5. Private Debt

• Private Credit

  • Cash Based Strategies

  • Asset Based Strategies

• Insurance Linked Securities

• Structuring

• Credit Risk

• Credit Derivatives

• Private Debt = Asset Class

• Private Credit = Investment Strategy

• Leveraged Loans

• Direct Lending

• Mezzanine Debt

• Distressed Debt

• Grew from $200bn in 2007 -> $1.6tr in 2023

• Banks reduced lending post GFC due to increased regulations

• PE Funds

• Hedge Funds

• BDCs

• Loan-to-own strategy

• Fulcrum securities strategy

• Loans made expecting default

• Goal is asset repossession or control

• Used in distress situations

• Senior debt that is not repaid in cash during bankruptcy

• Conversion into equity in reorganized firm

• Value from post-reorg ownership

• Standardized template for OTC derivatives -> also credit agreements (credit risk in derivatives)

• Provides commonly used legal and credit provisions

• Reduces negotiation time between market participants

• Corporate bond yield = risk free rate + credit spread

• Credit spread compensates for default risk & illiquidity

• Higher credit risk -> higher spread

• Typically unrated

• Implied credit quality -> B

• Falls in speculative (high yield) grade

• Investment Grade

  • Lower credit risk

  • Lower spreads

• Speculative Grade

  • Higher credit risk

  • Higher spreads

• Investment Grade

  • Moody’s: Aaa, Aa, A, Baa

  • S&P/Fitch: AAA, AA, A, BBB

• Speculative Grade

  • Moody’s: Ba, B, Caa, Ca, C, D

  • S&P/Fitch: BB, B, CCC, CC, C, D

• Indenture -> legal contract between borrower & lender

• Includes covenants to protect credit/collateral quality -> no quality decrease

• Affirmative -> borrower must do

• Negative -> borrower must not do

• Incurrence -> covenant tested for specific action (new debt-taking)

• Maintenance -> must be met regularly

• Growth of covenant-lite loans since 2007

• Weaker lender protections

• Minimal covenants

• Preserve Collateral (max. LTV)

• Control Cash Flow (no dividends)

• Limit business risk (limit debt)

• Performance requirements (solvency ratios)

• Reporting requirements (performance)

• Senior debt

  • High priority

  • High recovery rates

  • Low risk/return

• Junior debt

  • Low priority

  • Low recovery rates

  • High risk/return

• Senior Secured First-Lien Debt

• Senior Secured Second-Lien Debt

• Senior Unsecured Debt

• Junior / mezzanine / subordinated debt

• Preferred Equity

• Common Equity

• Bonds offer liquidity but higher credit and interest rate risk

• Loans offer seniority and protection but lower liquidity

• Market: Public

• Regulation: Higher

• Liquidity: Higher

• Default Risk: Less senior (riskier)

• Interest Rate Risk: Higher (fixed coupon; non-callable)

• Market: Private

• Regulation: Lower

• Liquidity: Lower

• Default Risk: More senior (less risky)

• Interest Rate Risk: Lower (floating rate; prepayable)

• Syndicated (group of) bank loans to non-investment grade

• Used for large borrowers -> first or second lien

• Coupon: pays 1.25%-2% above market rate (e.g. SOFR)

• Growth boosted by secondary market -> affter credit rating inception 1990

• Led to originate-to-distribute model -> bank originate loans and sell to investors to move risk & collect fee

• Market relies on CLOs & mutual funds

• Lending to mid-sized borrowers

• No bank as intermediary

• Includes Asset-Based Lending

• Revolving Loans -> secured by inventory & receivables

• Term Loans -> secured by PPE (Property, Plant, Equipment)

• Credit Analysis

• Legal Expertise (restructuring)

• Strong access to deal flow

• Sits between Senior Debt and Equity in capital stack

• Hybrid instrument -> debt & equity features

• Convertible Bonds

• Subordinated Bonds + Warrants

• Convertible Preferred Shares

• IPO or large equity issuance

• J-curve no issue -> regular, immediate cash returns

• Borrower Size: Large

• Seniority: First / Second Seniority

• Asset Claim: First Second Lien

• Credit Rating: Required

• Covenants: Extensive

• Term: 5 years

• Principal Repayment: Install Payments

• Coupon Form: Cash / Floating

• Coupon Rate: Floating + Spread

• Prepayment Penalty: None

• Equity Kicker: No

• Recovery Rate: 60%-100%

• Liquidity: High

• Borrower Size: Large

• Seniority: Subordinated Seniority

• Asset Claim: Unsecured

• Credit Rating: Required

• Covenants: Moderate

• Term: 7-10 years

• Principal Repayment: Bullet Payments (only interest during loan; principal at maturity)

• Coupon Form: Cash / Fixed

• Coupon Rate: 5%-8%

• Prepayment Penalty: Large

• Equity Kicker: Potentially

• Recovery Rate: 40%-50%

• Liquidity: Low

• Borrower Size: Medium

• Seniority: Lowest Seniority

• Asset Claim: Unsecured

• Credit Rating: Not Required

• Covenants: Limited

• Term: 4-6 years

• Principal Repayment: Bullet Payments

• Coupon Form: Cash / PIK / Fixed

• Coupon Rate: 8%-11%

• Prepayment Penalty: Moderate

• Equity Kicker: Always

• Recovery Rate: 20%-30%

• Liquidity: Minimal

• Interest is not paid in cash during loan

• Interest is capitalized -> added to principal

• Principal + accrued interest repaid at maturity

• MBOs

• Growth

• Acquisitions

• Recapitalizations

• Real Estate

• LBOs

• Bridge Financing

• Mezzanine Funds

• Insurance Companies

• Banks -> stretch financing (senior lenders lend more than usual; higher leverage)

• Board representation

• Borrower restrictions

• Flexibility -> Acceleration

• Assignment -> cannot be sold without consent

• Takeout provisions -> option to repay

• Subordinated Debt with Step-Up Rates

• Subordinated Debt with PIK Interest

• Subordinated Debt with Profit Participation

• Interest rate increases over time

• Lower cash burden in early years

• Step-up may depend on meeting financial targets

• No cash interest paid until maturity or refinance

• Interest capitalized into principal

• PIK toggle lets borrower choose cash vs. PIK -> each interest period

• Used for higher-risk borrowers

• Provides equity upside to investors

• Warrants give right to buy shares in the future

• Capital raised for a specific project

• Secured by project assets and cash flows

• Common in real estate and infrastructure

• Public-private partnerships use mezzanine

  • Public sector defines required service

  • Private partner finances, builds, and operates project

  • Project revenues or government payments repay debt and generate returns

• Debt financing for VC-backed companies

• Provided by specialized banks and venture debt funds

• Target IRR: 12%–18%

• Volume: $1M-$20M

• Duration: 1-3 years

• Interest rate: 9%-15%

• Fees: 1%-2%

• Dilutions: warrants covering 5%-15% loan amount -> <2% equity dilution

• Covenants: minimal / none

• Repayment: at next financing round

• Reduces Equity Dilution

• Cheaper than equity financing

• Faster / simpler than equity raise

• Capital to reach milestones

• Focus on loss prevention -> not warrant upside and receive startup shares

• Low default rates (3%)

• Defualts limited by VC follow-on financing -> pay debt

• Issuer in or near default

• Meet one of following:

  • Credit rating equal/lower CCC/Caa

  • Market price < 50% less than of par (face value)

  • Yield > 10% above risk-free rate

• Amount printed on bond & issuer to repay at maturity

• Usually 100 per bond

• Face value = principal owed

• Chapter 7

• Chapter 11

• Liquidation

  • Liquidation of assets

  • Business ceases operations

• Reorganization

  • WIthin 120 days: debtor files plan

  • Next 60 days: debtor negotiates with creditors

  • After 180 days: no plan accepted -> any claimant may file a plan

• Reorganization plan agreed with creditors before court filing

• Similar debt claims grouped into classes

• Plan approved by >50% of claimants and ≥66% of claim value in each class

• Holding ≥33⅓% of a class can block approval

• Claims paid in strict order of seniority

• Court confirms plan despite creditor objections

• New, super-priority secured funding during bankruptcy

• Debt-to-equity swap for control

• Debt or debt-to-equity without control

• Undervalued distressed securities

• Investor buys distressed debt at discount

• In bankruptcy/restructuring -> debt converted to equity

• Investor controlling shareholder -> leads operations

• Investor holds debt or converts to minority equity stake

• No intention to control management

• Goal is to benefit from company recovery -> sell when credit quality improves

  
  

• Investor buys debt or equity priced below intrinsic value

• Market overly pessimistic about default or recovery

• No need for restructuring -> profit from market re-rating

  
  

• Measures expected loss from defaults

• Minimum loss compensation a credit spread must cover -> then add risk premium

• Default Rate * (1 - Recovery Rate)

• Investor outperforms when:

  Credit spread > Credit loss rate + required risk premium

• Credit loss rate: 10% * (1 - 0.7) = 7%

• Minimum required credit spread: 7% + 5% = 12%

• Distressed debt investors

• Invest in companies in or near bankruptcy

• Seek profit from restructuring, recovery / control

• Active / positive role in restructuring -> resolve bad debt

• Credit cycles are driven by monetary policy -> not investors

• Key skill: identify fulcrum security -> rising leverage; up in capital stack

• Negative perception -> negative connotation of loan-to-own (buy low; sell high)

• Volatility -> low (exacerbated by smoothing)

• Correlations -> High for all types except DL

• Returns -> Distressed debt & DL highest returns

• Timing -> deployment in crisis outperformed

• Single loan combining senior and junior debt in one instrument

• Reduction of claims accepted by creditors in bankruptcy

• Option to pay interest in cash or by adding to principal each interest period

• Mezzanine lending backed by PE sponsor

• Lender lends amount above traditional limits

• Higher interest & possible equity kicker

• Fee paid by borrower between commitment and funding

• Compensates for capital being reserved

• Accrues until loan is drawn

• Asset-Based Loans

• Asset-Backed Securities (ABS)

• Loan to distressed borrowers

• Loan secured by specific assets

  • Revolving loans -> short-term, liquid assets (inventory, receivables)

  • Term loans -> long-term, fixed assets (PPE)

• RMBS (Residential Mortgage-Backed Securities)

• CMBS (Commercial Mortgage-Backed Securities)

• Auto-Loan ABS

• Credit-Card ABS

• RMBS

  • Securities backed by home mortgages -> monthly mortgage payments

  • CPR (Conditional Prepayment Rate) -> measures how fast borrowers repay early

• CMBS

  • Securities backed by commercial property mortgages

  • Cash flows from rental -> less frequent prepayment than RMBS

• Loan secured by specific collateral

• Typical collateral

  • Receivables, inventory, real estate

• Loan size: $10M - $50M

• SMIDs

• Non-investment grade firms

• High working capital needs

• SPVs

• Lockbox

• Use SPV to hold collateral

• Protects assets from borrowers bankruptcy

• Gives lender direct control over collateral

• Customer payments go into a lender-controlled account

• Borrower cannot divert cash flows

• Ensures debt service is paid first

• Reduces cash flow diversion risk

• Total value of assets supporting the loan

• Assets are pledged to lender if default

• Maximum loan amount lender willing to lend after reducing collateral to reflect senior claim

• Amount is calculated from value of eligible collateral -> deselect ineligible values

• % lent per dollar of collateral

• Temporary higher advance rate for seasonality

• Used to fund seasonal working capital needs

• Higher advance rate in acquisition or LBO

• Larger companies -> fund working capital

• Smaller companies -> component of capital structure

• Distressed companies -> bridge loan for restructuring

• Revolving + Term Loan

  • Revolving -> like credit card

    • Preapproved limit drawable by borrower; used for working capital

  • Term -> long-term loan; borrow once

    • Repayment is gradual (amortizing) or at end (bullet)

    • Secured against fixed assets

• Key Ratio

  • Fixed Charge (FC) coverage

    • (EBIT/FC) / (interest+FC)

• Covenant Flexibility

  • often springing covenants -> activated only in distress

• Valuation Risk (Change in collateral value)

• People & Process Risk (Lender controls borrower)

• Hedging Risk (Difficult to hedge as private & illiquid; basis risk)

• Legal Risk (Ensure security interest)

• Timing/Exit Risk (Default & collateral lose value)

• Security backed by a pool of mortgages

• Investors receive cash flows from mortgage payments

  
  

• Pass-through MBS -> investor receive pro-rata share of interest & principal repayment of pooled mortgage

• Collaterized Mortgage Obligation (CMO) -> Cash flows are restructured into tranches (maturity, risk) with different priorities

• Low credit risk -> supported by U.S. government

• Prepaymenr risk -> borrower’s right to repay early -> affect size & timing of returns

• Lower interest rates

• Path Dependence

• Other drivers of prepayment

  • regional economic activity, maturity

• Hiher prepayment due to:

  • borrower refinancing when rates fall (low opportunity costs)

  • Home sales increase -> mortgages repaid early

  • Investor -> reinvestment risk: early repayment, reinvest at lower rate -> income declines

• Prepayment depend on past interest rate moves

• Refinancing burnout:

  • Borrower refinance once -> after many refinancings -> further rate cuts don’t increase prepayments

    
    

• PSA Benchmark

  • Standard for modeling mortgage prepayments

  • Expressed as CPR -> Conditional Prepayment Rate

• Standard: 100(%) PSA

  • CPR = 0.2% Month 1

  • CPR increase = 0.2% per Month until Month 30

  • CPR = 6% capped after Month 30

  • 200 PSA -> twice speed / 50 PSA -> half speed

• Models focus on forecasting cash flow & mortgage pools

  • Agency RMBS -> government-backed, low credit risk -> prepayment & interest rate risk

  • Non-Agency RMBS & CMBS -> no guarantee, higher credit risk -> focus on defaults & loss correlation

• Graduated payment mortgages

• Option ARMs

• Balloon payment loans

• Low payments at start

• Payments increase over time

• Risk -> payments become unaffordable

• Flexible payments in early years

• Borrower may pay less than full interest -> negative amortization

  • full payment

  • interest-only payment

  • minimum payment (less than interest -> outstanding interwest added to balance)

• Risk -> loan balance grow over time

• Small regular payments

• Large final payment at maturity

• Risk of default -> often requires refinancing

• Historically -> investors focused on in inrest rate & prepayment risk

• Post-GFC -> default risk matters (especially subprime mort)

• Debt-to-income ratio (low prio)

• Loan-to-value ratio (low prio)

• Credit score (high prio)

• Home loans to borrowers with weak credit quality

• Characteristics: low credit score -> high DTI / LTV

• Carry higher interest rate to compensate default risk

• Avg. Return -> rel. high (above equities)

• Volatility -> very high (highly levered / unstable returns)

• Sharpe -> low (poor risk-adj. perf.)

• Skewness -> strongly negative (large downside risk)

• Kurtosis -> very high (extreme tail events)

• Mortgage REITs offer high returns but severe downside risk (max. DD of 70%)

• Not equity substitutes -> behave like leveraged credit strategies

• Car loan backed by the car

• ABS backed by a pool of auto loans -> CF from car loan payments

• Prepayment Risk

  • Driven by vehicle sales, trade-ins, accidents, repo

• Credit Risk

  • No government backing & recourse loan

  • Loans may be prime, near-prime or subprime

• Prime -> strong credit quality

• Near-Prime -> avg / weaker credit quality

• Subprime -> poor credit quality

• Overcollaterization

  • Collateral principal > securities (loan sum) issued

• Reserve accounts

  • Excess interest retained -> part of interet goes to res. ac. for bad times

  • Protects senior tranches from losses

• Amounts (receivables) owed by consumers on credit cards

• Receivables generate interest and fee payments

• Receivables are pooled and securitized into one credit-card ABS for investor

• Short-lived collateral -> receivables are repaid / reborrowed frequently

• Master trust structure —> multiple ABS series

• Interest-only (lockout) period -> after: principal amortization period

• Recourse loans -> lender can pursue borrower’s other assets

• External credit enhancements

  • Cash collateral account

  • 3. party guarantor

  • Collatal invested amounts (CIA)

• Internal credit enhancements

  • Subordination

  • Spread accounts (cash for losses at exit)

  • Overcollateralization

• Legal process -> lender gets right to seize collateral

• Applies if default

• Covenant that limits how much net debt borrower can have

• Common in cash-based loans

• Protects lender from excessive borrowing

• Borrower legally assures that no other party can make a claim on the respective collateral

• Critical in default event

• Non-bank lenders (e.g., private credit funds)

• Provide loans when banks reduces credit due to regulation

• Funds operating outside traditional banking rules

• Interest owed is greater than interest paid

• Unpaid interest is added to the loan balance

• Common in option ARMs

• Risk that hedge does not perfectly offset actual losses

• Occurs when payout is based on different reference than exposure

• Risk-transfer security -> convert insurance risk into tradable securities with high yield and event-driven downside

• Insurance hedge event risk -> investor receives coupon payments

• Event -> investor loses (part of) principal -> used to pay insurance claim

• Insurance company -> wants protection against losses

• SPV -> to issue the bond

• Investors -> provide capital and earn risk premium

• Investors buy cat bond issued by SPV

• Investor principal -> collateral trust

• Collateral invested in safe assets (e.g., Treasuries)

• Insurance company pays insurance premiums to SPV

• Investor receives

  • risk-free rate (from collateral)

  • Risk premium (insurance premium passed through)

• Defined insured event happens

• Investors loses (part of) principal

• Principal used to pay insurance company’s claims

• Indemnity

• Industry loss

• Parametric

• Modeled

• Payout based in issuer’s actual insurance losses

• Losses are between attachment (loss start) & exhaustion point (max. loss)

  • Pro -> payout amounts actual loss (no basis risk)

  • Con -> moral hazard (insurer incentive to adjust losses) & time to settle (no knowledge of losses quickly)

• Payout based on total industry losses

• Losses estimated by idnependent 3. Party

• Trade-off -> issuer bears basis risk

• Payout triggered by exceeding set natural parameters (Richter scale)

• Payout is fast and objective

• High basis risk -> parameter doesn’t capture losses

• Trigger occurs but insurer has low losses or vice versa

• Payout based on modeled loss estimates

• Uses independent catastrophe model

• Trade-off -> faster than indemnity / less basis risk than parametric

• Total Coupon rate = SOFR + Spread

• Spread = constant + (loss multiple * exp. loss)

• Exp. loss = (porb. of event * annual monetary loss) / principal

• Secured Overnight Financing Rate

  • Risk-free reference interest rate

  • Base rate for floating-rate instrument

  • Replaced LIBOR

• SOFR based on overnight repo transactions

• Repo transaction = one party borrows cash overnight and returns next day

• Borrower gives U.S. Treasury securities as collateral

• Treasury bills -> short-term

• Treasury notes -> medium-term

• Treasury bonds -> long-term

-> all securities are highly liquid & safe -> near risk-free rate

• Low liquidity (infrequent rading, wide spreads)

• Negative skew (rare but large losses)

• Issuer credit risk (non-catastrophe-related loss risk; SPV failure)

• Alternative Beta (comp for event not market risk)

• Alpha Opportunities

  • Security selection (choosing risk/return cat bonds)

  • Market timing (after event)

  • Complexity arbitrage (exploit opportunities others avoid)

• Policyholder living longer than expected -> prolonging payouts

• Faced by insurers, pension plans, social security programs

• Hedged through longevity swaps

  • Index-based

  • Indemnity-based

• Pension fund -> wants to hedge longevity risk

• Counterparty -> takes longevity risk

• Pension fund pays fixed payments

  • Based on assumed mortality rates + margin

• Counterparty pays floating payments

  • Based on actual mortality experience of the pension plan

  • Longevity increase -> payment increase