A Survey of Private Debt Funds

Steven N. Kaplan is the Neubauer Family Distinguished Service Professor of Entrepreneurship and Finance at the University of Chicago Booth School of Business. This post is based on a recent paper by Professor Kaplan; Joern Block, Professor at the University of Trier; Young Soo Jang, a Ph.D. Student at University of Chicago Booth School of Business; and Anna Schulze a Ph. D. Student at University of Trier. 

After the Great Financial Crisis triggered tightening of banking regulation, corporate lending has increasingly migrated out of the banking sector. Private debt (PD) funds and collateralized loan obligation funds (CLOs) are two of the major types of nonbank intermediaries that have filled this gap. Private debt funds raise capital commitments through closed-end funds (like private equity) and make senior loans (like banks) directly to, mostly, middle-market firms (i.e. firms with annual revenue between $10 million and $1 billion). According to the 2022 Preqin Global Private Debt Report, private debt is projected to become the second-largest private capital asset class by 2023, following private equity (PE).

Despite its explosive growth, the private debt market remains relatively understudied. While previous studies have broadened our understanding of the private debt market (Chernenko et al, 2022; Davydiuk et al, 2021; Jang, 2022; Loumioti, 2019; Munday et al, 2018), each looks at a different segment of the market. There still is much that is not known about private debt funds, particularly compared to other types of intermediaries (banks, PE funds, and CLOs).

Accordingly, in this post, we survey and ask a broad set of questions to a meaningful group of private debt general partners (GPs). They comprise of 38 U.S. and 153 European private debt investors managing roughly 35% of assets under management (AuM) of the private debt market. Their predominant investment strategy is direct lending where the loan is bilaterally negotiated between a borrower and a single lender (or a small group of lenders) with an expectation hold the loan to maturity, which contrasts with most bank-syndicated loans that are often traded in the secondary market. Our survey loosely follows the framework used by Gompers, Kaplan, and Mukharlyamov (2016 and forthcoming) for PE GPs and Gompers, Gornall, Kaplan and Strebulaev (2020 and 2021) for venture capital (VC) GPs.

We first ask how the GPs source, select, and evaluate deals. U.S. investors source largely from PE sponsored deals while European investors source both from PE sponsors and independently. In selecting deals, U.S. debt investors prioritize stable cash flows while European debt investors, consider management, the business and cash flows more equally – more like PE investors. The cash flow result for the U.S. is consistent with Jang (2022) who find that direct lenders put more emphasis on cash flows than banks when lending to small firms. It can also be related to the prevalence of sponsored deals. Because PE sponsors are actively involved in firm operations and governance, their presence may mitigate lenders’ concern over mismanagement.

Both U.S. and European private debt investors target unlevered gross returns that imply substantial premiums over the comparable risk-free Treasuries and BB-rated bonds. If these are indeed expected and realizable returns, they explain why the investors (limited partners) in the private debt funds find those investments attractive. This result is consistent with the higher rates found from previous studies. We also note that private debt funds generate these returns using appreciably less leverage than that used by banks and CLOs.

We also ask the GPs how they compare private debt relative to bank financing. Private debt investors believe that they provide financing to companies that banks would not otherwise provide. They also lend at higher multiples than most banks would allow. They attribute banks’ reluctance to firms’ small size, lack of accounting standardization/transparency, lack of commitment and lack of tangible assets. These are broadly consistent with previous studies.

Second, we ask how the GPs monitor their portfolio companies. Private debt funds proactively negotiate for both negative covenants and (cash flow-based) financial covenants. Private debt loans, therefore, appear to incorporate a mix of traditional bank loans and covenant-lite leveraged loans by both restricting borrowers’ actions ex-ante through negative covenants and still influencing borrowers’ behaviors ex-post upon financial covenant violations. They also use other methods used by banks to monitor their investments – periodic meetings and updates of financial statements – but appear to monitor them more frequently than banks do. These results contrast with most previous studies that find that nonbank lenders are more arms-length than banks (Chernenko et al., 2022; Gopal and Schnabl, 2022; Loumioti, 2019). If anything, direct lenders appear to be more monitoring-intensive than banks, consistent with Jang (2022).

Third, given the importance of PE sponsors to the private debt market, we ask the private debt investors about their interactions with the sponsors. European and, particularly, U.S. debt investors find their interactions with the PE sponsors to be advantageous. The sponsors help with deal quality, with deal sourcing and in reducing information costs. These benefits allow the private debt lenders to lend more and to craft more effective covenants. These advantages are consistent with the benefits of leveraged buyouts described by Jensen (1989).

Finally, we survey the GPs’ outlook on the current and future environment of the private debt market. At the time of the survey, both U.S. and European debt investors were very optimistic about the near-term and longer-term future of private debt investing. The U.S. investors were concerned with the influx of money coming from existing and new funds. The European investors also were relatively more concerned with competition from banks.

Overall, the private debt market is both different from, but shares characteristics with the other types of intermediaries that we are familiar with. Like banks, private debt funds make loans and monitor using covenants. Different from banks, they make cash flow-based loans at higher leverage to smaller companies, charge higher interest rates, use less leverage in their funds, appear to monitor more often and tend not to make asset-based loans. Like CLOs, they make cash flow-based loans, rely on PE sponsors, and use negative covenants. Different from CLOs, they lend to smaller companies, use financial covenants proactively, and use less leverage in their funds. On several dimensions, private debt funds are closer to PE funds in that they have a similar LP base, relatively low leverage and relatively high return expectations.

It is still an open question as to why the private debt markets have grown so much in recent years and why private debt investors believe that growth will continue. It also is a puzzle why private debt funds have been able to operate successfully without the high leverage from short-term debt and deposits emphasized by banking theories of optimal lending and delegated monitoring (e.g. Diamond, 1984; Diamond and Rajan, 2001).

It is possible that the private debt firms innovated in a way that allows them to lend to and monitor the borrowers more effectively. The reliance of private debt funds on PE sponsors is consistent with this explanation.

Regulatory frictions also may matter. Erel and Inozemtsev (2022) conclude that regulatory changes have played an important role, disadvantaging bank lending to the types of companies funded by private debt. Interestingly, banks appear to be entering the direct lending business with JP Morgan recently announcing a new direct lending unit. The regulatory explanation implies they will operate at a disadvantage to the private debt funds.

The complete paper is available for download here.

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