

Private Equity, Private Debt und Direct Lending
Three terms that are often used in the same context and are not uniformly defined. But what does each term actually mean? In this article we want to give you an overview. The three terms are briefly described in the overview below:

Private Debt and Private Equity on the example of an enterprise
To start with, let's take a look at private equity and private debt using the example of a company that is looking for outside capital. When a company needs outside capital, there are two options available:
First, the company can sell shares to investors. The sale proceeds of the shares flow into the company and thus increase liquidity. An investment in a company through the purchase of shares is referred to as private equity. The private equity asset class is therefore based on buying shares in a company and benefiting from the future success of the company. Private equity investors often have a strong influence on the company in order to be able to control the growth and thus the profit of their investment themselves.
Second, the company can obtain outside capital in the form of a loan. These loans can either be traded publicly on the financial market, e.g. standard bonds, issued by banks or, without involving the financial market, by private and institutional investors and funds. The latter is referred to as private debt in the narrower sense. An example of private debt would be an SME loan from a private debt fund to any company. But a personal loan from Crowd4Cash is also private debt. The private debt asset class is characterized by the fact that capital is made available to a company without buying shares in the company. The profit is generated through interest payments, which are always the same regardless of the performance of the company.
Private Debt Boom since the financial crisis 2008
After the financial crisis in 2008, banks were subject to much stricter regulations on lending to companies, making it very difficult for medium-sized companies in particular to obtain bank loans. This gap in the market was gradually closed by private investors and funds. Private debt grew strongly and became an established asset class for funds and very wealthy private investors. Private debt is very attractive for investors because predictable investment returns enable high liquidity and the risk-return profile is significantly better than that of similar investments. And there are also advantages for borrowers. Borrowers can benefit from the speed and flexibility that a loan from a private debt fund offers. In contrast to banks, private debt companies and funds usually specialize in a certain type of company to which they lend. Once a suitable company has been found, the loan can be paid out quickly. The funds are ready. Due to the increasing attractiveness and awareness of this asset class, investors are sometimes just waiting to be able to invest their money in private debt investments.
However, a risk remained until a few years ago. Because private debt was a new asset class of this magnitude, no one knew how this asset would perform in a crisis.
The answer came 12 years later with the global corona pandemic. At the beginning of 2020, stock market prices collapsed worldwide. However, private debt investments were hardly affected. The default rate remained at an astonishingly low level of around 1% in 2021. Private debt even continued to grow during the pandemic as many companies looked for quick and flexible liquidity during this time. They found this in the bulging coffers of private debt companies and funds.
The overhang of private debt capital has grown significantly since 2011. Especially with interest rates falling, more and more investors wanted to shift their investments to private debt. Too much capital chasing too few deals secured enough. In the pandemic year 2020, for the first time in a long time, more capital was placed than was made available.
Private Debt in low-yield-environment
But why is there such a large overhang of private debt capital? The answer must be sought in the low interest rate environment. Institutional investors, insurance companies and pension funds have always been looking for investments that guarantee regular returns and at least compensate for inflation. In the low interest rate environment of the past few years, this has become increasingly difficult. The once popular standard bonds threaten to lose value. Since inflation is constantly rising, there is a risk of higher interest rates again in the future, which means that standard bonds on the financial market could lose value due to more attractive competition. Private debt offers the advantage of achieving a higher return without increasing the overall risk. Unlike bonds, private debt is not traded on the financial market. In addition, many private debt investments have a floating interest rate. This means that investors are protected from interest rate increases.
The interaction of Private Debt and Private Equity
Private debt will continue to grow not only because of the current low interest rate environment and potentially rising interest rates, but also because private equity investments are booming. Some private equity strategies are briefly explained below:
We remember that private equity is always about the acquisition of company shares. Compared to private debt, these investments are associated with a higher risk but also with a higher return. Private equity companies (PEG) collect equity from institutional investors, banks and very wealthy private investors. The PEG thus buys company shares and tries to actively influence the company and promote its growth. Total returns of 15% are quite normal here. However, PEGs try to make these company shares with as little equity as possible and with as much outside capital as possible. For what reason?
The answer lies in leverage. As long as the overall profitability of an investment is higher than the interest costs of the borrowed capital, the return on equity increases with increasing debt. What is that supposed to mean? A lot can be described and written here. The easiest way to explain the leverage effect is with an example table.
Definitions:
OP=overall profitability, RE=return on equity, BR=borrowing rate, G=gearing, E=equity, DC=debt capital, PP=pure profit
Example:
A PEG now buys shares in a company for CHF 1 million. Part of this is financed with DC with BR=5%. After one year, the shares can be sold for CHF 1.2 million. Here we have an overall profitability of OP=20%. The following table now shows how the RE increases with increasing G:
E |
DC |
G=DC/E |
OP(absolutely) |
interest cost |
PP=OP(absolutely)-interest cost |
RE=PP/E |
1'000’000 |
0 |
0 |
1’000’000*0.2 =200’000 |
DC*0.05 =0 |
200’000-0= 200’000 |
200’000/1'000’000 =0.2=20% |
800’000 |
200’000 |
0.25 |
1’000’000*0.2 =200’000 |
DC*0.05 =10’000 |
200’000-10’000= 190’000 |
190’000/800’000 =0.2375=23.75% |
500’000 |
500’000 |
0.5 |
1’000’000*0.2 =200’000 |
DC*0.05 =25’000 |
200’000-25’000= 175’000 |
175’000/500’000 =0.35 =35% |
200’000 |
800’000 |
0.75 |
1’000’000*0.2 =200’000 |
DC*0.05 =40’000 |
200’000-40’000= 160’000 |
160’000/200’000 =0.8 =80% |
10’000 |
990’000 |
0.99 |
1’000’000*0.2 =200’000 |
DC*0.05 =49’500 |
200’000-49’500= 151’500 |
151’500/10’000 =15.5 =1550% |
1 |
999’999 |
0.99 |
1’000’000*0.2 =200’000 |
DC*0.05 =49’999 |
200’000-49’999= 150’000 |
150’000/1 =150’000 =15’000’000% |
We are amazed to find that with 99% debt, an PP of CHF 150,000 can be achieved from an equity of CHF 1, which corresponds to an RE of a whopping 15 million percent. This RE is of course only theoretical and never practically achievable. However, here it is easy to see why PEGs are interested in financing their projects with a high G.
This is where private debt comes into play. Since private equity is associated with an increased level of risk, banks find it difficult to invest in private equity quickly and flexibly. The regulations since the 2008 financial crisis prevent banks from taking too much risk. Instead, the required third-party capital is provided by Private Debt. If the private equity market is booming, this will also be reflected in the private debt business. The demand for capital remains high. Because PEG's typically generate a profit across their entire portfolio, lending to PEG's is very attractive and safe for private debt funds. The loaned capital comes back at a predictable time, including interest. So private debt is a fixed-income investment.
Direct Lending for smaller investors
Fixed-income investments that generate a profit even in a low-interest environment are not only in demand for insurance companies and pension funds. Many smaller private investors also keep part of their portfolio in such investments because they offer a high level of security. Fixed-income provides diversification in any investment portfolio. The problem with small investors, however, is that classic fixed-income investments, such as bonds, hardly generate any returns and investments in private debt are primarily reserved for institutional investors, insurance companies, savings banks and investors with very large assets. With certain Swiss providers, private investors do not even have access to the description of the private debt offers. However, there is a subcategory of private debt that is accessible to the vast majority of investors, even on a small budget. Namely direct lending. In the broadest sense, direct lending means any direct lending from the investor to the borrower, without a third party. In a narrower sense, this includes peer-to-peer lending and crowdlending.
Direct lending on innovative Swiss crowdlending platforms increases the yield from the bond quota of an investment portfolio with a similar risk. Gross returns of 5 to 7% with a default risk of less than 1% and high scores speak for themselves. Of course, you can weigh up the risk-return profile yourself. As with all investments, you can also invest more ambitiously or more carefully in crowdlending. The scores from (A+ to D) on the Crowd4Cash platform give a good overview here. Diversification is important when investing, both in relation to different asset classes and within an asset class itself.
Little risk with wide diversification
Direct lending lives up to its reputation as a secure investment. Especially if there is enough diversification. This diversification can be easily achieved in crowdlending with Crowd4Cash, since the minimum investment amount per project is just CHF 500. For this we want to calculate a little and remember the beautiful, dear stochastics from school. Here's something for the mathematician among investors. If you want to make yourself a little more comfortable, you are welcome to jump to the next table.
We want to find out how the probability of a loss decreases with increasing diversification. For this we assume that the return is R=5% for successful investments and that exactly I=CHF 500 is invested in each project. The probability of failure is p=1%. The profit from a successful project is therefore CHF 25, the loss in the event of a failure is CHF 500. The number of investments is n. It therefore takes 20 successful projects to compensate for a failure. With n investments, there is no loss if a maximum of n/20 projects fail. Let this probability be S=success. S is calculated as follows:
S = probability (maximum n/20 defaults)
Number of investments |
S = probability of a profit ≥ 0 |
Probability of a loss = 1-S |
20 |
98.31% |
1.69% |
40 |
99.25% |
0.75% |
160 |
99.996% |
0.004% |
320 |
99.999996% |
0.000004% |
Here it becomes clear why diversification is so important. Small investors can only achieve this broad diversification on platforms like Crowd4Cash with a small minimum amount.
Private Debt, Private Equity and Direct Lending in a nutshell
Private debt is a relatively new asset class that has grown significantly since the 2008 financial crisis. Banks had to regulate their risk and could grant fewer loans to SMEs. This gap has been filled by Private Debt on a grand scale. In contrast to private equity, where investors buy company shares in the hope of being able to sell them profitably at a later, unknown point in time, private debt provides capital that is repaid at a fixed point in time, including interest. Private debt assets are fixed income investments. Classic private debt is operated by funds, insurance companies and very wealthy investors. Private debt often provides the outside capital that is required for private equity projects in order to increase the return on equity. Private debt is often operated with very large amounts. Direct lending at Crowd4Cash offers normal investors the opportunity to participate in private debt and benefit from a very attractive risk/return profile, especially if the low minimum amount of CHF 500 is always used. The best thing to do is to start here today and move part of your bond quota to Direct Lending at Crowd4Cash.
Sources:
https://trustabcapital.com/what-is-a-private-debt-fund/
https://askanydifference.com/difference-between-private-debt-and-private-equity/
https://de.wikipedia.org/wiki/Private_Equity
https://de.wikipedia.org/wiki/Leverage-Effekt
190614_Unternehmensfinanzierung mit Private Debt in der Schweiz FINAL (hslu.ch)
Pitchbook Global Private Debt Report 2021 Annual