• Ritika Khetawat, Guest Writer
  • December 30, 2020
  • LinkedIn

The Role of Private Debt Within Impact Investing

Impact Investing has witnessed incredible growth, capturing fund AUMs and mind-shares alike over the last two decades. The allure of delivering positive real world change while making a financial return has attracted a growing number of investors to this sector. AUMs grew to an impressive US$715Bn1 by the end of 2019 versus a mere ~US$36Bn2 in 2012 – a twenty-fold increase in less than a decade. While most investors associate impact investing with private equity, 70%3 of all impact investors surveyed by GIIN in 2020 had active private equity investments. However, it is the private debt asset class, which in-fact, has been the largest contributor when it comes to AUM growth, accounting for 21% of all impact AUMs, versus 17% for private equity3.

Surprised? Let’s think about it. A primary source of financing for micro-credit, a sub-sector of microfinance that is leading the way in driving financial inclusion for underbanked communities, is private debt. SMEs, the backbone of emerging economies, employing 7 in every 10 individuals4, are supported primarily by private debt lending. Development finance, which has a long legacy of driving infrastructure development in emerging economies, is also often structured through private debt. It is high time that this asset class has its moment in the sun.

What is private debt and how large is the market?

Private debt refers to debt investments that are not financed by a bank and are not traded or issued in open markets. This asset class grew exponentially in the aftermath of the 2008 financial crisis, when heightened regulatory restrictions dried up bank funding, leaving smaller, less established businesses looking for alternative sources of credit. Since then, the appeal of private debt, with higher yields and longer tenures, attracted investors and borrowers alike, growing AUMs more than 200% from US$240Bn5 in 2008 to US$800Bn6 in 2020. 

How does private debt work within impact investing?

Private debt deployment within impact investing happens primarily via private debt funds. These funds are very close in structure to private equity funds, and are capitalised by pension funds, foundations, banks, and public sector funders. Investments by these private debt impact funds come in various forms, including, but not limited to:

  • Providing working capital for grassroot impact organisations
  • Funding microfinance institutions that cater to underbanked communities
  • Infrastructure financing for community development projects
  • Merging multiple impact focused assets and structuring them as a senior or subordinated note

So, what has led to the rapid growth of private debt within impact investing?

Diversification appeal with low investment threshold: In terms of returns and volatility, private debt is often positioned as the asset class between public debt and private equity. The low correlation with other asset classes offers a valuable portfolio diversification avenue to fund managers seeking to add impact capital to their portfolios. Furthermore, private debt investment thresholds are also much lower versus private equity or public debt (average deal size of US$3Mn for private debt versus US$7Mn for public debt and private equity impact investments in 20202).

Ease of structuring debt capital for desired impact outcomes: Debt instruments enable deal structuring to specifically allocate proceeds to environmental or social outcomes. Lenders can negotiate terms which stipulate certain interest rates contingent on environmental or social outcomes. Companies that are not inherently impact orientated can also raise debt to start funding more impact aligned projects. 

Growing momentum in Asia: Private debt has seen favourable growth trends in Asia given higher yields and lower leverage multiples. With sustained growth fundamentals, the credit demand from lucrative mid-cap businesses in Asia remains underserved, as banks are limited by capital requirement restrictions and tend to focus more on the bluechip large-caps. This, coupled with a significant infrastructure funding gap, ($1Tn per annum as per ADB)7 has led to steady growth in private debt in the region. As per the 2019 Preqin report, the number of private debt investors in Asia quadrupled from 2014 to 2019 – with AUMs doubling to US$64Bn in the same period. However, the total amount only represents 7% of the global private debt AUM, indicating that there is still considerable room to grow8.

Challenges remain – data is the key

The challenge within the impact sector is that those who need financing the most tend to be small- or mid-sized enterprises that lack proper financials, data, and credit scores to accurately determine their risk levels. These borrowers also usually operate in segments which involve complex interaction between the government and private sector (e.g. healthcare, education, community development etc.). This makes risk assessment even more difficult for lenders.

With the proliferation of mobile technology and smart phones, artificial intelligence (AI) and big data tools are increasingly being employed for credit assessment in such scenarios. Using machine learning for credit scoring can enable assessment of non-traditional data sources for borrowers with limited credit history; thus expanding the investment scope for investors within debt markets.

The Road Beyond COVID-19 – Crisis or Opportunity? 

We saw private debt experience its genesis in the aftermath of the 2008 financial crisis. As we look forward from the midst of another unprecedented crisis, COVID-19 looks to bring unique opportunities for private debt investing to create significant positive social impact. The pandemic has widened the gap between credit haves and have-nots globally. For example, in the United states, small enterprises are suffering the worst credit crunch since the 2008 financial crisis, with dwindling bank funding, no access to bond markets and limited trickle-down effect from central bank capital infusions. In emerging economies, the situation is even more dire, as government capital infusions are often not available forcing many enterprises to reduce business or just completely close, leading to widespread income loss for individuals and households.

A capital infusion through private debt markets has the potential to reverse this negative spiral. Private debt investing can play a key role in post pandemic recovery by deploying capital to support businesses strapped for cash, thereby maintaining income and salaries, and sustaining production. For private debt investors this is a great way to become long term growth partners of high yield generating investee businesses who had relied on bank funding in pre-pandemic times.

We are at a critical juncture with an opportunity for impact investing to drive fundamental change for social and environmental justice. Private debt is certainly a key tool in the toolbox that investors can use to achieve their social and environmental objectives in addition to financial returns. We invite you to get in touch and explore how investing in private debt markets can create long-lasting positive impact.