Private Debt: the 4 most frequently asked questions by entrepreneurs

The popularity of Private Debt in Europe and the Netherlands is significantly increasing in recent years and therefore gains popularity as an attractive form of financing. In this article the most frequently asked questions by entrepreneurs about Private Debt are asked and answered such as: What is Private Debt exactly? Which forms of Private Debt are most applied? And what are the differences between Private Debt and bank financing or even attracting external shareholders?

 

1) What is Private Debt exactly?

The term ‘Private Debt’ is generally applied to financing that is not provided by banks, but by private and institutional investors through credit funds. These investors often look for a relatively higher return that fits a form of financing with a relatively higher risk profile.
In the past 10 years, a proverbial “gap” has emerged for non-bank financiers to play a greater role in the financing industry. The continuous development and increase of regulations (Basel III and IV), with the aim of safeguarding the financial health of banks, has strongly influenced traditional bank loans in the aftermath of the 2009 financial crisis. The upswing of Private Debt is also clearly reflected in the figure below. The data collected by Preqin (Preqin data insights) shows an increase in the number of Private Debt funds in Europe and the accumulated capital raised (CAGR: 21.9%) since 2009 until 2017.

2) What are popular forms of Private Debt?

Private Debt comes in many different shapes and sizes. Figure 2 shows the relationship between the potential risk and return associated with each form of financing or investing. In case a company goes bankrupt, the bank has the most preferent position as senior lender and is first in line with the trustee. An investor in Equity on the other hand has the most junior position and comes last in line as a shareholder (i.e. Equity is therefore subordinated to all other forms of capital), but due to this risky position, the potential returns are higher.

  • Bank debt: this form of financing, provided by banks, is secured by collateral. Long-term bank loans are generally repaid in a linear way in 5 years and is the cheapest form of capital due to the low risk profile.
  • (Senior) Direct Lending: this is the cheapest form of Private Debt while often (secondary) collateral is used, which leads to a relatively lower risk profile.
  • Mezzanine Financing: a mezzanine loan is often subordinated to bank financing and usually has no collateral. Mezzanine loans are therefore seen by banks as equity-like and therefore strengthen the solvency of a company. Because of this higher risk profile, the costs are higher.
  • Distressed Debt: initial loans provided to company that are sold at a discount, because these companies are in financial distress.
  • Equity: this represents the shareholders and the ownership of a company. In the event of a bankruptcy, the shareholders are repaid as the last creditor. For this reason, this form of capital runs the highest risk, but it also has the highest potential return of every layer in the capital structure.

3) What are the biggest differences with bank debt?

Figure 2 shows a clear difference in the risk and return profile between Private Debt and bank financing. However, Private Debt is still often compared by entrepreneurs to bank financing. At first a logical assumption, because just like bank debt Private Debt remains a loan on the balance sheet that requires interest payments.

However, there is no Private Debt fund in the Netherlands that tries to compete with a bank and its pricing.

“However, Private Debt is often compared by entrepreneurs to bank financing …”

These are the biggest differences:

  • For most of the transactions, mainly Management Buy-Out (MBOs) and acquisitions, Private Debt works as additional financing on top of bank debt. Private Debt is then used as additional leverage on top of bank financing to increase the leverage in an MBO.
  • Private Debt funds are willing to take more risk compared to banks and therefore to provide more leverage then a bank. Of course, they are willing to this against higher pricing then traditional banks.
  • Private Debt offers more flexibility for entrepreneurs. For example, the covenants (agreements and conditions to protect the loan) are a lot lighter and simpler. Alongside this benefit companies can also have a longer grace period in which no repayment is requested. This helps companies retain the cashflow which can then be used for example for investing in controlled growth.

4) What are the largest differences between using Private Debt or attracting an investor in Equity?

The fact that Private Debt can be used as additional leverage to bank financing also means that in many cases it can be used as an alternative for attracting an investor in Equity (shareholder). This mainly applies to mezzanine financing, while these loans are fully subordinated to the bank and therefore the most ‘equity-like’ form of Private Debt.

If an entrepreneur historically needed (non-banking) capital to complete a transaction, the most common move was to look for an investor. And compared to Private Debt this of course has its advantages. For example, you don’t pay an interest coupon on an investment in Equity and there is no repayment pressure.

However, attracting a shareholder also has some disadvantages compared to Private Debt. Let’s briefly discuss an example whereby an entrepreneur is looking for additional capital to accelerate his growth (see also: Pride Capital mezzanine@work Spotzer).

First, the existing shareholders dilute by issuing and selling new shares. This dilution effect using Private Debt is marginal compared to an investment because a financier, as mentioned above, does not acquire a shareholding.

“Private Debt is an expensive form of debt, but a cheap form of equity”

Furthermore, in many occasions valuation discussions arises between the current (selling) shareholders and the (buying) investor for various reasons. These discussions relate to for example differences in opinion regarding potential future value of the company.

In addition to the previous points, attracting an investor in Equity can also lead to major changes in the governance and control within an organization, such as certain veto rights (dismissal of key employees) or exit pressure.

With Private Debt both the discussion about valuation and changes in governance have a considerably more limited role. A Private Debt financier provides a loan instead of acquiring a (majority) shareholding. This makes a discussion about valuation and control much less relevant.

“With Private Debt both the discussion about valuation and changes in governance have a considerably more limited role.”

The last major difference between Private Debt and attracting an investor in Equity are the costs. In the short term, due to the interest payments that must be paid, the costs are higher for Private Debt. However, attracting a shareholder would ultimately lead to giving away more potential upside (future value). Under the assumption that a company performs as expected, it is therefore plausible that attracting Private Debt is the cheaper alternative to an investment in Equity.

Which form of financing ultimately is the best?
There is not one ideal form of capital that suits every situation. However, we can conclude that Private Debt is more flexible and is willing to bear more risk than bank financing. On the other hand, this type of debt is more costly than bank debt. But, Private Debt, like bank financing, remains a debt element on the balance sheet compared to an investment In Equity. Nevertheless, if a company is performing as expected, entrepreneurs are giving away more potential upside when they attract shareholders compared to using Private Debt. Private Debt is therefore often seen as an expensive form of debt, but a cheap form of equity.

Want to know more?
Do you still have questions about Private Debt or are you interested in the possibilities of Private Debt for your company? You can contact:

Bas Welten
Pride Capital Partners
Bas@pridecapital.nl
020-427 42 42

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