Private debt: attractive financing solution, even in the midst of a crisis

The COVID-19 pandemic is expected to amplify the momentum of this asset class that became established funding following the 2008 crisis.

While banks were traditionally the first interlocutors for companies in the event of financing by external capital, another financing instrument is gaining in relevance for small and medium-sized enterprises: “private debt”, or “private” financing, unlisted. on the stock market, of companies by non-banking companies.

This asset class has been transformed in recent years, moving from a niche strategy to an attractive and demanded alternative solution. The financial crisis of 2008 acted as a catalyst for this development: due to increasing regulation and increased capital requirements for banks, they increasingly withdrew from financing companies, in particular on the rather illiquid segment of the mid-market (EBITDA between 10 – 30 million euros). Since this period and specifically for smaller companies, with a value of up to 500 million euros, access to syndicated loans is often complicated and long. However, the financing needs of these companies have persisted and since then they have been more and more frequently covered by private debt funds.

The global private debt market grew between 2007
and mid-2018 at an average annual rate of 13.4%.

According to a study by the University of Lucerne (HSLU), the global private debt market grew between 2007 and mid-2018 at an average annual rate of 13.4%. The capital allocated to private debt funds has been valued at more than 750 billion dollars. According to the estimates of the authors of the HSLU study, the volume of the Swiss private debt market has averaged over the past few years to around 3 billion francs.

Strong intertwining with private equity

Around 80% of private debt financing is intended for companies held in private equity. The two asset classes are thus strongly intertwined and private debt is usually particularly relevant in markets where private equity is widespread. In Europe, the United Kingdom is the leader in this area, followed by France and Germany. According to the HSLU study, the Swiss private equity market grew by more than 15% between 2016 and 2019, which suggests a concomitant growth in private debt.

Loan takers benefit from the flexibility

For borrowers, financing by a private debt fund has two decisive advantages: more flexibility and less complexity. Private debt funds are financially able to grow flexibly with the borrower. They are thus often used in high-growth areas of activity, where tailor-made financing solutions are particularly appreciated. In addition, private debt simplifies relations between the parties, because the loan taker, contrary to what happens during negotiations in the context of a syndicated loan, has a single interlocutor. This offers a speed advantage which can be decisive for the success of a competitive transaction.

For investors, private debt promises returns
higher than, in particular, bonds listed on the stock exchange.

Attractive risk premiums

For investors, private debt promises higher returns than, in particular, listed bonds. Investments are less liquid and investors are compensated accordingly by an illiquidity premium. The absolute returns of private debt funds have in the past reached 7% to 8% (in EUR), but it is the risk-adjusted returns that particularly attract investors, since the historical default rates of this asset class are significantly lower than for liquid financing. This can be explained in particular by the high level of control over financing that private debt funds hold as sole funders.

COVID-19 favors private debt

It has long been unclear how this relatively new asset class would perform in a challenging market environment. In this context, the first results from the COVID-19 pandemic are promising and should further promote the dissemination of these investments. Indeed, the current crisis has prompted banks to withdraw from mid-market financing. In order to still be able to cover the persistent financing need, another solution must be available. The investment possibilities will therefore also increase in the future for private debt funds.

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