Private debt is an area that has been of interest to asset investors, both for its promise of diversification and its promise of high carry. Unlike traditional investments (i.e., stocks and bonds), private debt is lending to private companies or individuals. This article discusses private debt, its advantages and disadvantages, and its place in an investment portfolio today.

What is Private Debt?

Private debt means non-publicly traded loans or debt instruments. It includes direct lending, mezzanine financing, and distressed debt. Rather than bonds seen in public markets, private debt discussions occur between the borrower and lender.

Examples of private debt include:

• Direct Lending: Loans to mid-sized companies, often by private funds.
• Mezzanine Financing: Debt and equity jointly, at higher returns but higher risks.
• Distressed Debt: Investments in distressed enterprises, such as those that might have "big upside" but are risky because of the consequence of very high returns expected despite risk.

The Growth of Private Debt

Private debt has grown significantly in recent years. It is estimated that by 2026 the size of the global private debt market would be around $2.69 trillion compared with $1.4 trillion at the 2020s levels. This growth is due to the limitation of banking regulation and so, companies are searching for new financing institutions.

Why Invest in Private Debt?

Private debt offers a range of advantages that are exploited to the advantage of investors.

• Attractive Yields: Private debt normally has higher interest rates than fixed-income securities, etc. For example, direct lending funds typically provide returns ranging between 7% and 10% (per annum rate) on average, whereas returns from investment-grade bonds are on average 2% to 4% (per annum rate).
• Diversification: Private debt is less sensitive to public markets, a cushion when the stock market becomes disoriented. This is one of the most excellent supplements for portfolio diversification.
• Predictable Cash Flows: The income from the private debt investments with the fixed payable coupon is very interesting and easily so it will deliver a predictable revenue to investors.
• Access to Unique Opportunities: Private debt investing offers access to market niche (e.g., real estate credit impaired or small business loans) that is otherwise inaccessible to the public market investor.

Risks of Private Debt

Despite its appealing aspects, private debt has its own risks such as:

Illiquidity: Private debt investments are long-tenor and, ideally, never, can be reassigned, sold. Lock-up periods often range from 3 to 10 years.

Credit Risk: Borrowers may default on their loans. Extensive due diligence is necessary in order to minimize this risk.

Economic Sensitivity: During economic downturns, it is challenging for firms to meet debt obligations and default risk increases.

Regulatory Risk: Policy amendments may influence private debt market, particularly in judicially regulated sectors.

Key Metrics for Evaluating Private Debt Investments

When it comes to private debt, investors should look at the following indicators:

• Internal Rate of Return (IRR): Measures the annualized return of an investment. Typical private debt funds aim for an IRR in the range of 8% to 12%.
• Default Rates: Sets the loan default rate (i.e., the proportion of loans in default−i.e., the proportion of loans accruing defaults). Default rate below 2% is acceptable in private debt funds.
• Loan-to-Value (LTV) Ratio: Measures the loan amount relative to the asset’s value. A lower LTV ratio indicates lower risk.
• Net Asset Value (NAV): Reflects the fund’s performance over time.

How to Get Started with Private Debt?

Investing in private debt requires careful planning. Here are practical steps to get started:

• Understand the Market: Discuss variations in private debt and the risks private debt poses. Online resources and financial advisors can help.
• Assess Your Risk Tolerance: Private debt involves illiquidity and credit risk. It must be consistent with both your expressed, financial goals and your risk tolerance.
• Choose the Right Fund: Many private debt investments are available through specialized funds. Find funds with good history and low fees.
• Diversify Within Private Debt: Diversify investments across sectors and geographies to reduce risk.
• Monitor Performance: Review the investment performance indicators periodically and decide, based on your investment performance, whether your investment is performing as expected.

The Role of Technology in Private Debt

Technology is changing the private debt landscape, opening the market for the individual investor. Platforms, like Yieldstreet and PeerStreet, are now opening the door to individual investors to invest in private debt transactions with as little as a $1,000 minimum investment. For example:

• Yieldstreet: Targets alternative investments (private debt) with historic returns of 8% to 12%.
• PeerStreet: An expert in real estate debt, providing diversified with favorable yields.

Future Outlook of Investing in Private Debt

Private debt is an emerging asset class, offering the promise of high returns, diversification and niche opportunities. But time commitment and familiarity with the risks is not taken for granted. By leveraging the chosen performance metrics, the synergy of technology, and portfolio heterogeneity, it will be made feasible to compete markedly in this rapidly growing industry. As private debt continued to grow, it has become an essential building block for a successful modern investment portfolio.