Fri. Jun 2nd, 2023

private debt capital market assumptions

Private Debt Capital Market Assumptions

Private debt investments involve non-bank institutions granting loans directly to private companies or purchasing secondary market debt securities from existing holders, often including funds.

An expanding global economy has resulted in increased corporate loan applications to finance growth. This demand has in turn lead to an explosion in supply of private debt funding worldwide – AUM reaching almost US$900bn by 2020.

Long-term return assumptions

When assessing private debt investments, one must make certain long-term return assumptions about them. These include their sensitivity to changes in interest rates and capital appreciation/distributions as well as any risks of market or credit defaults.

Private debt strategies present investors with an unparalleled opportunity to diversify their portfolios and enhance the risk-return profile of fixed income holdings, yet their implementation can be complex and requires close consideration of any tradeoffs that might exist.

Private debt differs from syndicated leveraged loans or high yield bonds in that it’s typically not rated and issued unrated, making its credit risk difficult to evaluate. Furthermore, as it doesn’t often trade on secondary markets, liquidity may also be limited.

Investors may find it challenging to access asset classes during periods of economic turmoil when market liquidity may become more unpredictable.

Volatility can create large fluctuations in the value of a private debt portfolio. Therefore, it is vital that investors carefully review loan agreements and terms so that their investments do not become overexposed to negative events.

Investors should also keep inflation and rising interest rates in mind when considering how private debt loans might perform in terms of returns. While floating rate deals may help mitigate some of this effect, an increase in rates can reduce the value of assets like private debt loans over time.

Figure 1 depicts how rapidly the private debt market has expanded since the financial crisis. We believe that changes to both supply and demand sides should continue to support its rapid expansion.

Reduced bank lending activity as a result of Basel II Directive IV and quantitative easing programmes has created an asset class gap which nonbank market participants have filled by increasing private debt strategies available to investors and increasing interest in this asset class from institutional investors. These trends suggest that private debt may offer institutional investors an attractive alternative to traditional bank-issued securities by providing greater risk and return opportunities.

See also  What is a Home Equity Loans Rate?

Risk-adjusted return assumptions

Investors looking to diversify their portfolios will find the private debt capital market an appealing place. In an environment characterized by ultra-low interest rates, this asset class can deliver an attractive yield while helping protect against inflation.

Private debt funds provide investors with a diverse range of investments, from senior loans to mid-market companies and unitranche facilities, to special situations. Their structures may vary and their terms depend on your investment objectives.

These investments typically employ floating-rate securities to protect against rising interest rates, helping reduce inflationary effects on returns since fixed-rate bonds tend to lose value over time.

However, private debt funds can be riskier investments than public debt instruments and investors should ensure they understand their portfolio’s credit risk before allocating capital towards one.

Fund managers face particular scrutiny from investors as they must conduct sensitivity analyses on underlying companies to ascertain whether debt repayments become more expensive should interest rates rise. To do this effectively requires rigorous underwriting standards and an organized investment approach.

Private debt strategies may differ considerably from conventional investments in terms of performance. Furthermore, their illiquid nature makes gauging returns accurately across short time horizons difficult.

Performance measurement techniques have been devised to address some of the limitations plaguing private debt sector, including irregular cash flows and delayed valuations. While advanced measures such as Direct Alpha and KS PME may help alleviate some problems associated with private debt financing, they still may present certain restrictions and restrictions that impede their effectiveness.

Private debt investors frequently experience liquidity issues that lead to market sell-offs. To protect themselves during such times, however, security and manager selection is an effective strategy in providing personalized risk and return profiles that suit each investor.

Risk-adjusted volatility assumptions

Private debt is an alternative investment asset class that has recently seen increased popularity with investors. Although illiquid, private debt has provided steady returns over time and represents an excellent option for portfolio diversification.

See also  Home Equity Loans For Bad Credit

Post-crisis changes on both sides have propelled the expansion of the private debt market, specifically regulation aimed at curbing risky lending practices which has encouraged nonbank market participants to enter corporate lending markets and fill a funding gap while opening up an income channel that funds are eager to exploit.

As the private debt market expands both in terms of volume and liquidity, investors need to be wary of risks such as liquidity risk, credit risk and any impact from market or economic volatility on these assets.

One important consideration when investing in private debt loans is their varying rates and shorter maturities, helping reduce overall investment risk while offering potential protection from rising interest rates on public securities.

However, it must be remembered that these characteristics alone do not guarantee low risk and less volatility for private debt markets compared to public ones – especially high yield segments where default and severity-adjusted spreads may be significantly higher than in public markets.

Therefore, investors should closely assess return and volatility expectations in private debt capital markets when compared with public markets. They should evaluate private debt investments equally across public markets while fully analyzing default- and severity-adjusted spreads for accuracy.

Liquidity in the private debt market has also become increasingly valuable to investors. Investors can take advantage of its enhanced liquidity to purchase more competitively priced private debt than they could on public markets, thus increasing potential returns and growth of this segment of finance. Furthermore, investors can take advantage of opportunities at different maturities for further investing.

Liquidity assumptions

Liquidity assumptions are an essential component of any investment analysis; they become particularly pivotal when looking at private debt as its investments tend to be highly illiquid. Therefore, investors need to understand what value they receive for this limited liquidity as well as ways they could potentially exit a position at an acceptable price.

Since 2000, the private debt market has experienced unprecedented growth, driven by investors’ desire for higher returns. Today, assets managed by funds specifically engaged in direct lending exceed $412 billion.

See also  What is a Home Equity Credit Line?

Funds like these also stand to gain from post-crisis central bank policies like QE, NIRP, and ZIRP which aim to revive economic growth through cheap credit. This has given non-bank lenders a significant boost when it comes to funding small and middle market companies which would otherwise be excluded from public capital markets due to tighter underwriting standards.

Since the last recession, non-bank lenders have increasingly turned to loans from private credit arrangers as sources of financing. Since these illiquid loans do not freely trade on secondary markets, their values were less affected during a downturn than investments like commercial paper or short-term lines of credit.

However, liquidity should remain relatively low in the private debt market when compared with public debt due to smaller and more highly leveraged borrowers in this segment. This factor will likely remain true throughout the world.

This practice protects the private debt market from liquidity-driven events such as “leverage-driven liquidity”, which are becoming more frequent in public markets. Furthermore, private debt investments that remain illiquid provide natural pre-maturity liquidity as long as interest rates and spreads remain manageable.

Private debt can also be less liquid due to lenders and sponsors having the expertise needed to assist borrowers in handling business and operational matters, helping to proactively manage a borrower’s finances should there be an economic downturn or another form of distress.

Jeffrey Augers
Latest posts by Jeffrey Augers (see all)

By Jeffrey Augers

Jeffrey Augers is a highly skilled and experienced financial analyst with over 12 years of experience in the finance industry. He has a proven track record of delivering exceptional financial insights and recommendations to clients, empowering them to make informed decisions and achieve their financial goals. Jeffrey holds a Bachelor's degree in Finance from the University of Michigan, and an MBA from the Wharton School of Business.