What investors need to know about risk in the private debt market

Research Digest What investors need to know about risk in the private debt market

In “Private Debt and the Role of Venture Capital & Private Equity Sponsors” published in Management Science (2023), Axel Buchner and his co-authors examine the key role played by venture capital and private equity (VCPE) firms in the private debt market. Some private debt funds lend to companies owned or controlled by VCPE sponsors, whereas sponsor-less private debt deals involve lending to companies without VCPE backers. This paper examines the roles and interactions between private-debt funds and VCPE sponsors in the provision of private debt.

Why study this

Loans are crucial for companies to finance later-stage investments such as buyouts and growth. While banks have traditionally been key sources of debt for companies, the recent global financial crisis has led to a significant shift from bank to non-bank lending, so private debt funds have been growing rapidly and are now an important player in the global debt market. Private debt has also attracted the attention of investors, since it has become the third largest asset class in private capital, with more than $800 billion under the management of private-debt fund managers in 2019. Yet little is known about private debt and its link with venture capital and private equity (VCPE) providers.

Findings

Sponsor-less deals (involving companies not VPCE-owned or controlled) generate a significant premium of around 5-6 percentage points over comparable sponsored deals.
The researchers observed this positive premium over the three decades they studied except during the great financial crisis of 2007-2009.
This premium associated with sponsor-less deals compensates for the higher risk and cost of risk mitigation due to unresolved information and agency problems.
In sponsored deals, VCPE sponsors may reduce information and agency costs, e.g., screening and certifying portfolio companies, and take equity stakes and board seats to gain control and align their incentives with the owners of portfolio companies.
Sponsor-less investors mitigate the extra risk through closer screening and monitoring of portfolio companies, thereby emulating the roles of VCPE backers.
However, well-diversified investors who are limited partners of private debt funds (pension funds and other institutional investors) should not expect a premium for bearing the extra risk of sponsor-less investing, as this risk is diversifiable.

Empirically, we find that sponsor-less investors indeed adopt a more hands-on investment approach involving higher equity stakes, greater use of warrants and representation on company boards.

Key insight

In the absence of a VCPE sponsor, lenders adapt their lending decisions and processes to replicate some of the roles otherwise undertaken by sponsors.

Impact

The results are of importance for both the managers of private companies, who need to accommodate lenders' approaches to risk compensation and mitigation in sponsor-less deals, and the managers and owners of private-debt funds who can thus understand how to mitigate the risk of sponsor-less investing through deal design and monitoring mechanisms. The results are applicable to other alternative sources of finance, such as peer-to-peer lending and venture lending.

Final takeaway

Private debt without VCPE sponsors generates higher returns due to the higher default risk.

Authors

Axel Buchner Professor of Finance, Chair in Entrepreneurial Finance and Corporate Finance at ESCP Business School (Berlin campus)

Susanne Espenlaub Professor of Accounting and Finance at Alliance Manchester Business School (UK)

Arif Khurshed Professor of Finance at Alliance Manchester Business School (UK)

Abdulkadir Mohamed Chair of Accounting and Finance at Leeds University Business School (UK)

Campuses

Berlin