In our recently published article, we examined the strategic role of private credit in a falling interest rate environment. We emphasised its potential as a diversification tool, highlighting its resilience, lower correlation with public markets, and ability to deliver attractive risk-adjusted returns. The discussion positioned private credit as an essential component of investor portfolios, particularly for those seeking stability amid volatility. In this article, we will further explore private credit by delving into its various types, providing a detailed analysis of their advantages and limitations. Special attention will be given to mezzanine debt and real estate credit, examining their unique opportunities, especially in property development where collateral-backed loans offer enhanced security and appealing returns.
Private credit refers to financing provided by non-bank entities directly to borrowers, bypassing traditional public markets. This growing segment of alternative lending offers tailored solutions to meet the unique financial needs of borrowers, often operating in spaces underserved by conventional banks or capital markets. Unlike public credit, where capital is raised through standardised debt instruments like bonds traded on exchanges, private credit involves bespoke lending arrangements negotiated privately between lenders and borrowers.
This market has evolved to cater to a diverse range of borrowers, including middle-market companies, startups, infrastructure developers, and real estate investors. Private credit provides flexibility in terms of loan structure, interest rate terms, and repayment schedules, making it attractive to borrowers seeking more adaptable financing solutions. For investors, private credit offers the potential for enhanced yields, lower correlation with public market volatility, and greater control over investment terms.
As an umbrella term, private credit encompasses a variety of asset classes, each serving specific purposes and carrying unique risk-return profiles. These include direct lending, which focuses on middle-market corporate loans; distressed debt, involving the purchase of troubled companies’ obligations; and mezzanine financing, blending debt and equity-like returns. Other types include infrastructure and venture debt, catering to project and startup financing, respectively, and asset-backed lending, which ties loans to tangible collateral.
In the sections that follow, we will explore the key types of private credit in detail, shedding light on their distinct characteristics, advantages, and strategic roles within investment portfolios.
1.1 Direct lending
Direct lending involves loans provided directly to middle-market companies or small and medium-sized enterprises (SMEs). These loans, typically secured by collateral such as accounts receivable or inventory, offer stability and predictable cash flows. Direct lending has grown significantly, fueled by the retrenchment of traditional banks from SME lending due to stricter capital requirements. It appeals to investors seeking steady returns, often ranging between 7-10%, depending on the credit quality of the borrower. However, illiquidity remains a challenge, as these loans are less tradable than public debt instruments. Successful direct lending strategies often emphasise diversification across industries to mitigate risks and capitalise on specific sectors’ growth potential. For instance, technology and healthcare have been prominent beneficiaries of direct lending in recent years.
1.2 Distressed debt
Distressed debt focuses on purchasing the bonds or loans of companies experiencing financial distress, often trading at steep discounts to face value. This strategy allows investors to profit from either a company’s successful turnaround or its liquidation. Distressed debt investing is inherently risky but can yield returns upwards of 20% in favourable cases, particularly during periods of economic recovery. Key to success is deep due diligence and understanding of the company’s restructuring potential. For instance, hedge funds and private equity firms capitalised on distressed retail sector assets during the 2020 pandemic recovery. However, this strategy requires investors to tolerate volatility and illiquidity, making it suitable for those with longer investment horizons.
1.3 Special situations
Special situations investing targets unique opportunities arising from corporate events, such as mergers, spin-offs, or asset sales. These investments often require bespoke financing solutions tailored to the specific needs of the borrower. Returns depend on the investor’s ability to navigate complex transactions, with yields varying widely based on the risk profile of the situation. This segment has seen increased activity in sectors such as renewable energy and technology, where companies seek funding for strategic shifts. Despite its high return potential, this strategy involves considerable risk, as the outcomes are heavily dependent on the success of the corporate event in question.
1.4 Infrastructure debt
Infrastructure debt involves financing large-scale projects like highways, airports, or renewable energy facilities. These loans are often structured with long maturities, matching the asset’s operational lifespan, and are backed by government guarantees or robust cash flow projections. Investors benefit from stable, inflation-linked returns, typically in the 5-8% range, making it a popular choice for pension funds and insurance companies. However, the capital-intensive nature of these projects means they are susceptible to regulatory and construction risks. For example, renewable energy projects often secure financing through infrastructure debt, with demand growing as governments push for sustainable energy initiatives.
1.5 Venture debt
Venture debt provides funding to startups and early-stage companies, often as a complement to venture capital equity investments. These loans typically come with higher interest rates and warrants, giving lenders equity upside in the borrowing company. Venture debt offers startups the ability to scale without significant equity dilution, making it a popular choice in technology, healthcare, and fintech sectors. For instance, companies in their post-Series A or Series B funding stages often use venture debt to bridge financing gaps between equity rounds. For investors, the strategy offers high yields, sometimes exceeding 15%, but carries significant risks tied to the startups’ high failure rate.
1.6 Asset-backed lending (ABL)
Asset-backed lending involves loans secured by tangible assets such as real estate, inventory, or equipment. This structure provides a safety net for lenders, as the collateral can be liquidated in default scenarios. Asset-backed lending is common in industries with high-value, easily sellable assets, such as logistics and manufacturing. For investors, this strategy offers moderate risk and returns, typically in the 6-8% range, depending on asset quality. However, market liquidity for the collateralised assets and the borrower’s financial health are critical to managing risks. For example, during the COVID-19 pandemic, asset-backed lending became a critical source of liquidity for companies struggling with cash flow disruptions. In the retail sector, inventory-backed loans helped stabilise businesses facing declining sales and supply chain challenges. Similarly, in the logistics industry, loans secured by high-value equipment or vehicles offered predictable cash flows to lenders while allowing borrowers to expand their fleets.
1.7 Mezzanine debt
Mezzanine debt is a hybrid financial instrument that combines elements of debt and equity, offering a unique position in the capital structure of a company. It sits subordinated to senior debt but holds priority over equity, balancing higher yields for investors with flexible financing options for borrowers. This structure often includes equity-like returns through features such as warrants or conversion rights, enhancing its attractiveness for both parties involved.
For companies, mezzanine debt is particularly valuable when seeking growth capital without significant equity dilution. By providing access to funds without ceding substantial ownership stakes, it supports expansion initiatives while preserving control for existing shareholders. This financing model is especially adaptable, serving various sectors and industries effectively. In property development, for instance, mezzanine debt has become a critical tool for small and medium-sized developers requiring flexible funding solutions to address the growing demands of the market.
From an investor’s perspective, mezzanine debt offers enhanced yields compared to senior secured loans, compensating for its higher risk. Its subordinated nature carries the potential for higher returns, including upside linked to the company’s success through equity-linked components. This combination of fixed-income stability and equity growth potential makes mezzanine debt an appealing choice in diversified portfolios.
In a falling interest rate environment, mezzanine debt maintains its attractiveness due to its unique hybrid structure and flexibility. Unlike in rising rate scenarios where mezzanine investors benefit from premium pricing, the appeal in a declining rate market lies in borrowers’ increased access to affordable senior financing, which enhances project feasibility. Mezzanine lenders can offer supplementary funding when senior debt leaves a gap, ensuring projects are fully capitalised.
1.8 Real estate credit
Real estate credit refers to loans secured by property assets, such as land, commercial buildings, or residential developments. This form of private credit typically supports property development projects, acquisitions, or refinancing needs. Real estate credit can take various forms, including development loans, bridge financing, and permanent mortgage loans. The collateralised nature of these loans provides an inherent layer of security for lenders, as the underlying property can be claimed in the event of borrower default.
This type of financing plays a crucial role in the real estate sector by bridging the funding gap often left by traditional bank loans, especially for small and medium-sized developers. Falling interest rates improve the affordability of such financing for borrowers while sustaining demand for funding in the property development sector. Furthermore, developers in this space often exhibit a willingness to pay premium rates for access to reliable and flexible capital, particularly for projects with strong market potential.
Real estate credit’s appeal lies in its risk-reward profile. On the one hand, the property collateral mitigates default risks, while on the other, lenders benefit from competitive interest rates often paid by developers eager to access timely and flexible funding. These features make real estate credit a cornerstone of private credit markets, with significant activity in jurisdictions like the UK, where legal protections and market systems offer further reassurance to investors.
In conclusion, private credit strategies offer investors diverse opportunities to achieve attractive risk-adjusted returns. Among these, mezzanine debt and real estate lending hold particular promise in the property development sector. Mezzanine debt provides enhanced yields through its hybrid structure, balancing higher returns with manageable risks, especially when backed by collateralized real estate assets. Real estate credit offers a lower-risk investment avenue, supported by tangible collateral and strong market demand from small and medium-sized developers willing to pay premium rates for secure financing. These strategies balance security and yield, providing structured financing solutions tailored to borrowers’ needs while ensuring robust protections for investors. With rising demand for flexible capital and collateralised structures, mezzanine debt and real estate credit remain pivotal within private credit portfolios, presenting compelling opportunities for investors seeking both stability and profitability in a dynamic economic landscape.
Sources:
- https://www.cambridgeassociates.com/en-eu/insight/private-credit-strategies-introduction/?msclkid=c04f615394a61ab94c64066ffedb8416&utm_source=bing&utm_medium=cpc&utm_campaign=bing-sem-nonbrand-private%20credit-uk&utm_term=private%20credit&utm_content=Private%20Credit%20%7C%20UK
- https://www.morganstanley.com/ideas/private-credit-outlook-considerations
- https://www.investopedia.com/terms/m/mezzaninefinancing.asp
- https://www.agc.org/sites/default/files/Images/Construction%20Markets/AGC%20Guide%20to%20Construction%20Financing%202nd%20Edition-FINAL%20%282%29.pdf
This publication has been prepared by Elbrus Capital Partners LLP
Publishing date
18 December 2024
Language, English
Contact
www.elbruscp.com
