Table of Contents

Private Debt

The 30-Second Summary

What is Private Debt? A Plain English Definition

Imagine your town has two businesses. One is a massive, publicly-traded corporation like Coca-Cola. When Coca-Cola needs to borrow billions of dollars, it can sell bonds on the public market. Anyone with a brokerage account can buy a Coca-Cola bond, and these bonds are traded every day. This is public debt. The other business is “Steady Eddy's Premium Hardware,” a successful, family-owned regional chain. It’s a great business with consistent profits, but it’s not a global giant. Steady Eddy wants to borrow $30 million to open five new stores. He can't sell bonds on the public market—it's too complex and expensive for a business his size. His local bank, meanwhile, has become very conservative since the 2008 financial crisis and is only willing to lend him half of what he needs. Where does Steady Eddy turn? He turns to the private debt market. Private debt, at its core, is a vast and vital lending world that operates in the shadows of the public markets. It consists of specialized investment funds—often called “private credit” funds—that raise capital from institutions (like pension funds and insurance companies) and wealthy individuals. They then act like a new generation of sophisticated banks, lending this capital directly to companies like Steady Eddy's. These are not stock-market transactions. Each loan is a private, negotiated deal between one lender and one borrower. The terms—the interest rate, the repayment schedule, the rules the borrower must follow (called covenants)—are all customized. Because these loans are not publicly traded, they are illiquid. The lender can't just click a button and sell the loan to someone else. They are committed to holding it, often for years, until it's repaid. To compensate for this lack of liquidity and the inherent risk of lending to smaller companies, private debt lenders demand, and usually receive, higher interest rates than they would on comparable public bonds.

“The first rule of investment is don't lose. And the second rule of investment is don't forget the first rule. And that's all the rules there are.” - Warren Buffett. This principle is the very soul of a good private debt investor, whose primary job is the careful assessment of risk to ensure the return of capital before considering the return on capital.

This vast market has exploded in size over the last decade, becoming a critical engine of growth for the thousands of medium-sized businesses that are the backbone of the economy.

Why It Matters to a Value Investor

At first glance, “private debt” might sound like a playground for Wall Street insiders, far removed from the core tenets of value investing. But if you look under the hood, you’ll find that the discipline of a great private debt manager is almost a perfect reflection of value investing principles. It's about fundamental analysis, not market speculation. 1. The Ultimate “Bottom-Up” Business Analysis: A private debt investor cannot simply look at a stock chart or a quarterly earnings headline. To make a loan, they must become a temporary expert in the borrower's business. They conduct intense due_diligence, interviewing management, analyzing financial statements for years back, understanding the company's competitive position, and modeling its future cash_flow. They are not buying a ticker symbol; they are lending to a living, breathing business. This is the exact same “know the business” approach that Benjamin Graham and Warren Buffett have championed for decades. 2. A Built-in Margin of Safety: The concept of a margin of safety is value investing's north star. In private debt, this isn't just a theoretical buffer in a stock's price; it's contractually built into the loan itself in several layers:

3. The Reward for Patience and Illiquidity: Value investors are temperamentally suited for the long term. They understand that market volatility is often just noise. Private debt forces this discipline. Because the loans are illiquid, investors cannot panic-sell during a market downturn. Their reward for this forced patience and for locking up their capital is the “illiquidity premium”—a higher potential return than what's available in the more flighty public markets. They are paid to ignore the market's manic-depressive mood swings. 4. The Circle of Competence is Paramount: A value investor knows not to stray outside their circle of competence. This is brutally enforced in private debt. You cannot be a tourist. A successful lender needs deep expertise in credit analysis, legal documentation, and specific industry dynamics. For the individual investor, this means your circle of competence isn't about picking the individual loans, but about having the ability to pick a skilled, trustworthy, and disciplined manager to do it for you.

How to Apply It in Practice

For an individual, directly lending millions to a private company is not feasible. The practical application of this concept involves investing through vehicles that pool investor capital and are managed by professionals.

The Method: Accessing Private Debt

  1. 1. Honest Self-Assessment: Before anything else, understand that this is not a core holding like an S&P 500 index fund. Ask yourself:
    • Do I need this money in the next 5-10 years? If so, the illiquidity of most private debt vehicles makes them unsuitable.
    • Do I have a high tolerance for risk and complexity? You are taking on credit risk and manager risk.
    • Am I looking for income or growth? Private debt is primarily an income-generating asset class.
    • 1)
  2. 2. Choose Your Vehicle: Your options for accessing this market vary widely in terms of accessibility, liquidity, and complexity.
    • Business Development Companies (BDCs): This is the most common route for individual investors. BDCs are companies that are publicly traded on stock exchanges (like the NYSE or Nasdaq). Their entire business model is to invest in the debt (and sometimes equity) of private, middle-market American companies. You can buy and sell shares of a BDC just like any other stock. They are required by law to pay out at least 90% of their taxable income as dividends, often resulting in high dividend yields.
    • Closed-End Funds (CEFs): Some CEFs focus on private credit or a mix of public and private debt instruments. Like BDCs, they trade on an exchange and can offer high income distributions.
    • Private Funds (for Accredited Investors): These are the traditional private equity-style funds with long lock-up periods (often 7-10 years), high investment minimums, and a “2 and 20” fee structure (a 2% annual management fee and 20% of profits). This is the least liquid and least accessible option.
  3. 3. Perform Due Diligence on the Manager: When you invest in a BDC or a fund, you are not just buying a portfolio of loans; you are hiring a management team. This is the most critical step. Your focus should be on:
    • Underwriting Philosophy: Read their investor presentations and annual reports. Do they prioritize safety or chase the highest yields? Are they focused on specific industries where they have an edge? A conservative, value-oriented approach is what you want to see.
    • Track Record: How has their portfolio performed through different economic cycles, especially during downturns like 2008 or 2020? Look at their history of loan defaults and losses.
    • Fee Structure: Fees are a direct drag on your return. Understand the management fees and any incentive fees. For BDCs, these are detailed in their public filings. High fees can turn a good investment into a mediocre one.
    • Alignment of Interests: Does management own a significant amount of stock in their own BDC? This is a strong sign that their interests are aligned with yours.

Interpreting the Key Metrics

When analyzing a BDC or a similar vehicle, you are acting as a value investor evaluating a financial company. Key things to look for include:

A Practical Example

Let's put this all together. The Borrower: “Healthy Harvest Organics,” a private company with $100 million in annual revenue, wants to acquire a smaller competitor for $40 million. Their bank will only finance half of the deal. The Lender: “Bedrock Capital BDC,” a publicly traded Business Development Company. Bedrock's investment team performs deep due diligence on Healthy Harvest. They love the company's stable customer base, strong management team, and consistent cash flow. The Deal: Bedrock agrees to lend Healthy Harvest the remaining $20 million. The loan is structured with multiple layers of protection for Bedrock and its shareholders:

The Individual Investor: You, a value investor named Susan, are looking for a high-income investment to diversify your portfolio of stocks. You cannot lend directly to Healthy Harvest. However, you can analyze and buy shares in Bedrock Capital BDC. You research Bedrock and find that:

  1. It trades at 95% of its Net Asset Value (a 5% discount).
  2. Its management team has a 15-year track record with below-average default rates.
  3. 85% of its portfolio is in conservative first-lien loans.
  4. It pays a 9.5% dividend yield, which is fully covered by its investment income.

By buying shares in Bedrock, Susan gains indirect exposure to a diversified portfolio of carefully underwritten loans to dozens of companies just like Healthy Harvest, all while benefiting from the professional management and risk controls of the Bedrock team.

Advantages and Limitations

Strengths

Weaknesses & Common Pitfalls

1)
Many direct private credit funds are only available to “accredited investors,” meaning individuals with a certain level of income or net worth.
2)
Secured Overnight Financing Rate, a benchmark interest rate