interest in private debt, an emerging asset class amongst the investing public.
Private debt refers to loans or bonds issued by private companies, as opposed to public companies whose debt is traded on public markets. Here are two examples to illustrate the differences -
Public debt example – a large retailer goes to a traditional bank to raise a $3 billion public debt offering to expand operations over the next 5 years. Investors can buy and sell these bonds every day that the bond market is open.
Private debt example – a mid-sized retailer goes to a non-bank entity, such as an investment fund to raise $25 million to build 5 stores over the next year. They use their existing buildings as collateral for the loan. The investment fund then creates shares that can be purchased privately by limited investors.
Advantages of Private Debt
Potentially Attractive Returns: One of the primary reasons investors consider private debt is the potential for higher returns compared to traditional fixed-income investments. Many of these investments are made to smaller “middle market” companies, who have not had great access to capital following the 2008 Financial Crisis when regulations made it much more difficult for traditional banks to lend to these companies. Because they have fewer choices, they often are forced to pay a higher interest rate.
Portfolio Diversification: Because traditional banks don’t lend in this space, there are large areas of the credit markets that most bond investors don’t have exposure to. Because of that, its performance is not necessarily correlated with traditional stocks and bonds, making it a valuable tool for reducing overall portfolio risk.
Source: Pimco
Risk Mitigation: Since most of the companies being lent to in this space do not have as many alternatives, they are often required to put up significant collateral to protect investors in the event of a default.
Less interest rate sensitivity when rates are rising: Often these loans are written with “floating” rates, meaning if interest rates increase or decrease, the interest rate on the loans increases. This is a big reason they have become so popular over the past few years since bond investors were paid more as rates rose.
Disadvantages of private debt
Illiquidity: A significant drawback of private debt is its illiquid nature. Unlike publicly traded bonds, selling private debt can be challenging and time-consuming, which can be a disadvantage during times of financial stress. It is not uncommon for there to be “gate” limits, meaning they will only redeem a certain percentage of the total portfolio (typically 5-10%) per quarter. While this may seem like a disadvantage, it can sometimes be helpful for investors since it prevents the fund from having to liquidate temporarily depressed assets.
Lack of Transparency: Private debt often lacks the transparency of publicly traded securities. Investors may have limited information about the issuer's financial health and creditworthiness.
Credit Risk: Private debt carries credit risk, and investors may face a higher risk of default compared to investing in more established public companies. For this reason, many suggest considering these funds as an alternative to a junk or high-yield bond fund.
Vetting funds: There are many funds in this space, some old and some new. There is not nearly as much information on these funds as there is for typical bond mutual funds or ETFs. Because of that, the vetting process can become overwhelming and lead to poor investments in funds with high fund fees and a less structured investment process.
Private debt can be an attractive addition to an investment portfolio, offering the potential for higher returns and diversification benefits. However, it also comes with unique challenges, including illiquidity, credit risk, and fund selection. Whether or not investors should consider adding private debt to their portfolios depends on their individual financial goals, risk tolerance, investment horizon, and access to funds.
Happy Planning,
Alex
This blog post is not advice. Please read disclaimers.