The Private Debt renaissance

Michael Milken is generally regarded as the father of the Junk Bond market.  His innovation extended high yielding debt to companies to ensure that profits would be paid out to investors rather than held as retained earnings.  The theory is that forcing companies to pay out profits is better than leaving those companies to invest their free cash in sub-optimal projects.  There are many corporate finance aspects to issuing high yield bonds with the focus on the shareholder/manager conflict of interest within a company.  Less attention has been paid to the impact of investor preference for risk.

I am regularly asked ‘…what is the next big thing in Finance?’ I think that investors are tired of bearing equity risk without control so that other ways to earn a competitive rate of return are being actively sought.  Private debt could solve this problem.  The long-run equity premium is about 7% over cash which, with a cash return  of 2-3%, means that a rate of return of 9-10% is about what investors can expect in nominal terms from investing in equities.  This comes with equity risk, however, which averages about 18% as measured by the standard deviation of equity returns.  Is there a way to lock in, say, a 10% return while reducing or limiting risk?  This is where private debt comes in.  Private debt contracts have the ability to transfer risk from the shareholders back to a firm’s managers.  The investors specify a market rate of return that they want to receive from a company which then tries to meet the objective as interest.  If they meet the interest payment then the investor is happy, if not then they go into receivership which re-allocates claims.  Private Equity firms are leading the charge for Private debt.  These institutions can deal with both debt issuance and bankruptcy.

The private debt phenomena differs from Milken’s model in that it aims to achieve a macro-finance outcome of achieving a specified rate of return while limiting risk.  Milken’s focus was the micro-economics of forcing managers to pay out profits.  These are different objectives achievable with the same financial instruments.  The interesting aspect of the private debt market is the scale that it can reach.  Almost every listed and unlisted company can participate in the private debt market.