Editor’s Note: Drawn by attractive risk-adjusted returns relative to most traded credit vehicles, institutional investor interest in the private debt space has surged over the past year, bringing with it a shift in the traditional attitude about alternative lenders. Rob Allard, founding partner of Firebreak Capital, explains why private debt has become the fastest-growing segment of non-bank finance.

What is the Private Debt Opportunity?

By Rob Allard, Founding Partner, Firebreak Capital

By now, most investors are familiar with the basic story that increased regulation, whether intensified capital requirements or expanded regulatory oversight, has had a dramatic impact on the financial services industry. The post-2008 regulatory environment simultaneously restricted traditional bank lending while propagating the explosive growth in direct lending and fintech—the application of new technologies to financial transactions.

Accompanying the regulatory shift is an even more profound change in consumer attitudes. Quite simply, how people access finance, the source of the financing, and the degree of trust extended to the providers has shifted, leading to acceleration of growth in alternative, non-bank financial service providers.

Banks in the U.S. now account for only 14.8% of the leveraged loan market, down from 63.2% in 1998, according to Wells Capital Management’s 2013 Bank Loan Market Overview. This trend is evidenced in a variety of other bank activities across consumer, real estate and business lending as the institutions refocus on core borrowers. For example, it has never been easier for large, rated corporations to access finance in the public markets for straightforward financing requirements.

Ultimately, as banks recover from the biggest financial crisis in living memory, and adjust and adapt to the greatest regulatory changes since the 1930’s, they will slowly get back to the business of lending. That said, the landscape is permanently altered as regulators prefer smaller, less systemically impactful, less complex and more judiciously funded entities in the future.

Accordingly, direct lending and fintech can certainly expect some “traditional” competition in the future. However, long term, the area of custom, borrow-solution, structured finance is not something that banks will be able – or willing – to undertake. The result? Non-bank finance is set to grow, with the fastest-growing sector being private debt

Quite simply, private debt is debt (loans or securities) not originated and distributed in the public markets. It is basically the sibling to the much larger and well-established private equity offering. Private debt is often referred to as shadow banking, which garnered a negative reputation during the financial crisis.

However, the new alternative balance sheets emerging to fill the growing void left by the retreat of banks are a very different animal from the pre-crisis leveraged vehicles that made up the shadow banking sector. It includes long-established strategies like middle market and mezzanine finance, as well as emerging strategies like structured finance and direct lending.

The initial attraction to the asset class was the incremental return vs. what was available in other fixed income products. However, the growing interest is the result of compelling risk-adjusted and absolute returns that can be achieved.

Different private debt strategies will have differing risk return profiles, so investors must be mindful of the credit cycle and other macroeconomic risks, but when executed correctly, structured finance strategies offer high recovery and high-single-digit floating returns. If effectively risk-managed through the cycle, they should generate double digit returns to investors.

Source: http://www.finalternatives.com/node/32088