One way to look at a private debt portfolio is to understand how underlying loans rank according to their position in the capital structure. Capital structure, also known as “capital stack”, is the term used to represent a combination of a company’s debt and equity financing. The complexity and variety of debt and equity solutions will depend on the size of the underlying company, its access to resources, and whether it operates in private or public markets.
Senior Debt
Senior debt strategies include loans that occupy the highest rank on the capital stack and are first to be repaid in the event of default. Since the credit risk of such loans is considered lower compared to those that are ranked below, the expected return profile is also lower compared to strategies focused on maximizing returns (eg. distressed debt, specialty finance). Investors looking for a private debt strategy focused on capital preservation and strong downside protection will typically choose to invest in senior debt.
Senior secured lenders are also referred to as direct lenders. Direct lenders work closely with middle-market companies that are unable to get traditional financing. Borrowers benefit from greater flexibility in structuring loan solutions, faster turnaround, and lower capital requirements compared to traditional lenders, such as banks. Direct lenders commonly use a combination of balance sheet assets and operational cash flow to secure loans. Depending on a borrower’s credit quality, direct lenders will determine the appropriate loan to value (“LTV”) ratios for each asset type. Assets with lower liquidation values tend to receive lower LTVs.
The key element of any capital preservation strategy is loss mitigation. Direct lenders in this space rely on the senior and secured position of their loans as well as use their market expertise to anticipate defaults and reserve against potential losses.
Subordinated Debt & Equity
As you move down the capital stack, the risk profile of the loans increases as the probability of loss given default increases. Strategies that are focused on maximizing returns will prefer subordinated/convertible debt combined with potential equity exposure. To compensate investors for the additional level of risk, unsecured and subordinated loans will typically have much higher coupon rates as well as potential upside from equity participation.
Summary
When selecting a private debt strategy, investors need to decide what function private debt allocation will perform in their portfolio: preserve capital or maximize returns. Private debt strategies focused on writing senior secured loans will be appropriate for investors who seek to protect their capital while earning a higher income compared to traditional fixed income. Investors with a higher risk appetite might find compelling strategies that offer equity-like upside found in distressed debt or specialty finance.
Cortland Credit is an asset-based direct lender that is focused on short-duration, senior-secured assets. The key to our strategy is a very disciplined approach to due diligence and underwriting that enables us to select businesses with robust business models, strong management teams, and identifiable collateral to secure each deal. Our conservative lending model offers investors consistent monthly income, low volatility, and diversification benefits combined with strong principal protection.
Over time we will cover more crucial topics in private debt to help investors learn more about this asset class and be able to choose a private debt strategy that is right for you.
*This material contains the current opinions of the author and such opinions are subject to change without notice. This material is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. All investments contain risk and may gain or lose value.