Private debt as an alternative to bank financing - Rothschild & Co

Private debt emerged in the 2000s as a financing option sitting between senior bank loans and shareholders' equity. Its growth accelerated after the 2008 global financial crisis, when banks restricted lending, particularly to SMEs and highly leveraged companies, under tighter capital adequacy regulations. Private-sector institutions, including insurers and debt funds, filled the gap as investors sought diversification and returns. According to Rothschild & Co, private debt has become a must-have alternative to bank loans for intermediate-size companies, particularly those consolidating their market position or funding acquisitions. Pitchbook data cited by Rothschild shows the asset class's AuM has tripled over the last decade.

The term private debt generally refers to unitranche senior debt as well as subordinated or junior debt. Unitranche, introduced in 2012, replaces a junior/senior debt combination with a single lender, giving borrowers speed, flexibility and a closer lender relationship. For lenders, it carries senior-level collateral with a higher yield, since it can support higher leverage. Subordinated debt ranks below senior debt and above equity, offering higher returns for higher risk.

Rothschild highlights several structural features of private debt. As unlisted instruments, these loans are not subject to market volatility and can offer an illiquidity premium over listed bonds. Private debt funds have shorter investment periods (2-3 years versus 3-5 years for private equity) and holding periods (2-3 years versus 4-6 years). Because the instruments rank higher in the capital structure than equity, investors face less exposure in the event of borrower default. Returns are typically paid as regular quarterly coupons over the 6-8 year fund life, barring credit events, and debt is often variable-rate, which is advantageous in the current high-interbank-rate environment.

The market has shifted since the war in Ukraine, rising inflation and rapid rate increases. Large Cap transactions (above EUR 300 million) have become more complex, with fewer deals concluded in 2023, and most are executed through debt funds. Banks have resumed syndicating loans since end-2023 as liquidity improved. In the Small & Mid Cap segment, lenders have been highly selective over the past two years, leverage has structurally declined and margins have risen, which Rothschild describes as a favourable risk/return adjustment for lenders. Subordinated debt, including PIK and mezzanine, has returned to the market. Rothschild notes slightly higher default rates and more restructuring and distressed debt as borrowers face tougher conditions. Non-cyclical sectors such as health care are attractive to lenders, while cyclical firms face difficulty obtaining financing. ESG criteria have also become a priority, with instruments such as ESG margin ratchet loans linking interest rates to environmental, social or governance targets, such as reducing GHG emissions.