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.