Investing in private debt can lead to high returns without high risk, says Jonathan Bell
Recently I have seen an increase in the number of investors allocating to illiquid investments in the hope of potentially higher returns than those in quoted equity markets. In addition to private equity, these investors should consider investing in private debt rather than corporate bonds or syndicated loans.
Historically, more than 80 per cent of corporate lending in Europe has been provided by traditional banks, compared to just 20 per cent in the US. Following the financial crisis, the combination of loan losses and tighter regulation resulted in a collapse in new bank lending to mid-sized corporates. In turn, private debt has taken off as direct lenders have moved to fill the gap.
Private debt is not as exciting as private equity and the long-term returns are likely to be lower, but it offers several advantages: a regular income stream (typically 7-8 per cent per annum), a quicker return of capital (normally within five to seven years), and the potential for a small capital gain in addition to the income stream. Transactions are typically with medium-sized companies (earnings before interest tax and depreciation of $10-75 million) with stable earnings. Loans might also be made to finance the purchase of real estate or infrastructure assets.
We estimate that for the same level of risk, the returns are higher than those available from corporate bonds or syndicated loans. Indeed, it seems possible to create a portfolio of direct loans that carries a lower risk and a higher return. For example, the average yield to maturity on syndicated loans traded on the secondary market is 4.5 per cent in Europe, compared to average annual yields on a typical direct loan portfolio of 7 per cent. At the same time the average leverage of private loans is below, or similar to, that of equivalent syndicated loans or corporate bonds, while the number of covenants (adding extra protection) applied to private debt are higher.
The two main drawbacks for direct debt investors are that it is very difficult for individual investors to build portfolios of direct loans and that investors need to be prepared to tie up their money for five to seven years. For those able to put up with the illiquidity there are several funds, some of which use leverage to increase the return for investors, providing exposure to portfolios of direct loans.
Jonathan Bell is CIO of Stanhope Capital
This feature first appeared in the July/August issue of Spear's, which is available at WHSmiths travel store and independent newsagents. To subscribe, visit www.spearswms.com/subscribe