Risks and rewards of private debt

As traditional asset classes struggle to generate yield in the current low-rate environment, alternative investments such as private debt could boost your clients’ portfolios.

Private debt — which is debt financed outside of the traditional banking system — enjoyed a meteoric rise following the financial crisis of 2008, when banks tightened their lending rules, forcing many borrowers to turn to private capital lenders.

According to Andrew Luetchford, partner and national capital advisory leader with Deloitte Canada, more than half of the debt in the U.S. is private, and “the pace of growth is still very much alive.”

Luetchford was one of several speakers at alternative asset manager Ninepoint Partners LP’s inaugural Alt Thinking Investment Forum in Toronto on Thursday. The event focused exclusively on private debt investments, which offer higher yields than traditional asset classes with the trade-off of lower liquidity.

Private debt can take many forms, including relatively lower-risk infrastructure debt and senior debt, as well as higher-risk subordinated debts and mezzanine debt. It is generally subject to covenants to ensure the borrower can repay the loan.

As an investment opportunity, private debt first caught on with institutional investors seeking additional yield. Luetchford said there are currently about 850 private debt investment funds in North America, including about 30 in Canada. Some invest in sectors such as real estate and infrastructure, while others invest only in distressed companies.

Borrowers are typically eager to work with private lenders, which can offer financing arrangements that are more customized than those offered by banks, according Joe Mattina, partner at PENFUND, which provides junior capital to mid-market companies.

“We can provide a lot more flexibility [than banks],” Mattina said. “Typically, large institutions have underwriting rationales and disciplines that they stick to, whereas the private debt community can get a little bit more creative and ultimately structure to the need of the borrower.”

But, like banks, private equity lenders will have losses.

“There isn’t a single private debt fund on the planet that’s batted 1.000,” said Mark Horrox, principal at private equity lender Third Eye Capital. He added that a good management team that “knows how to handle trouble” can ensure investors that they’re in good hands.

“You must have a transparent relationship with your investors,” Horrox said. “The more you guys know and understand what you’re investing in, the more comfortable we are that you both understand the strategy and are happy to be in that strategy.”

Marc Wasserman, partner and national chair of the insolvency and restructuring practice at Osler, Hoskin & Harcourt LLP, said that private lenders are generally interested in helping their borrowers succeed.

Wasserman said that when a bank notices that a borrower may not be able to repay its loan, the bank’s main objective is to mitigate the loss. Private lenders, on the other hand, are more motivated to work with their clients to resolve any issues.

“Their objective is not reducing loss,” Wasserman said. “They see opportunity where others see risk.”