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Wealth Managers Guide to Private Debt, Income Diversification Beyond Traditional Fixed Income



The Evolving Portfolio


The role of a wealth manager is to find the right balance between preserving and growing capital in a dynamic world. A few decades ago, wealth managers followed a fairly simple formula. Through traditional investing, they would build portfolios consisting predominantly of equity and fixed income (or investing in “public markets”) where equities were used for growth and fixed income was used for capital preservation.



Today, wealth managers continue to invest into the public markets, but the number of options has increased dramatically, and there are many more subcategories within equity and fixed income strategies. In addition, wealth managers can now choose from a range of options in the private markets, including real estate, private equity, hedge funds, and private debt. While these “alternative investments” may be less liquid, they can provide attractive options for wealth managers seeking to achieve their clients’ goals.


Institutional investors have led the way into these alternative investments. A recent article in the Economist(1) claims “Institutional investors are rushing headlong into private markets, especially into venture capital, private equity and private debt”. An increasing number of wealth managers are also using alternative investing: venture capital and private equity for growth and private debt for yield and preservation of capital. Investors are turning to private debt strategies as an alternative to traditional fixed income where yields are low and the potential for volatility is high. This has led to the significant interest in private debt, a growing asset class that is approaching $1 trillion in total assets.


Private debt is designed to be the “income” and “capital preservation” solution within the alternative investing world. Investors invest into a private loan, which is often secured by important collateral. There are many types of private debt strategies (business lending, real estate, consumer, aviation, etc.) but the commonality across such strategies is that borrowers are typically small to medium in size which lack the same access to capital as larger borrowers. Private debt borrowers often pay higher interest rates because they lack the access to bank funding. However that does not necessarily mean that they are riskier; it means they are smaller with fewer options.

Private debt offers distinct advantages in a low return environment. Investors are attracted to the high yields and low correlation with the broader markets. Some private debt offers investors an opportunity to invest in the highest parts of the capital structure that are typically collateralized by the company’s assets and often considered better credit quality than the lower parts of the structure such as traditional corporate bonds. In addition, smaller sized private debt typically exhibits lower default rates than large syndicated loans and unsecured bonds. Finally, some private debt is floating rate and can benefit investors in a rising interest rate environment relative to traditional fixed income that can deteriorate in value.



SUMMARY OF PRIVATE DEBT VS OTHER FIXED INCOME



What is Private Debt and Why Does it Exist?


Private debt covers the lending of money to companies and individuals by entities other than banks. The asset class emerged over the past few decades as consolidation in the banking industry and tighter banking regulations made certain types of lending (small to medium sized loans) less attractive for large traditional banks. As middle market banks merged into larger entities, they left a huge void for fast growing, well-collateralized but smaller borrowers that need liquidity to fund expansion or to run their operations.

Private debt funds have emerged to provide more flexible capital and bespoke expertise in certain types of private lending. Private debt represents loans within the private sector. While that means the loans are less liquid, it also means they experience less volatility as prices are based on the value of the loan and not events which effect the price of publicly traded securities.

The private debt industry has experienced tremendous growth in recent years. The industry is currently estimated to be over $800 billion in assets and is on track to reach around $1 trillion in assets under management(“AUM”) within the next year as its growth has been compounding at 20% per year(3).



Private Debt Assets Under Management 2007 -2019

The growth in private assets is driven by the belief that higher returns can be achieved. A recent article in the Economist(1) suggests that private equity and venture capital raise efficiency, revenue and profitability in private companies as the firms have better management habits than entrepreneur or family-owned businesses. Compared to public investments, returns may be higher because private companies are typically owned by a small group of investors that hold management accountable, reducing the “agency cost” which exists where there are many owners and no one with a large enough stake to make it worthwhile to monitor the companies closely. The same can be said for private debt strategies as the fund managers closely monitor their borrowers and often see themselves as a partner to the borrower, as lending agreements are often structured to align interests.

Increased regulation by banking institutions has also contributed to the growth of the private credit industry as it has become too expensive for banks to hold many loans on their balance sheets.

Finally, the rise of technology has also contributed to the growth of the industry as private lenders have been able to access and analyse data more efficiently. Many private lenders have built sophisticated, streamlined processes tailored to specific asset types.



Types of Private Debt Funds


There are several types of strategies within private debt, including: BUSINESS (“SMALL MEDIUM ENTERPRISE” or “SME”) LENDING – is the funding of small and medium-sized enterprises. There are many types of SME lending products ranging from merchant cash advances at high interest rates for small companies to large loans with warrants (upside equity participation)for medium-sized businesses.

REAL ESTATE (or “HARD MONEY”) LENDING – is a strategy which involves lending to companies or real estate developers against real estate collateral. A typical strategy would be a short-term high interest rate loan used to improve and stabilise an asset so that it can qualify for traditional financing. This can be an attractive strategy but investors should consider the loan to value (“LTV”) of the collateral, the lender’s experience in taking over collateral in times of default and the stage of development of the project. It is also important to identify the seniority of the loan and whether or not leverage is being used.

CONSUMER LENDING – is a strategy which lends to consumers, either directly through certain merchants or by buying loans from origination platforms such as Lending Club and Prosper. While this strategy allows for considerable diversification, investors should understand whether collateral exists and how defaults are accounted for. Moreover, they should attempt to stress test results in a challenging environment such as occurred in 2008-09.

AVIATION FINANCE – refers to the lending of capital to airlines and leasing companies so that they can purchase (or refinance) commercial aircraft. Leasing agents have become a core part of the aviation industry as leasing reduces the initial capital outlay for airlines, provides access to the latest technologies and models, and allows airlines to adjust the size of their fleet to mirror demand.


LIFE SETTLEMENTS – is a transaction in which an individual with a life insurance policy obtains a loan against the policy or sells the policy to another person or a fund, who then assumes responsibility for paying the premiums and receives the proceeds of the policy at maturity. This strategy can provide high returns and is typically non-uncorrelated to traditional investments. However investors should understand this strategy typically requires multi-year liquidity given the nature of the underlying asset. LITIGATION FINANCE – is the practice where a third party unrelated to the lawsuit provides capital to a plaintiff to finance their case. In return,the lender will either receive a fixed interest rate or a portion of any financial recovery from the lawsuit.

TAX LIENS – is when a landowner fails to pay the taxes on his or her property giving the city or county in which the property is located the authority to place a lien on the asset. Funds have been created to buy pools of these tax liens as properties that have liens attached them it can’t be sold or refinanced until the taxes are paid and the liens are removed.



Advantages of Private Debt Strategies

There are many advantages of the privatization of credit and a broad range of beneficiaries: FROM A SOCIETAL STANDPOINT – Smaller to medium size businesses are the lifeblood of the economy as they produce the most jobs. Advancements in private debt has provided more resilience to the economy as small but growing companies can secure critical funding while the specialisation of the lender provides more stability to the overall financial system.

FROM A BORROWER STANDPOINT – An alternative access to capital from a reliable partner who understands their business, has more flexibility in structuring loans and can close on a loan faster is very powerful. The borrower often considers the alternative lender as a true partner as the lender specializes in their field and may provide expertise and relationships that help the borrower achieve their goals. In many cases, a business or project development plan with milestones is required and closely monitored to better the chance of success by the borrower.

FROM AN INVESTOR STANDPOINT – The yields can be higher, and the volatility can be much lower than traditional fixed income investments. Private debt allows an investor to invest in high interest loans without the risks and headaches associated with investing into the asset directly. Private debt typically has much lower volatility than traditional fixed income because it typically does not have to be “marked to market”, which can cause substantial price fluctuations as market conditions and interest rates change.

Further, private debt lenders take a different approach to lending where they focus on collateral rather than more traditional measures such as cash flow and FICO scores. In the event that they end up owning the collateral, it is important to ensure that the lender has the expertise to manage and eventually sell the collateralized asset, which allows them to maximise return in the case of defaults.


Considerations When Investing Into Private Debt Funds


LIQUIDITY – While the returns can be much greater in private debt compared to traditional fixed income, investors need to understand that private loans are generally illiquid and not regularly traded on organized exchanges. Investors need to closely consider the liquidity of the underlying investment to ensure that it is appropriate for their liquidity needs as loans can range from 30 days to 7-10 years. Investors should consider whether there is an active secondary market for the loans and the potential impact a market downturn would have on their liquidity.

COLLATERAL – Private loans may have no collateral, subordinated collateral or good collateral. The strength of the collateral and the ability to take over the collateral and have a positive outcome when there is a default varies by strategy. Typically, there is a relationship between the size of the loan and the level of collateral that the lender receives. The initial underwriting of the asset and the ability to manage the asset received requires significant experience and execution capabilities. Investors should consider the lender’s experience in managing the assets and should carefully understand whether the debt they are receiving is subordinated to others. In cases where the debt is subordinated to others, the investor should receive a higher return for the excess risk.

Cash Flow Repayment Priorities

LEVERAGE – Investors need to understand if private debt funds are utilising leverage to magnify returns. While bridge facilities to fund loans are common, some strategies rely on high amounts of leverage to deliver returns. A careful analysis of the amount of leverage used should be considered by the investor. Keep in mind that leverage can come in the form of a direct loan or through more complicated structures such as securitizations.

REPORTING AND TRANSPARENCY – Valuation reports on the investments should be performed or supervised by reputable third parties. The role of independent fund administrators and auditors provide an additional layer of comfort that the portfolio is being properly valued.

OTHER CONSIDERATIONS – Investors should consider the longevity and resilience of the track record (e.g., a 2-year track record may not illustrate a fund’s performance in challenging times), and the total capital flows into a particular strategy in order to avoid over-capitalized sectors.



Summary


The proliferation of private debt funds offers investors new ways to generate returns ranging from the mid-single digits to 20%+. Private credit strategies can be a strong alternative to traditional fixed income in the search for yield and capital preservation. However, investors need to understand the risks of their investments and decide whether they want to prioritize minimizing risk or maximizing return.


Investors should understand that associated costs of investing in private debt strategies. A proper understanding of liquidity is crucial as it is important to focus on strategies that match an investor’s liquidity needs. Monitoring of investments is also imperative and the cost of such monitoring and the sourcing of new investments can be quite high. Finally, it is important to find the right strategies for the right investors. There are many private credit strategies emerging, and investors need to have comfort in the strategies they invest into and the confidence in the team executing the strategy. Investors should generally seek to avoid leverage for the extra return, unless they are very familiar with the strategy and the associated risks.


At Glide Capital, we believe that the private credit world has many promising opportunities for investment compared to other investment strategies. However, in order to take advantage of the stability this asset class can provide, it is extremely important to conduct meaningful due diligence and to significantly diversify the portfolio. If your firm doesn’t have the resources to focus on this work, we suggest finding a partner that does. Glide has spoken to over 500 managers in the private credit industry and has built significant resources. Our firm then partners with wealth managers to efficiently build a portfolio which provides broad exposure to the private credit strategy for their investors.




Thanks to our Contributor


Glide Capital LLC 3323 NE 163rd St Suite 305, North Miami Beach FL 33160 Phone: (305) 783-3316 Email: IR@glideplatform.com


ABOUT GLIDE CAPITAL


Glide Capital LLC (“Glide”) specializes in building efficient solutions to invest into the private debt industry. Glide provides individual investors with an opportunity to invest into a well diversified portfolio of private debt managers through a single investment. Glide also provides wealth management firms with a customized solution to build their clients their own private debt portfolio, tailored to the specific needs of their firm.

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