Why the capital stack matters for debt returns

At its core, private credit operates on a simple principle: a private credit manager pools capital from investors and lends it to businesses. These loans generate returns through interest payments made by borrowers. One of the benefits for investors lies in the potential for a higher income stream compared to traditional investments like term deposits or corporate bonds.

The interest rate charged on these loans is determined by the private credit manager based on a variety of factors, including the borrower's creditworthiness, the loan's purpose, level of gearing, exit strategy and prevailing market conditions. It's a balancing act between offering competitive rates to attract sound borrowers, whilst also generating satisfactory returns for investors.

While recent media articles have raised concerns about private credit’s risk profile, exploring how private returns are generated, the role of the capital stack, and the critical factors influencing risk pricing can help guide investors.

Well-regarded financial adviser Michael Kitces believes that private debt offers an attractive strong risk/return profile relative to other more traditional forms of fixed-income investments like corporate investment-grade and high-yield bonds. “Consistent with the Böni and Manigart research, [US] private debt offerings were both much more efficient in delivering risk-adjusted returns, producing higher Sharpe ratios,” he wrote after an extensive analysis of returns and risk from US private debt funds from September 2010 to September 2022. ^[1]

The capital stack and its significance

The capital stack represents the hierarchy of funding sources for a project or business. Pertinent to the capital stack is the waterfall, which outlines the loan repayment priority to different investors in the event of a default.

In property-backed private credit, the capital stack typically comprises three key levels:

1. Senior or first mortgage: Occupying the top of the stack, a first mortgage is a first ranking charge over a real estate to secure monies loaned. This primary lien (secured against the real estate assets) takes precedence to all other mortgages and financial encumbrances on title. If the property is sold or if the borrower defaults, the first mortgage is paid in priority over any other mortgage or charge against the property. Given the superior security position, the investor returns on senior debt loans are lower.
2. Junior or second mortgage: Subordinated to senior debt, junior debt carries higher risk. Second mortgages are required when a borrower is unable to procure additional funding from the senior debt lender. Due to the increased risk, these types of loans command a higher interest rate.
3. Preferred Equity. Subordinated to debt (senior and junior), preferred equity ranks in priority over traditional equity. Preferred equity is generally unsecured and offers higher returns when compared to secured debt positions in the capital stack.
4. Equity: Occupying the bottom of the capital stack, equity represents ownership in a company. Equity holders have little immunity are last to be repaid should a default occur.