April 10, 2021 • 4 min read • Private Equity

 

Lately, private equity (PE) has undoubtedly been a hot topic in the investment world. Driven by iconic firms such as Blackstone and KKR, private equity has seen stellar performance in recent years. These firms have been able to snap up assets thanks to an influx of capital and a booming PE market. Let us consider the other side of this equation: Who is providing debt financing to these private equity firms? Why are they willing to do so? This article will explore the world of private credit and explain why it is becoming an increasingly vital part of the private equity ecosystem.

Private credit (PC) is extended to companies and individuals. PC typically shines brightest when fixed-income public markets are out of balance. As the name implies, private credit instruments are not publicly traded investments. Rather, they are originated and held by lenders other than banks, sometimes referred to as “shadow banks”. Private credit takes on various legal forms including loans, bonds, notes, or private securitization issues. Private credit encompasses various strategies, including real estate debt, distressed debt, direct lending, mezzanine financing, and structured financing. Interest rates are set on a strictly negotiated basis, usually based upon the assessment of the risk/reward ratio. This is often at a more favorable interest rate than consumer credit cards.

Direct lending has been increasing notably since the Great Recession and the installation of the Dodd Frank Act and the Volcker rule, limiting bank exposure to private equity loans within the middle-market. Private lenders have served as an attractive option for borrowers, especially for private equity investors and/or sponsors. Due to the speed of execution of direct lending transactions, PE has enabled firms to be more nimble and execute their deals faster.

In addition, private credit managers often align with borrowers backed by private equity firms. PE managers have specific industry/operational expertise, which adds a layer of protection from downside. Private debt funds have not only proven effective for mitigating downside risk but also for providing investors with a premium on the interest paid in return for the illiquidity and price stability that private credit can provide. According to Adams Street Partners, private debt fund yields have outperformed high yield bond yields; private debt funds yield approximately 7%, versus high-yield bonds yielding approximately 4.73%, as of Q1 of 2021.

In short, private credit is an accessible way for businesses to raise capital. The investor lends money to the company in exchange for interest payments. To reduce the risk of the loan, PC lenders will typically impose covenants on the borrower and/or collateralize assets that secure the loan. The interest payment percentage will highly depend on the security of the debt. For example, a 1st lien senior-secured loan may yield 4-5%, while an unsecured loan may yield higher. 

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