Understanding Alternative Investment Assets in Detail

When venturing into investments, we often encounter two main characters – equity and debt. They’re the backbone of any investment strategy, regardless of the market’s nature or the company’s phase. Each plays a unique role, each offers different benefits and risks to investors.

The world of alternative investments is no different. Private equity and private credit have both emerged as popular choices of assets among investors. In this chapter, we’re going to explore the differences between these concepts in detail.

Private credit is like a friendly neighbourhood alternative to a traditional bank loan. It’s where private funds, institutional investors, and non-bank entities lend a hand to businesses in need of cash.

Take, for instance, the owner of your local bakery who’s dreaming of a bigger kitchen to start catering. He’s at a crossroads for funding: the familiar route of a bank loan or the path less travelled with a private lender.

Banks are the old-school choice, but private lenders offer a more flexible journey. They’re not just about handing out cash; they tailor their support to fit the unique needs of businesses, especially those on the brink of growth but not quite fitting the strict criteria of banks.

Think of the bakery owner who doesn’t quite tick all the boxes for a traditional bank loan. This is where private credit comes into play. It’s not about rigid, cookie-cutter solutions; it’s about stitching together a financial plan that fits the unique situation of the bakery, just right.

• Direct Lending: This is a cornerstone of private credit, where funds provide loans directly to small and medium-sized enterprises (SMEs). Direct lending is prized for its flexibility and accessibility, offering an alternative to traditional bank loans with more negotiable terms and structures.
• Mezzanine Financing: Sitting uniquely between debt and equity, mezzanine financing offers lenders a blend of fixed-income security and equity upside. These instruments are often used in leveraged buyouts and growth financing, providing capital to companies in transitional phases.
• Distressed Debt: This niche area involves investing in the debt of companies facing financial hardship or bankruptcy. Investors in distressed debt navigate complex legal and financial landscapes, often aiming to influence the restructuring process or capture equity-like returns in scenarios of a successful turnaround.
• Venture Debt: This is a form of private credit that is especially designed for startups and emerging companies. Venture debt is typically structured as a combination of a loan along with warrants or rights to purchase equity. It offers an alternative financing option for companies in their early stages, where cashflow might still be unpredictable and traditional bank loans are not feasible.
  
• Real Estate Private Debt: A sector-specific form of private credit, this type focuses on lending within the real estate market. It includes financing for development projects, acquisitions, and refinancing, playing a pivotal role in real estate investment strategies.
• Special Situations and Opportunistic Credit: This diverse category encompasses lending to companies in unique or challenging situations, such as corporate restructurings, turnarounds, or other scenarios where traditional funding sources may not be available or suitable.

A significant shift in the private debt landscape emerged following the Global Financial Crisis. Prior to the crisis, most businesses turned to conventional banks for their loan needs, particularly for higher-risk ventures.

Post-crisis, however, these banks shifted their approach, increasingly avoiding investments perceived as high-risk. This was primarily due to the introduction of stricter capital requirements under frameworks like Basel III. These regulations required banks to maintain higher capital reserves against risky assets to buffer against potential losses and high-risk lending less attractive. For example, the Tier 1 capital requirements (for a bank’s core capital, equity and reserves) was increased from 4% to 6%. As for Tier 3, which included a riskier tier of capital was eliminated.

This change opened a door for private or direct lenders. These lenders were willing to take on the risks that banks were avoiding. They were not seen as presenting a systemic risk and, in the US context, were not insured by the FDIC. So, they have a different regulatory regime as compared to banks, which does not impose high capital requirements. As a result, the amount of money managed in private debt—referred to as assets under management (AUM)—has seen a notable increase.

In 2022, private credit investments surged by an immense 89% and reached $10.2 billion. This growth is led by the emerging and developing markets — Asia, Middle East, Africa, Central and Eastern Europe and Latin America — in particular.

According to Jeff Schlapinski, Managing Director, Research at Global Private Capital Association (GPCA), “There are persistent financing gaps unaddressed by global or local banks that private credit funds are helping to fill.”

The rise in private debt is more than just a reaction to the banks’ reluctance. It’s a response to a market need. Many companies, especially mid-sized ones, found themselves in need of funding options outside of traditional banking systems.

Source

Private debt lenders filled this gap, offering loans tailored to these companies’ specific needs. The flexibility in the terms and conditions of these loans surpasses what traditional banks typically offer. This makes them particularly appealing to companies in special circumstances or those in search of more tailored financial solutions.

Returns from private debt often favourably compare to those of public debt. Investors in private debt are usually compensated for the illiquidity risk with higher yields, known as the ‘illiquidity premium’.

Some private debt investments also offer ‘floating rate’ returns, which vary based on underlying interest rates, providing flexibility in a rising interest rate environment.

The risk profile of private debt investments can vary significantly. Unlike public debt, where credit ratings by agencies like Moody’s, S&P, and Fitch provide a standardised risk assessment, private debt often lacks such transparent credit ratings. Therefore, assessing the risk of private debt investments can be more complex and requires thorough due diligence.

Scenario 1: A Tech Startup’s Quest for Growth

A tech startup, with a revolutionary product, needs capital to scale up operations and enter new markets. They choose private equity, trading a stake in their company for not just funding but also the expertise and industry connections that the PE firm brings. This partnership fuels their growth journey, leveraging the PE firm’s resources and network.

Scenario 2: A Family Business in Need of Capital

A family-owned manufacturing business faces a temporary cash flow crunch due to market fluctuations. They opt for private credit, securing a loan that allows them to weather the storm without giving up any ownership or control. The loan is structured to align with their cash flow, ensuring they can manage repayments without undue stress.

Scenario 3: A Mature Company Seeking Expansion

An established retail chain plans to expand its operations nationally. They choose private equity to leverage the strategic and operational expertise the PE firm offers. In exchange for a significant equity stake, they gain access to capital and a partner that actively contributes to refining their expansion strategy and execution.