Private Debt: definition and relevance in the market

The world of alternative investments has seen a huge growth in recent years, with Private Debt standing at the heart of this expansion. But what exactly is Private Debt and why has it gained such a relevance for both investors and companies?

When we talk about Private Debt, we are referring to unlisted financing that bypasses traditional public markets in favor of so-called private markets. This type of investment is often characterized by greater flexibility because it is better suited to the specific needs of companies. Private Debt consists of various financial instruments, including direct loans, senior or mezzanine financing, sometimes secured by real assets, and additional subordinated loans.

Its growing popularity over the past decade can be attributed to several macroeconomic scenario factors, including:

1. the low interest rates that have characterized the market - before the peaks of 2023, which may now be mitigated by the latest ECB decisions - have pushed investors to seek higher yields than those offered by traditional bond markets.
2. regulatory restrictions introduced with the Basel III standards since late 2013 have made it more difficult for a banking entity to lend money to a borrower due to tighter equity standards, opening up space for other alternative lenders.
3. investors' preference for greater portfolio diversification has grown as the traditional 60-40 portfolio and positive correlation between stocks and bonds have failed to provide protection and diversification. Incorporating alternatives such as Private Debt provides better diversification and portfolio performance.

The European market also saw a decline in the first half of 2023 compared to 2022 on investments but inflows are positive, according to the H1 2023 Global Private Debt Report [1] which as of June 2023 recorded inflows of more than €9.6 billion, denoting a growing market, as evidenced by the numerous activities of European private debt funds in the first half of 2023.

In Italy, Private Debt, although declining in terms of investment YoY 2023 over 2022 (which was a record year), is growing from a funding perspective: according to recent data from AIFI (Italian Association of Private Equity, Venture Capital and Private Debt) [2] funding in the Italian market in 2023 was +14%, which highlights growing confidence in the sector and underscores the importance of institutional support for its development.

Difference between Private Debt and Private Equity instruments

Although Private Debt and Private Equity are two sides of alternative investments, they differ significantly in terms of structure, risks, and objectives.

Private Equity involves the purchase of stakes in unlisted companies with the goal of increasing their value over time through both strategic and operational actions. Private Equity investors usually take an active role in the management of companies, seeking to improve their performance so that they can then sell them at a higher price, thus providing not only capital but also their expertise and relational strength. 

Private Debt, on the other hand, involves lending capital to companies, expecting to receive an interest payment and to get the capital back when the loan expires: investors in Private Debt, therefore, do not participate directly in the management of the companies and their returns are mainly derived from the interest paid on the loans, making them more predictable than Private Equity earnings.

Therefore, the risks associated with Private Debt are generally lower than those of Private Equity. This is because, for example, in the event of a company's default, creditors (debt investors) have priority over shareholders (equity investors) in the distribution of the company's assets. However, the return potential of Private Debt is usually lower than that of Private Equity, going hand in hand with the different risk profile.

PRIVATE DEBT: MAIN FINANCIAL STRATEGIES

Private Debt includes a variety of financial instruments that can be used to meet the specific financing needs of companies.

The main ones include:

• Direct Lending: these are loans made directly to companies without the intermediation of banks. They are often used to finance acquisition, growth or restructuring operations and have a higher speed of disbursement than traditional bank loans, especially when managed by fintech players;
• Mezzanine financing: it stands halfway between senior debt and equity participations. It allows companies to raise capital without excessively diluting ownership. It often includes warrants or options convertible into shares.
• Distressed debt: it is the purchase of debt of financially distressed companies at "discounted" prices, with investors interested in making a profit from restructuring and recovering the company.
• Secured debt: collateral are assets that the company offers as security for the loan, and it is common to find them especially in real estate. This way, if the company fails to repay the loan, the lender can use the assets put up as collateral to recover the money lent. A debt can be secured regardless of its position in the capital stack, so both a senior loan and a mezzanine loan can have collateral or guarantees.

IMPORTANCE OF PRIVATE DEBT FROM THE PERSPECTIVE OF ENTERPRISES AND INVESTORS

Private Debt plays a crucial role for both enterprises and investors, offering significant benefits to both parties.

For companies, it can provide:

• easier and quicker access to finance compared to public markets. This is especially important for SMEs and startups that may have difficulty obtaining traditional financing.
• more flexible terms than standard bank loans, which allows companies to negotiate terms that best suit their specific needs.
• greater control, because unlike private equity, private debt does not require divestment of company shares, allowing entrepreneurs to retain full management of their companies.

On the other hand, from the investors' point of view, it allows them to:

• earn high returns, thanks to higher interest rates than traditional debt securities, offsetting the higher risk taken by investors.
• diversify their portfolio, reducing dependence on public equity and bond markets.
• protect capital, as debt takes priority over equity instruments in the event of corporate failure.

These aspects highlight how Private Debt has become a key pillar in the alternative investment landscape, offering win-win solutions for both parties involved in the financing process.

How to apply Private Debt in real estate investments

Private Debt has found particular application in the real estate sector, providing an essential source of financing for projects ranging from the development of new properties to the renovation of existing buildings, with a focus today on environmental sustainability.

One of the key players in this area is YELDO itself: we offer off-market Private Real Estate deals in various markets, including Italy, Switzerland, Spain and Portugal. These investments offer the opportunity to access real estate projects that are not available to the public, allowing investors who rely on us not only to earn attractive returns with a low level of risk, but also to diversify their portfolios.

While investing in real assets, Private Debt can be leveraged for a variety of different purposes. For example, it can finance the purchase of land and the construction of new properties, providing needed capital at a stage when project cash flows are still negative. Or, it can be used to renovate existing buildings, improving their value and making possible a subsequent sale or lease on more advantageous terms.

The flexibility of Private Debt makes it particularly suitable for the real estate sector, where projects can significantly vary in size, duration, and financial requirements.