Banks have grown more selective about business lending in recent years. Thanks to tightened standards and stiffer capital requirements imposed after the 2008–09 financial crisis, it’s become harder for many prospective borrowers to access capital.

But private debt funds have stepped in to fill the gap, according to Trier University’s Joern Block, Chicago Booth PhD candidate Young Soo Jang, Booth’s Steve Kaplan, and Trier’s Anna Schulze. These funds are “lending to firms that banks find too risky and charging higher interest rates,” they say. Half of the corporate borrowers that receive private debt funding would not qualify for traditional bank financing, according to the study.

Little research has been done on such private lenders, according to the researchers, who note that there’s not even a standard definition of private debt. They define the funds in question as those that raise money through private equity and similar closed-end funds, then make senior loans like banks do.

Block, Jang, Kaplan, and Schulze surveyed 38 US and 153 European private-debt-investor general partners and investment decision-makers in August and September of 2021. Their sample represents more than $300 billion of combined assets under management, or more than a third of the almost $1 trillion total private debt market.

Most of the funds they studied followed a direct-lending model, where borrowers and a single lender or a small group of lenders negotiated directly with the expectation of holding the loan to maturity.

Similar to private-equity funds, the private debt funds’ largest capital suppliers or limited partners were insurance companies, pension funds, and high-net-worth individuals, the survey reveals. US fund leverage (the ratio of contributed or equity capital to borrowed funds) averaged 42 percent, while European funds averaged 11 percent. Both were significantly lower compared with bank lenders (which typically use leverage of 90 percent) and collateralized loan obligation funds (whose leverage often exceeds 80 percent of total committed capital).

European-based private debt funds aimed for annual returns of 8.7 percent, and US-based funds aimed for 8.16 percent. By comparison, at the time of the survey, German five-year bonds had interest rates of –0.7 percent; US five-year Treasury notes were less than 1 percent, and US BB-rated bonds, which are unsecured and of longer duration, carried rates of roughly 3.2 percent.

Private debt fills the gap

In selecting loan deals, US managers targeted organizations averaging close to $290 million in revenue and just over 1,000 employees, while European managers focused on businesses with €170 million (USD$180 million) in revenue and about 800 employees, the researchers find. US-based managers prioritized stable cash flows, while European debt investors, similar to PE investors, assigned equal weight to management, the underlying business, and cash flows. US and European funds typically provided loans of between five and seven years.

The private debt market tends to monitor loans using covenants, but unlike banks, the private debt lenders in the survey avoided asset-based loans and favored cash-flow-based loans to smaller companies. They also monitored their loans more frequently: the researchers cite a study from Penn State’s Matthew Gustafon and the Federal Reserve Bank of Chicago’s Ivan Ivanov and Ralf Meisenzahl using the US Treasury Department’s Shared National Credit Program data that finds 50 percent of bank-syndicated loan borrowers provided information to lenders once a month or more often. But Block, Jang, Kaplan, and Schulze’s survey indicates that in the US, 62 percent of private debt borrowers provided information monthly, and 85 percent did so once a month or more.

Private debt lenders said they are better than their banking counterparts at evaluating and managing cash-flow risk, and the companies they serve tend to be smaller than typical bank borrowers, with less accounting standardization or transparency and fewer tangible assets.

Some reports suggest private debt funds have outperformed the leveraged loan and high-yield bond markets since 2004 despite lending to riskier borrowers, offering looser borrowing conditions, and using less leverage than banks or collateralized loan obligation (CLO) funds. These alternative lenders are projected to become the second-largest capital-lending source by 2023, behind private equity, according to a 2022 report by investment data company Preqin.

As of third quarter 2021, private debt investors remained optimistic about the prospects for future growth and success in the private debt market. A July 2022 announcement that JPMorgan Chase will create a new direct lending unit may indicate that big financial institutions will soon enter the direct lending business, but the researchers suggest that they will be at a disadvantage because of greater regulation faced by banks.

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