You don’t need to be a genius to understand what happens when you lend money to a private company, but there are important things you need to know.
Let’s take the mystique out of private loans!
Investments in Private Debt
Whether called Promissory Notes, Senior Notes, Senior Secured Notes, or Subordinated Notes, they’re all a form of debt investment representing an obligation by a Borrower (the Issuer) to repay a Lender (potentially you) the borrowed amount (the Principal) with interest (aka Coupon) by an agreed-upon date (the Maturity Date).
Debt Securities are also referred to as Fixed Income Securities because they provide Investors with a specified rate of return through payment of an annualized interest rate that is typically paid by the Issuer monthly or quarterly on the outstanding Principal balance. Equity Securities, on the other hand, provide Investors with a share of the Issuer’s profits, but only after the Issuer has first satisfied the payment obligations of all of its debt securities and loan obligations.
Maturities (i.e., when the Principal is due to be repaid) can be short-term (say 90 days) to over 10 years. In many cases, amortizing Principal repayment is established when the debt Security is issued. Amortization involves the scheduled, partial return of Principal over the life of the Note or Loan.
The repayment schedule of a debt Security should easily be services by the projected cash flow to be generated by the Issuer’s business during the period the debt Security is outstanding so the Company can repay the borrowed Capital when it is due.
The debt’s Maturity generally should also match the Issuer’s intended use of the funds raised through the debt. For example, funds used for short-term working capital (such as financing Accounts Receivable or Inventory) should generally have a Maturity of less than one year. Funds for Capital Expenditures (equipment acquisition, property acquisition or facility enhancement) are typically raised through Securities having longer maturities which match the expected life of the asset being funded (say 3 to 10 years).
All debt has a specific Maturity; however, situations may arise where the Issuer needs the repayment schedule to be extended because it cannot meet the original repayment schedule. In such cases, investors may elect to Foreclose and require the Issuer to liquidate its assets. Alternatively, Investors may agree to restructure the debt through a Forbearance Agreement. If investors agree to a restructuring, the debt will be assigned a later Maturity Date, but also typically with a higher Interest Rate (a Penalty Rate), because of the inconvenience and potentially greater risk of the Issuer having defaulted on the original terms.
Why an Investor Might Lend Funds Privately
- The interest rate or coupon on private debt Securities is usually higher than for public equivalents, e.g. high yield, or Junk Bonds.
- Debt investment has less risk than an equity investment within the same Company. Under bankruptcy laws, all forms of lending have higher claims to the value of liquidated Company assets in bankruptcy than do equity shareholders.
In short, there are numerous benefits to lending Capital to a Company, though the return on a debt investment would normally be lower than returns to equity investors for the same Company, if it is successful.
What Motivates Issuers to Borrow Instead of Issue Equity?
- Additional equity issuance dilutes the existing shareholders ownership in the Company and their participation in profit’s and future capital gains.
- Borrowing is less expensive than issuing equity if the Company’s equity value is growing faster than the interest rate on the debt.
Types of Lenders
Private lenders include individuals, non-bank Finance Companies, Specialty Lenders, banks, Mezzanine Funds and Special Opportunity Funds, among others.
Forms of Private Debt
There are several forms of private lending, with the primary differences being 1) their claim on Company assets in a foreclosure or bankruptcy related liquidation and 2) the rate of return investors should expect based upon the relative Liquidation Preference:
- Senior Secured Debt – Debt that has a claim (or Collateral Interest) against Company assets, such as plant, equipment, Inventory or real estate. Senior Secured Debt holders have the highest claim against the assets of the Company in the case of bankruptcy. Because it is collateralized, rates often are lower than unsecured debt, particularly Subordinated debt.
- Subordinated Debt or Mezzanine Debt – This junior debt is considered the riskiest form of debt because it is subordinated in Liquidation Preference to Senior Debt. Mezzanine loans carry the highest rates of return to Investors. Investors are often awarded Common Equity Warrants, a form of Purchase Option with Put Rights, in order to create a higher total return to Investors than just the Interest rate.
- Bridge Loans – Companies use Bridge loans, also known as Interim Financing or Gap Financing, when waiting for long-term financing and need money to cover expenses in the interim. A Bridge loan is a short-term loan (usually less than one year) used until a Company secures permanent financing or removes an existing obligation. It allows the Issuer to meet current obligations by providing immediate cash flow. These typically carry relatively high interest rates and are usually secured by some form of Collateral and are senior to other forms of indebtedness.
If you’d also like to read about private equity investments, please read “Why Invest in Alternative Investments?”