Private debt offers a potentially more stable return profile than liquid credit markets.

By Kirsten Bode, Co-Head Private Debt Pan-European, Muzinich & Co.

Ongoing consolidation and an increasingly stringent regulatory environment within the traditional banking sphere have reshaped the global lending landscape for small and medium-sized businesses (SMEs). With banks, a lower willingness to take risks can be observed in the granting of new loans, while at the same time, there is a greater willingness to dispose of existing SME loans that are not part of the core business.

Many SMEs thus no longer receive any loans from banks at all or only short-term working capital financing. They lack the money for growth, investments, expansion, M&A activities or for turning around their business.

Entrepreneurial Approach of Private Lenders

With the withdrawal of the banks, private lenders have stepped into the vacuum that has formed. Private financial resources from private lenders can close this funding gap, as these lenders can act in a more entrepreneurial approach than banks. They may also have a greater speed of delivery and a good relationship with the debt advisor to secure the most attractive risk-return profile for their clients.

This trend is expected to continue, as borrowers in an environment in which the economic outlook for companies has apparently changed need to keep an eye open for creative financing solutions.

Alternative lenders such as private debt open up a wide range of investment opportunities, particularly for companies in the lower SME segment (with an EBITDA of 5 million euro to 50 million euro). Attractive market opportunities exist all over the world:

In the USA, there are 85,000 companies with a turnover of more than $25 million, in Europe, there are more than 140,000 companies with a total turnover of over 8 trillion euros and the Asian region is home to more than 150 million SMEs. All of them are looking for financing resources.

Diversification and Manager Selection Are Elementary

With a global allocation of capital to the private debt markets in the USA, Europe and Asia, this vast pool of prospective investments provides the potential for enhanced portfolio diversification on a geographical, asset and industry basis. Due to the scale and size of the market, there are higher barriers to entry.

Private debt providers with a local presence and credit analysis capabilities, who understand the local culture and legal regime, are therefore the key to a successful global investment strategy.

It can thus be valuable, during an unforeseen crisis such as a global pandemic, to have local teams on-site in the countries in which a private debt provider invests, in order to maintain relationships with borrowers and to prepare new transactions.

Conscientious Employees

It is of crucial importance to have an in-depth understanding of the risks and opportunities facing the businesses to which the loans are being granted. This involves both the financial situation of a company, as well as, for example, the way in which it deals with ESG guidelines.

Companies with careful corporate structures and guidelines, with conscientious employees and those who manage their environmental impact well are more likely to be financially resilient over longer periods of time. While valuations currently appear tight in liquid credit, an allocation into private debt may offer benefits over traditional fixed income – for example, a higher potential return due to the illiquidity premium.

At the same time, private debt investments are less liquid as a result, as the assets are fixed over a period of time of several years. A further advantage of private debt is a cash yield with a variable interest rate, which offers protection against interest rate increases and volatility. This also includes inflation. Due to their variable interest rates, private loans are thus well prepared for an inflationary environment, should it come to that.

Lending With new Opportunities

For a long time, it was unclear how the relatively young asset class private debt would prove itself in a challenging market environment. The first findings from the COVID-19 pandemic are promising. Adjustments to loan agreement conditions often went through constructively, as the negotiations with a single partner proceed more easily than with an entire banking consortium. These experiences are expected to encourage the spread of further investments in private debt.

In addition, the development of the European banking landscape will also open up new opportunities for alternative lending in the future. For traditional lenders, it is more difficult to provide long-term financing for companies without investment-grade status – a segment to which the lower SME segment to a great extent also belongs.

These companies will continue to require financing resources for their growth and development, especially if the economic recovery after the pandemic gains momentum.

Following the COVID-19-induced economic turmoil, it is a potentially attractive time to start deploying capital into the private debt markets on a global basis to capture the opportunities that have emerged to achieve compelling risk-adjusted returns within private debt.

Kirsten Bode has been Co-Head Private Debt Pan-European at Muzinich & Co. since 2015. She has more than 20 years of private market experience. Bode graduated from ESB Reutlingen and Middlesex University London with a B.A. (Hon) in European Business Administration.

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