Investing today is kind of like the parable of “Goldilocks and the Three Bears.” Stocks provide strong upside optionality, but equity volatility can be stomach-upsetting. Think 2007/2008. On the other hand, bond yields (as everyone knows) are currently painfully close to nil. Not much good to eat in that bowl. So investors can either risk losing meaningful principal in search of equity capital gains or give up those potential returns in exchange for safety. It’s a difficult choice, no doubt.
But there is a third option — a middle ground that has previously been available to only the most sophisticated professionals: investing in private loans. Why does it matter? Private loans generate high yields, benefit from security features that protect principal, and have fixed terms, which means you can choose an investment horizon that best suits your goals. In this middle ground, it is possible to earn double-digit annual returns in a low-interest environment and still not bet the house.
Private loans can take many forms, but at their simplest, they are privately negotiated loans to middle market companies that need capital to expand their businesses. Banks used to provide these loans in their daily course of business; now, not so much. This is not to say that the underlying credit of these middle market borrowers has gotten riskier. Rather, banks have become much more conservative. For example, many banks must now comply with stricter capital regulations, thereby limiting the types of loans they can make, as well as the size of their overall loan books. (A good primer can be found here.) Traditional banks also prefer to focus on making loans to large corporate borrowers, such as Fortune 500 companies. Hence, an opportunity has been created for non-bank lenders (family offices, direct lending funds, and UHNW individuals) to step in and provide private loans to middle market companies, earning outsized returns vis-à-vis the risk taken.
How big is the opportunity? Well, nearly 200,000 middle market companies operate in the U.S. alone, accounting for one third of U.S. private sector employment. Taken as its own country, it would be the third largest economy in the world. Many of these companies are family owned, and they typically produce annual EBITDA between $2 million and $50 million.
The demand for capital from this cohort is projected to be more than $1.3 trillion over the next five years. Moreover, the scaling back of bank lending has caused middle market companies to become anxious about being able to meet their capital requirements. For example, a survey of small businesses found that “44% of the firms believe credit availability is the greatest challenge.”
When matched with an undersupply of capital, this strong secular demand drives up the rates that middle market companies are willing to pay to obtain credit. Yields typically range from approximately 6% for the most senior secured tranche in large institutional transactions to 14% in smaller bespoke transactions. Moreover, when compared to other asset classes such as high-yield bond funds and public equities, private loans generate higher Sharpe ratios, an important metric that measures returns relative to volatility. For instance, the Sharpe ratio of private loans is around 30% higher than the S&P 500.