Private Debt Unlocked: Beyond the Basics

by Hagai Netser (CFA), Head of Core and Opportunistic Portfolios, Koda Capital

The full text of this paper is available below. To download a PDF copy of this paper, click here.

The spotlight on private debt has intensified, yet media coverage frequently reduces this intricate asset class to a one-dimensional narrative. While headlines may focus on select market challenges, sophisticated investors understand that private debt is underpinned by a nuanced framework of lender protections, valuation methodologies, and default management strategies—factors that are critical in assessing both risk and opportunity.

The content of this white paper assumes a foundational understanding of private debt and aims to provide advanced knowledge for those seeking to refine their investment approach and navigate the complexities of this market effectively. We explore the mechanisms that drive loan valuations, the role of covenants and collateral in mitigating risk, and the evolving landscape of default resolution. By unpacking these critical elements, we aim to provide the insights needed to navigate this asset class with greater confidence and precision.

Section 1: Introduction to Private Debt

Private debt has emerged as a significant asset class in institutional and high-net-worth portfolios, offering an attractive risk-reward profile in a time of compressed credit premiums. Private debt typically involves non-publicly traded loans made to small and medium-sized corporations, often with bespoke terms tailored to the borrower’s needs.

As referred to in our previous paper “An Introduction to Private Credit”, the primary forms of private debt include:

The growth in global private debt assets in recent years has been substantial:

Our approach to private debt investing begins with rigorous due diligence. For managers who successfully navigate our process, we maintain proactive oversight, acknowledging the bespoke nature of these strategies and the substantial level of manager discretion involved. By looking under the hood of each strategy and frequently obtaining loan-specific information (while adhering to manager and borrower confidentiality), we form educated views on the resilience of managers’ portfolios and practices. The short duration of private loans and frequent portfolio turnover make ongoing monitoring essential for identifying early signs of borrower distress and addressing potential issues proactively. This approach, underpinned by specialised expertise in private debt, allows us to navigate this asset class effectively and balance returns and risks across our investment programs.

Risk-return dynamics are a cornerstone of private debt investing. Private debt investors are often rewarded with yield premiums over public (traditional) fixed-income instruments, compensating for illiquidity risk and the bespoke nature of these loans. Given private debt’s historical stability and its tendency toward compressed outcome distributions, it is reasonable to expect this trend to persist or at least align with past patterns.

Additionally, historical data reveals that private debt has exhibited lower default rates compared to high-yield corporate bonds. According to Moody’s, the average annual default rate for private debt ranges between approximately 1.5-2.5%, significantly lower than the 3-4% average default rate observed in public high-yield markets. (5)

The Cliffwater Direct Lending Index (“CDLI”) seeks to measure the unlevered, gross of fees performance of U.S. middle market corporate loans, as represented by the underlying assets of Business Development Companies (“BDCs”), including both exchange-traded and unlisted BDCs, subject to certain eligibility criteria. The CDLI is asset-weighted and calculated quarterly using financial statements and other information contained in the U.S. Securities and Exchange Commission (“SEC”) filings of all eligible BDCs. The loans captured by the CDLI represent a large share of the direct lending universe and, importantly, represent loans that are originated and held to maximise risk-adjusted return to shareholders and investors.

Section 2: Lender Protections and the Advantages of Being a Sole Lender

Private debt lenders employ a range of protections to safeguard their capital and enhance their risk-adjusted returns. These protections are often embedded in loan agreements and customised to suit the borrower’s credit profile and business strategy. Covenants, both financial and operational, provide lenders with oversight and early intervention rights in the event of borrower distress. For example, financial covenants, such as maintaining a minimal debt service coverage ratio (DSCR), require borrowers to maintain sufficient cash flows to cover their debt obligations, typically set at a minimum DSCR of 1.2x to 1.5x operating cash flow. Additionally, leverage covenants may limit the borrower’s ability to borrow additional capital in order to prevent excessive leverage, with common debt thresholds ranging between 3.0x and 4.5x EBITDA. Operational covenants, such as restrictions on capital expenditures and requirements for regular reporting, further enhance transparency and control for lenders.

The scope and quality of covenants fluctuate over the credit cycle, tightening during periods of economic uncertainty or rising default rates when lenders adopt more conservative terms and loosening in more competitive, borrower-friendly environments. According to S&P Global Market Intelligence, over 90% of middle-market private debt transactions made in 2022 included financial covenants, underscoring their importance in safeguarding investor capital. (2) Covenant-lite loans, which lack these protections, are typically priced at a premium of 50 to 100 basis points to account for the increased risk exposure.

Key lender protections include:

Lenders often prefer to be the sole, or at least lead lender, in private debt transactions due to several key advantages:

• Control and influence: In situations where intervention is required, rather than dealing with multiple lending parties, sole lenders are positioned for swift decision-making, greater control over loan terms and enforcement of covenants. This supports better oversight and quicker decision-making in times of distress.
• Customisation: Loan structures can be fully tailored to meet the specific needs of both borrower and lender, enabling more effective alignment of interests.
• Speed and efficiency: Compared to syndicated lending, sole lenders can expedite loan approvals and amendments, reducing administrative delays.

While acting as a sole lender offers significant control and streamlined decision-making, it also presents challenges:

• Limited capital availability: Relying solely on one lender’s financial resources may limit the ability to support larger projects or clients.
• Concentration risk: Fund managers must actively manage concentration within their portfolios. Limited capital inherently results in higher allocations to individual loans unless additional lenders are brought into the deal to share the exposure. To mitigate this risk, diversification across multiple borrowers or sectors is essential. This reduces the reliance on any single relationship and enhances overall portfolio resilience.
• Resource constraints: Managing all aspects of the lending process independently can strain a fund manager’s operational capacity, potentially affecting their ability to conduct thorough due diligence, monitoring, and enforcement activities. Additionally, as a sole lender, a manager must rely entirely on their own capability to navigate all situations, including borrower distress or market dislocations. This contrasts with being a minority lender, where a manager can often rely on a larger, more resourced lead lender’s resources, expertise, and operational frameworks.

Section 3: Loan Valuations

While private debt funds must adhere to accepted accounting principles, these principles do not mandate specific methodologies for asset valuation. Prudent loan valuations are critical for lenders and investors in private debt markets. The key methodologies used to value loans by private debt managers are:

• Par plus accrued: Loans are generally valued at their par value (typically the amount borrowed) plus any accrued interest, reflecting the expectation of full repayment unless there are clear signs of distress. This approach represents the manager’s assessment of potential future capital loss, though it lacks a specific timeframe. The process is subject to annual audits and more frequent reviews by the fund’s trustee and/or administrator. However, these reviews do not typically match the depth of an audit. In practice, managers maintain considerable discretion when applying this method, especially in Australia, where it is the most common approach.
• Mark-to-model: Customised financial models assess loan value based on borrower performance and macroeconomic factors. This is a less commonly employed approach.
• Discounted Cash Flows (DCF): This method estimates today’s value of the expected future cash flows from a loan by applying a discount rate that reflects the loan’s duration and inherent risks, including default risk.
• Listed market comparables: This approach assesses risk premiums and estimates the loan’s value by referencing comparable loans that have recently transacted in the broader market. Adjustments are made for illiquidity, credit, and duration premiums. This is another less commonly utilised approach.

Private debt managers typically avoid marking down loans unless there are clear signs of borrower distress. This reflects their ‘hold to maturity’ approach and their ability to recover capital even in default scenarios. Loan covenants and collateral protections mitigate potential losses, further supporting stable valuations.

However, investors transacting in open-ended funds should be mindful of this practice. A portfolio with non-performing loans still marked at par can distort perceived value, creating a risk of overpaying for underperforming assets. Ensuring that underperforming loans are appropriately marked down is essential for transparency and accurate valuation.

Historically, private debt funds have shown lower volatility than public fixed-income markets. During the COVID-19 pandemic, for example, private debt funds saw an average decline of 5-10%, compared to 15-20% for public high-yield bonds (Source: Preqin Private Debt Report 2021). This stability has contributed to their growing appeal in institutional portfolios.

Section 4: Defaults – Why Do Private Debt Managers Downplay Them?

In the context of private debt markets, it is important to understand the key terms that shape how defaults are managed and valued. These definitions help contextualise managers’ motivations for avoiding or obscuring defaults.

A default occurs when a borrower fails to meet their obligations per the terms of the loan agreement. This could manifest in various ways, such as missing scheduled interest payments, failing to repay principal or violating other covenants outlined in the loan agreement. In the private debt market, defaults are more commonly defined by the specific terms of the loan or bond agreement, which might include triggers for restructuring, penalties or formal declarations of default. For example, a private debt borrower might miss an interest payment or breach a financial covenant, such as maintaining a certain debt-to-equity ratio, which would trigger a default event.

A default is not the end of the loan’s lifecycle but rather the beginning of a protracted and uncertain recovery process. The immediate reaction to a default is typically negative: lenders may face a loss of capital or reduced interest income, yet the actual outcome is uncertain and can vary significantly depending on the recovery actions taken by the lender. A borrower in default is typically subject to restructuring negotiations, asset liquidation or other recovery processes. However, the final outcome can range from the lender writing off the entry value of the loan, breaking even or securing an outcome that results in a higher return than the original terms of the loan.

For example, a distressed company may go through an asset sale process which may initially be viewed by the lender as a relatively weaker outcome. However, if the company recovers following a successful restructuring or stronger-than-expected asset sale process, the lender could receive a stronger outcome on their loan than initially expected and may even be successful in collecting additional penalty interest.

The range of outcomes from default proceedings:

• Better off: If a distressed company manages to recover quickly through effective restructuring or successful operational turnarounds, the lender might recoup a large portion (or entirety) of the principal and may even profit in some cases. This could occur if the company emerges stronger than before and can generate high cash flows, thus repaying the debt over time or triggering a refinancing event that benefits the lender. In such a situation, the lender may be successful in collecting any additional penalty interest that may be stipulated in the loan agreement.
• Worse off: If the recovery process is protracted, the borrower may be unable to generate sufficient cash flows or asset sales to repay the loan. As a result, the lender may suffer a loss on its original loan. Extended default processes often result in a discount being applied to the loan’s value, where the lender may only recover a fraction of the loan’s original amount.
• Breakeven: In many cases, the lender may recover sufficient capital to cover the loan principal but be unable to successfully recoup any unpaid interest. This situation can arise when recovery actions are costly or take too long, preventing the lender from achieving any significant return on their investment.

Recovery timeframes

A swift recovery following a default can lead to a high internal rate of return (IRR), though it often results in a lower total return on capital. Thus, a fast recovery may boost IRR without substantially increasing the total return on the original investment.

A common scenario involves a manager deciding between quickly recovering funds by compelling a distressed borrower to liquidate assets or taking control of a project or company to achieve potentially higher, equity-like returns. When a loan is restructured rapidly, the investor may recover their capital over a short timeframe, boosting the IRR given the short holding period (time the loan is outstanding). However, this approach may forgo the opportunity to fully capture the situation’s potential upside.

Loss Given Default (LGD) is a key measure in credit risk management. It represents the percentage of a loan or bond that is expected to be lost in the event of a default after considering recovery efforts (such as asset liquidation or restructuring). LGD helps illustrate the severity of loss a lender may experience if a borrower defaults, factoring in both direct losses and potential recoveries from assets or collateral.

For example, if a borrower defaults on a loan of $100 million, but the lender manages to recover $40 million through asset sales or restructuring, the LGD would be 60%.

Valuation challenges

Valuing a loan throughout the default and recovery process involves determining the present value of all of its future cash flows. These are highly uncertain and may fluctuate based on the default stage, recovery strategy and market conditions. The valuation process is highly complex, expensive and requires careful assessment of several factors (outlined below), which is why managers prefer to avoid it or at least minimise the frequency of valuing defaulted loans.

High uncertainty

The process of valuing a loan during the default and recovery stages is highly uncertain as it may involve the sale of assets such as inventory, real estate and/or equipment. These assets are often illiquid and can be difficult to value accurately. Furthermore, the valuation process itself is costly, requiring significant time and resources to assess the potential recovery. This process is commonly conducted by the fund manager in concert with an independent third-party valuer (an added cost to the process).

Given that asset sale outcomes can be uncertain and reliant on various factors, including market conditions and the borrower’s financial health, assigning a precise value to the recovery amount is inefficient, making it challenging to determine the loan’s value with any degree of accuracy.

Investor Sentiment

Investor sentiment also plays a critical role in the private debt market. Investors place their capital in funds based on expected returns and risk profiles. Significant or frequent defaults can trigger a loss of investor confidence. This is especially crucial for open-ended funds where investors continuously assess a manager’s track record.

For example, a lender may agree to ease a company’s debt covenants in exchange for a higher future interest payment, thus allowing the lender to avoid issuing a default notice. As a result, the fund manager avoids disclosing a default, an event which could have reduced the loan’s (and fund’s) valuation, shaken investor confidence and prompted investor redemptions. Instead, the private nature of the restructuring averted negative publicity that could have hindered future fundraising efforts.

Public awareness of defaults can lead investors to panic, potentially resulting in redemptions and forcing the fund to either liquidate assets during unfavourable market conditions or temporarily halt redemptions. By managing defaults discreetly or delaying their recognition, managers can maintain the perception of stability and protect investor confidence, key factors for the fund’s growth and capital management. Koda identifies this as a critical characteristic of private debt investments, emphasising the importance of ongoing due diligence, which includes continuously assessing a manager’s skill, transparency, and detailed analysis of each fund’s underlying loan portfolio.

Avoiding formal defaults

Lenders can often anticipate imminent defaults, whether they be driven by regulatory changes, market dynamics or borrower-specific issues. To avoid lengthy and costly recovery processes, including receivership and liquidation, lenders frequently engage with borrowers before formal covenant breaches occur. By negotiating interim solutions, both parties can circumvent the legal obligations of declaring a formal default, such as client disclosures, contract terminations and the charging of penalty interest.

This proactive approach allows for tailored modifications to the loan terms, potentially benefiting both the lender and the borrower. However, careful evaluation and consideration are required on a case-by-case basis.

Private debt managers commonly employ two approaches to avert formal defaults:

• Debt restructuring: A common tool used by private debt managers to provide borrowers with financial flexibility during periods of distress. This strategy typically involves extending loan maturities, reducing interest payments, revising repayment schedules or converting a portion of the debt into equity. By doing so, managers aim to ease the borrower’s immediate financial pressures, granting them time to stabilise operations, improve cash flows or secure alternative funding sources. In many cases, debt restructuring is a pragmatic and effective approach, as it allows fundamentally sound businesses (or projects) facing temporary liquidity challenges to recover without triggering a formal default. This strategy can prevent unnecessary asset liquidation, preserve the borrower’s enterprise value, and ultimately protect the lender’s capital. However, debt restructuring can also be misused. In extreme scenarios, managers may exploit this technique to artificially delay or conceal defaults, masking the true extent of their portfolio’s deterioration. This could involve repeatedly extending loan maturities without addressing underlying operational or financial weaknesses, creating a scenario where the loan remains technically performing, but the borrower’s ability to repay remains materially diminished. Such practices, sometimes referred to as “extend and pretend”, can result in further asset value erosion over time and increased losses for investors when defaults eventually materialise.
• Liquidity injection: In this approach, the lender provides additional capital to a struggling company to bridge short-term cash flow gaps, fund critical operational needs or enable the borrower to meet immediate debt obligations. This liquidity can take various forms including bridge loans, equity infusions or access to new credit facilities.

  The primary objective of injecting liquidity is stabilising a borrower’s financial position, ensuring that they can continue operating and generating cashflows while addressing the root causes of their distress. When applied appropriately, liquidity injections can prevent defaults, preserve the borrower’s enterprise value and create a pathway to long-term recovery and profitability.

• However, similar to restructurings, liquidity injections are not without risks. If the borrower’s financial distress stems from deeper, structural issues (such as an unsustainable business model, high fixed costs or declining market relevance), injecting liquidity may simply delay an inevitable default. In such cases, additional capital might be consumed without achieving meaningful improvements in the borrower’s financial health, ultimately resulting in a greater loss for the lender. Furthermore, liquidity injections can create a moral hazard if borrowers become reliant on repeated financial support rather than addressing core operational challenges. Managers must, therefore, carefully assess the borrower’s prospects for recovery before committing to additional funds.

Section 5: Collateral Volatility

Collateral serves as a fundamental safety net in secured lending, providing lenders with an additional layer of protection in the event of borrower default. However, the effectiveness of collateral in mitigating losses is highly dependent on its market value, which can fluctuate significantly over time. These fluctuations introduce uncertainty into loan recovery outcomes.

Key drivers of collateral volatility include:

Monitoring Collateral

Given the dynamic nature of collateral values, lenders must employ robust monitoring mechanisms to stay ahead of potential risks. This typically involves:

• Regular appraisals: Periodic revaluation of collateral assets by independent third-party experts ensures that asset values remain accurate and reflect current market conditions.
• Stress testing: Scenarios are simulated to assess how collateral values might behave under adverse conditions, such as a severe recession, rising interest rates, or a sector-specific crisis.
• Loan-to-Value ratio (LTV/LVR) monitoring: Regular recalculation of LTV ratios helps lenders understand their exposure relative to the declining or appreciating value of the collateral.

These measures allow lenders to identify early warning signs, such as sharp declines in asset value or deteriorating market conditions and take proactive steps to mitigate potential losses.

Conclusion

Navigating the landscape of private debt investing requires a nuanced understanding of the opportunities and challenges inherent in this asset class. Our approach emphasises rigorous manager due diligence, critical for identifying and mitigating risks while capitalising on potential returns. We ensure that sound decision-making processes underpin our investments by thoroughly assessing each manager’s investment strategies, operational capabilities and historical performance.

Moreover, the bespoke nature of private debt necessitates ongoing monitoring and proactive engagement with portfolio managers. Our expertise enables us to detect early signs of portfolio-level distress and respond effectively. Ultimately, we aim to strike a balance between risk and reward, ensuring that our investors benefit from the unique advantages of private debt investing.

References

Comparison of Private Debt, High Yield Bonds, Senior Loans and CLOs

Sources:

1. Koda Capital, Investment Strategy Group
2. S&P Global Market Intelligence
3. Cliffwater LLC. (2023). Cliffwater Direct Lending Index (CDLI)
4. Deutsche Bank. (2023). Private Credit: A Rising Asset Class Explained
5. Moody’s Annual Default Study, Private Debt Insights
6. Preqin. (2021). 2021 Preqin Global Private Debt Report