22 Oct. 2020
Green plant on brown round coins

Why companies might consider the private debt market

By Bill Wu

EY Canada Capital Markets Consulting Partner, EY Private

Driven leader with a passion for understanding business needs and providing tailored solutions.

22 Oct. 2020

Contributors: Shane Dunn, Walid Safri, Barkin Sayiner, Roger Leslie, Michael Campbell

What is private debt and why is it so popular?

Private debt has been around for decades as an alternative source of capital to traditional lending offered by banks. It wasn’t until after the financial crisis of 2008 that private debt grew in popularity as traditional banks became more regulated, focused on disciplined lending criteria and stepping back from providing capital. In fact, back in 2000, the private debt market was merely US$43 billion. At June 2019, it was estimated to be a US$800 billion market and on track to achieve a market size of US$1 trillion in the not too distant future.

Another big contributor to the growing private debt market is the overall low interest rate environment experienced over the past decade, as investors ranging from large institutional players, to family offices to investors looking for a better yields in their investment portfolio became attracted to the private debt market.

As COVID has affected the global economy in a negative way, many traditional banks have pulled back capital as concerns of default and higher risk plague their portfolios. This has presented an opportunity for the private debt market to step up and fill in the gap.

Private debt balloons

Source: Preqin.

Note: 2019 figures as of June 2020, all other figures are as of year end.

Who funds private debt?

The most active investors in the private debt market are pension funds, foundations, endowments and insurance companies, followed by family offices, fund of fund managers and others. For example, in 2018 the Canada Pension Plan allocated 11% to the Private Debt Market (source 2018 CPPIB Annual report).

Private debt spotlight

Source: Preqin Private Debt Spotlight March 2018.

Private debt to asset classes

Private debt is a general term and can be structured in many forms, ranging from direct senior secured debt all the way to junior capital like subordinated debt and mezzanine debt.

Private debt availability

Leverage multiples

Not surprisingly, the leverage multiples are down by about 0.9x as a function of total debt to EBITDA due to COVID-19 from all-time highs of 6.0x in 2019. Despite the pullback in leverage multiples, overall leverage in the first half of 2020 remains higher than after the financial crisis. The main difference with COVID is the decline in second lien, unsecured and subordinated debt instruments, and a bias to senior secured or first lien debt.

As traditional lenders fall within first lien debt availability, the private debt market typically fills the gap with a fulsome debt solution which covers first lien debt to mezzanine debt.

Historical LBO Leverage Levels

Source: S&P LCD Comps

Why should companies consider private debt?

Private debt has gained traction and attention since it offers an alternative to traditional debt sources that are governed by regulators, conservative risk appetite and structured covenants.

Although the cost of capital and fees for underwriting the private debt instrument(s) are more expensive, companies see the cost as a trade-off, obtaining an innovative way of borrowing capital outside of traditional banks.

  Traditional debt Private debt
Industry Banks would have limitations on specific industries and at time exit from specific industry due to concentration risk or losses Less restrictions and typically focused on industries where banks have stepped back
Margin/loan to value Traditional bank formula (i.e., up to 75% of assets) Can go up to 100%
Interest rate Traditional bank pricing, lower single digits Ranges from 8% to 25%
Security Secured, typically in first position
Secured, can be first or second and unsecured
Financial covenants 3-4 covenants that cover balance sheet, income statement and cash flow 1-2 covenants that cover balance sheet and cashflow
Structure Have flexibility; however, governed by covenants that meets the banks’ risk appetite Greater flexibility; governed by a couple of financial covenants as the debt provider understands the risk profile of the borrower and can offer longer term and amortization periods
Disclaimer

This publication contains information in summary form, current as of the date of publication, and is intended for general guidance only. It should not be regarded as comprehensive or a substitute for professional advice. Before taking any particular course of action, contact Ernst & Young or another professional advisor to discuss these matters in the context of your particular circumstances. We accept no responsibility for any loss or damage occasioned by your reliance on information contained in this publication.

Summary

Private debt has been around for decades as an alternative source of capital to traditional lending offered by banks. Private debt has gained traction and attention since it offers an alternative to traditional debt sources that are governed by regulators, conservative risk appetite and structured covenants. Although the cost of capital and fees for underwriting the private debt instrument(s) are more expensive, companies see the cost as a trade-off, obtaining an innovative way of borrowing capital outside of traditional banks.

About this article

By Bill Wu

EY Canada Capital Markets Consulting Partner, EY Private

Driven leader with a passion for understanding business needs and providing tailored solutions.