Private debt

Private debt ⇒ refers to lending to private entities. The terms used include the following:

• Direct lending: Loans made directly to a private entity without an intermediary. A leveraged loan refers to a loan made by a private debt fund using money borrowed from another source. That is, the fund’s portfolio of loans is leveraged through the use of fund borrowing to magnify fund returns.
• Venture debt: Lending to venture firms (start-up or early stage firms that are not yet profitable). Venture debt is often convertible to the venture firm’s common stock or combined with warrants granting the right to buy the venture firm’s common stock at a given price for a specified period.
• Mezzanine loans: Private debt that is subordinated—that is, has a lower priority of claims than the borrower’s existing (more senior) debt. May have special features such as conversion rights or warrants as compensation for the additional risk involved.
• Distressed debt: Purchasing the debt of firms in bankruptcy, in default on existing loans, or for which default seems imminent. Often, the fund becomes active in implementing a plan for the debtor firm to restructure its existing debt or make other changes that will result in an increase in the value of the acquired debt.

Private debt firms may also invest in a wide variety of other types of debt. Some private capital firms invest in both the debt and equity of their portfolio companies.

Risks and Returns of Private Capital

Given that private capital encompasses a variety of securities, from start-up equity to the senior debt of a mature company, the range of risks across the spectrum of private capital funds is very large. Additionally, investment in private equity or private debt funds may have quite limited liquidity.

Returns on private debt are necessarily higher than those on the debt of publicly traded companies because lack of liquidity increases the required returns on both private debt and private equity. Most often, both private equity and private debt funds are more active in the operations of the portfolio firms. Both venture capital and private equity firms often work as partners with a portfolio company’s management, or as part of its management, to develop and implement a business strategy. Fund returns are quite dependent on the ability of the fund manager to both select and manage fund investments.

It is important for investors to understand the various risks that an investment in a given private capital fund entails and not to view returns above those of traditional debt and equity investments as a “free lunch.” Diligence in manager selection is an important part of investment success.