Risk and Return of Private Debt vs. Other Private Market Investments

Introduction and Overview

You know how sometimes we search for a middle ground between super-volatile equity markets and ultra-conservative bonds? Private debt tries to fill that space, offering (ideally) more stable returns and consistent cash yields—though it also brings along significant complexities. In this section, we’ll look at the risk and return profile of private debt compared to other private market investments like private equity, real estate, and infrastructure. My own first foray into private debt was eye-opening: I realized how crucial it is to balance potential upside with the risk of a borrower defaulting. So let’s dig in.

Return Drivers for Private Debt

Private debt is largely driven by contractual interest payments. Unlike equity, where returns hinge on capital appreciation and, occasionally, dividends, private debt invests in the borrower’s promise to pay interest plus principal over time. But there can be more to it:

• Contractual Coupon or Interest. Typically, private debt has regular interest payments at a higher spread than public credit markets. You’ll often see private lenders negotiate floating-rate terms that adjust to benchmark rates, so if market rates rise, the coupon might automatically increase.

• Equity Kickers or Warrants. Once in a while, you’ll see an arrangement where the lender negotiates an equity “sweetener”—like a small ownership stake or warrants—to enhance total return. In buyout deals (discussed in Chapter 3), mezzanine debt typically carries these.

• Lower Volatility. Because of locked-in interest rates or structured deals, private debt can see steadier returns—though “steady” doesn’t mean risk-free. If the borrower defaults, lenders face potential loss of principal.

• Below-Investment-Grade Yields. Private debt can target businesses that aren’t rated investment-grade. The credit risk is higher, so yields are higher to compensate. Many smaller or niche borrowers struggle to get cheaper financing in the public markets, so they turn to private lenders who command a premium.

Comparison with Private Equity

Private equity invests in ownership stakes in companies, aiming for capital appreciation over a multi-year horizon. People often associate private equity with a “high risk, high reward” mantra. By contrast, private debt invests in a company’s capital structure at a more senior position (though “more senior” is relative—junior debt also exists). The ultimate difference:

• Return Outcomes. Equity returns are driven by changes in a company’s enterprise value. If a company grows significantly, equity returns can skyrocket. But if everything goes south, equity holders typically get wiped out first. Debt, on the other hand, prioritizes capital preservation with contractual interest payments, often with some security or senior claim on assets.

• Loss of Principal. One big reason private debt invests at a greater security level is to mitigate the risk of total loss. If a borrower defaults, the lender might still recoup some value by liquidating collateral. Equity holders can go to zero.

• Timeline for Returns. Equity returns often come in lumps—some big exit event or a recapitalization. Private debt, though, distributes returns more regularly via interest payments.

• Complexity and Fees. Both private equity and private debt structures may carry performance fees (like carry for equity GPs). However, direct-lending or private credit funds may have different fee setups than buyout or venture capital funds. We covered the alignment of interests in Chapter 2, so you might want to revisit that if you need more details.

Illiquidity and Complexity Premiums

Ever wonder why private debt yields are often higher than comparable public bonds? A huge part of that is the illiquidity premium. If you’re lending to a private company, you can’t just quickly sell the loan in the secondary market if you want out (there may be a secondary marketplace for large syndicated loans, but it’s nowhere near as liquid as public corporate bonds). Moreover, the documentation can be specialized, and structuring might be complicated. This complexity premium compensates lenders for the effort and risk of analyzing bespoke deals.

Here’s a quick diagram that conceptualizes the risk-and-return continuum:

    graph LR
	    A["Senior Secured Debt"] --> B["Subordinated Debt"]
	    B --> C["Mezzanine Debt <br/>with Equity Kickers"]
	    C --> D["Preferred Equity"]
	    D --> E["Common Equity"]

• Relationship-Based Deals. In the private markets, a longtime lender-borrower relationship can yield additional premiums. Borrowers might accept a higher interest rate to maintain a relationship with a trusted lender who understands their business.

• Difficulty in Marking Valuations. Private debt can carry less frequent mark-to-market reporting compared to exchange-traded instruments. Although that can reduce day-to-day volatility, it also introduces valuation challenges. As we saw in Chapter 2, subscription lines and capital calls can further complicate the timing of valuations.

Portfolio Diversification Benefits

From an overall portfolio perspective, private debt can serve as a diversifier. While private equity returns might be correlated with the macroeconomic cycle (and sometimes even with public equity indices), private debt tends to be more influenced by credit fundamentals, cash flow coverage, and borrower-specific factors. That said, in a severe recession, defaults can rise across the board—you can’t completely bank on zero correlation.

However, private debt might offset some public-market volatility thanks to:

• Lower Mark-to-Market Sensitivity. In times of market turmoil, private equity or public shares can see steep price drops. Private debt valuations might move more gradually, based on borrower fundamentals rather than daily trading.

• Downside Protection. Debt has a higher priority claim on assets, so in theory, it has better recovery potential than equity. That can buffer a portfolio’s downside, especially when combined with other less-correlated assets like private real estate or infrastructure (covered in Chapters 6 and 7).

• Unique Risk Factors. Still, “portfolio diversification” shouldn’t lull investors into a false sense of security. If the macro environment deteriorates, spreads can widen, defaults can spike, and those contractual interest payments might not arrive.

Key Risks in Private Debt

We’ve mentioned a few, but let’s lay them out cleanly:

Default and Credit Risk
Default risk is the risk the borrower won’t make interest or principal payments. Think about the concept of Loss Given Default (LGD). Even if a lender is secured, recovery can be a lengthy, complex legal process. Some deals are structured with collateral. In others, you’re basically relying on cash flows and the borrower’s intangible assets.

Covenant Erosion
Once upon a time, private lenders demanded a laundry list of covenants—financial and performance metrics that, if violated, triggered immediate recourse. But “covenant-lite” structures have become widespread, especially in frothy markets. That means less protection if things go sideways.

Market Environment
Macro factors can wreak havoc. In a rising-rate environment, many private debt instruments are floating rate, so coverage ratios could weaken for borrowers as their interest expense rises. In a recession, a borrower might see declining revenues, making it harder to service debt.

Illiquidity
Yes, we chalk it up as a premium, but the flipside is that selling private debt is much trickier than selling a public bond. If you need to exit quickly—perhaps to rebalance or meet unexpected liabilities—you might take a loss (or find no buyer at all).

Drawdown Risk
Private debt funds often have capital calls. In a market downturn, you might face a new capital call just as you’re wrestling with other liquidity demands. For large institutions, that can be a real headache if multiple private funds call capital simultaneously.

Example: Real-World Private Debt Scenario

Let’s imagine you’re managing a small endowment fund, and you decide to allocate, say, 10% to private credit. You’re looking at a mid-sized manufacturing firm that wants to expand but can’t access cheaper public debt. The yield on your loan is 9% floating rate, with an additional 1% possible if they hit certain performance targets (kind of a bonus interest). Short of a catastrophic failure, you expect these interest payments regularly—thus stabilizing your endowment’s cash flow.

Now compare that to a private equity deal where you buy shares of that same manufacturing firm. Maybe you end up with a 30% equity return if the expansion is successful—three times the upside. Or maybe it collapses and the equity is worth zero. Meanwhile, your private credit stake might be partially or fully recoverable depending on the firm’s assets and your loan’s seniority.

Using Private Debt in Asset Allocation

As you might recall from Section 1.5 (Integrating Private Investments into Strategic Asset Allocation), the general rule is to consider your overall portfolio objectives, risk tolerance, and liquidity requirements. Private debt can act as an income-oriented sleeve that complements higher-octane private equity or venture capital positions. By layering private debt in, you might lower portfolio volatility—provided you have the risk tolerance for less liquidity.

Asset allocators often blend private debt with other assets to achieve:

• Income Stability: Predictable interest payments can help meet ongoing cash needs.
• Moderate Total Return: Over time, the combination of coupon payments plus possible fees or equity kickers can reach mid- to high-single-digit returns.
• Downside Protection: Senior secured debt might protect principal better than equity in tough times.

Best Practices and Common Pitfalls

Best Practices
• Conduct Thorough Due Diligence: This includes deeper financial ratio analysis (discussed thoroughly in Section 4.4), robust stress testing, and an understanding of the borrower’s industry.
• Negotiate Covenants Wisely: Strong covenants help you exit or restructure quickly if performance deteriorates.
• Diversify Across Sectors and Borrowers: Concentrating your private debt in a single industry or region can lead to painful drawdowns if that sector collapses.
• Align with Reputable Managers: Since these deals are heavily relationship-based, working with an experienced GP or private debt manager often pays off.

Common Pitfalls
• Overlooking Liquidity Needs: The last thing you want is to face capital calls when liquidity is tight.
• Underestimating Macroeconomic Risk: Rising interest rates, recessions, or industry downturns can hamper borrower repayment capacity.
• Chasing Yield Blindly: Sure, a double-digit yield might look sweet, but it could come from a severely distressed borrower with questionable fundamentals.

Regulatory Considerations

From an accounting perspective, IFRS and US GAAP treat private investments with fair value approaches. However, private debt might be kept at amortized cost if it meets certain “held-to-collect” criteria. In practice, some funds choose fair value accounting with periodic marks to reflect credit risk changes. Also consider that private debt managers must abide by the CFA Institute Code of Ethics and Standards of Professional Conduct, particularly regarding fair dealing and reporting accuracy. For the exam, watch out for scenario-based questions exploring how managers could comply—or fail to comply—with these standards.

Conclusion

Private debt sits in a unique middle ground, offering stable yields with a side of complexity and illiquidity. Relative to private equity, it emphasizes dependable interest income and lower volatility at the cost of potential capital upside. Compared to public bonds, it offers juicier yields but lesser liquidity and more operational complexity. If integrated wisely into a diversified portfolio, private debt can provide a valuable stream of returns uncorrelated to public markets—though it’s hardly a slam dunk. Before committing capital, always stress test the borrower’s balance sheet, read the covenants thoroughly, and prepare for capital calls that might come at inconvenient times.

It’s like I learned the hard way early in my career—private debt can be a great fit if you appreciate its trade-offs. Now that we’ve walked through these nuances, you should have a stronger grasp of where private debt might fit in your overall strategy, how to weigh its risks, and what returns to realistically expect over the long haul.

References and Further Reading

• Preqin. (Annual Reports). “Global Private Debt Report.” https://www.preqin.com/
• Merton, R. (1974). “On the Pricing of Corporate Debt: The Risk Structure of Interest Rates.” The Journal of Finance, 29(2).
• International Financial Reporting Standards (IFRS)
• US Generally Accepted Accounting Principles (US GAAP)
• CFA Institute Code and Standards

Test Your Knowledge: Private Debt Risk-Return Dynamics