Private Debt Investments: Risks under the microscope

In previous publications we have looked at the attractiveness of private debt as an investment strategy. This time we analyse the risks of private debt investments and show why the manager selection is so important. This is particularly true in the current context, with the variable basis of its return (linked to floating interest rates), the capacity (and level) of regular distribution of this same return and the relatively low volatility of its performance. This time we analyse the risks of private debt investments and show why the manager selection is so important. 

As private debt is primarily a credit strategy, the main risk is logically a credit risk, which can be defined as the risk that a borrower will not repay the loan or pay the interest at the time defined in the credit agreement. It can also take into account any other breach of the terms of the loan agreement, for example the breach of "covenants". Covenants are limits that the borrower must not exceed, in particular the overall level of indebtedness in relation to financial performance. The most common covenants are the Interest Service Coverage Ratio ("ISCR") and the Debt Service Coverage Ratio ("DSCR").  The ISCR represents a borrower's ability to pay interest charges, while the DSCR represents a borrower's ability to pay all the charges related to the loan, including the repayment of the principal. Repayment capacity is usually represented by EBITDA, with adjustments to reflect the borrower's true ability to generate cash.

Although credit risk can be measured using credit scoring, it also requires a deep understanding of the debtor's business model and the quality of its organisation. It is important to note this here because these factors are analysis criteria traditionally linked to equity investments (private equity or listed shares). This risk and its consequence, the risk of loss, can be managed and mitigated using a number of techniques, including the use of collateral and/or guarantees. From a portfolio perspective, the risk of loss will be reduced by ensuring good diversification.

Like any bond or credit strategy, private debt constitutes an interest rate risk. Loan agreements usually contain interest rate adjustment clauses and it is therefore important to understand what proportion of the assets are floating rate and what proportion are fixed rate. While floating rates seem to allow investors to participate in the potential rise in rates, they also increase the credit risk of the borrower by weighing on their liquidity. We now see a vast majority of private debt portfolios with floating rates, and also with a floor rate, ensuring a minimum return for investors (except in default situations).

Market risk does not spontaneously come to mind in the context of a private debt investment strategy, but it is present. This risk arises when the credit is secured by a real asset whose market value may vary, or when the credit is sold on the secondary market. The security for the credit is mostly made up by the debtor's shares. We currently see advance rates of 50% to 60%, which means that the nominal value of the credit has a value cushion of 40% to 50%, in case the debtor defaults and the lender seizes and realises the company's shares held as collateral.

Currency risk is another risk that does not necessarily come to mind in the context of a private debt investment strategy. We are not talking about a currency risk related to a difference in currency between the mandate and the underlying asset. We are talking about a currency risk within the underlying assets or portfolio itself. This risk is certainly absent from many portfolios, but as soon as one looks at international strategies, there are bound to be discrepancies between the reference currency of the portfolio, the currency of some loan contracts and the reference currency of the borrower.

Although more abstract than the previous risks, a level of legal risk is indeed present in private debt portfolios. The risk will depend on the legal form of the loan contract but also on the jurisdiction of the borrower and will be reflected in the ease (or otherwise) of enforcement of the contracts, including collateral that secures the loans.

In terms of portfolio risks, we can also note concentration risk, geographical and sector risks, which are widely described in the marketing documents of the investment vehicle. And here we must not forget a basic principle of risk management, namely diversification.

To conclude, we believe it is important to check how these risks are addressed and managed by fund managers during a thorough due diligence process. Ideally, this process should be repeated on an annual basis, in order to assess risk management in a constantly changing environment.

The good news is that the private debt market has developed strongly in recent years with a wide choice of managers and products, which allows both selection and diversification of risks according to the appetite and profile of each investor. Moreover, this strong development has favoured the emergence of managers with experience and lessons learned during the financial crisis of 2007-2008. The quality of the teams we select, combining private equity origination and structuring competencies with credit analysis and credit recovery skills, is one of the key points giving us great confidence in the performance of this asset class over the medium term.