Private equity invests primarily in unlisted equity, with returns coming from the appreciation of companies. On an average annualized Internal Rate of Return (IRR) basis, global private equity funds had a return statistic of 15.3% from the period between 2010 and now. However, private debt funds invest in company debt instruments (for example, high-yield bonds), and the returns mainly derive from interest payments. During 2020, global private debt funds returned an average annualized return of between 7% and 9%. While private equity funds are riskier and more appropriate for long-term investors, the risks of private debt funds are lower, making them preferable to those seeking relatively stable returns.
Investment Object Differences
Private equity funds primarily allocate capital to private unlisted companies that have high growth potential or are in strategic transition. For example, the SoftBank Vision Fund invested around $7.7 billion in Uber in 2017 for a ~15% stake on an as-converted basis. When Uber went public in 2019, SoftBank earned over $3 billion from the partial sale of its equity, a 39% profit on its original investment. By contrast, private debt funds invest in corporate debt instruments such as high-yield bonds, leveraged loans, and direct agreements. Last year, the global private debt market raised $127 billion, with around 60% of that going towards mid-market companies ($50 million to $500 million annual revenue) — a segment for whom access to traditional financial markets is often trickier due to higher credit risks.
Differences in Return Models
Private equity funds generate profits through capital appreciation and sell-offs via exit mechanisms, like initial public offerings (IPOs), mergers & acquisitions, or stake sales. According to PitchBook, global private equity funds averaged a 15.3% IRR during the period from 2010 to 2020. For example, in 2007, Blackstone bought 70% of Hilton Hotels for $26 billion. About a decade later, Blackstone exited the investment in 2018, having made over $14 billion or 2.5 times its initial investment through operational improvements and capital restructuring. Meanwhile, private debt funds offer fixed interest income leading to more stable returns. In 2020, private debt funds (non-investment grade) returned an average annualized return of 7% to 9%, while high-yield bond exposure yielded around 8.5% according to Preqin’s data across different geographies and vintages. This relatively low volatility in returns becomes very attractive for many institutional investors looking for stable returns.
Comparing Risk Levels
Private equity funds are inherently riskier investments—higher risk means greater reward potential (but also the possibility of greater loss), especially in the beginning and during crisis times. For instance, last year, as a result of the global coronavirus crisis, overall returns on private equity funds plunged by 13%, while losses in private equity investments in young companies—startups and technology firms—were even greater. Research by Bain & Company shows that approximately 20% of private equity portfolios declined by more than 30% in dollar terms, year-over-year in 2020. Conversely, private debt funds are subject to fewer risks given their senior debt status and fixed interest income. S&P Global reported that in 2020, the worldwide default rate for private debt funds reached a margin of just 3.7%, while U.S. high-yield bonds recorded a default rate of only 4.1% during the same period—both significantly lower than the losses associated with private equity funds. Lower default rates associated with private debt funds provide a more attractive investment opportunity when the economy weakens.
Differences in Liquidity
Private equity funds typically have a longer life cycle. Global private equity funds hold their investments for an average of 6 to 8 years, with over half needing more than five years before they can be fully cashed out (Source: Cambridge Associates). Moreover, the timing of realization from private equity investments is often subject to market conditions, and uncertainty persists even in hindsight regarding when company development results will peak, leading to longer capital lock-up periods. Private debt funds, on the other hand, do require a lock-up period but are still more liquid. Debt instruments, such as leveraged loans and high-yield bonds, are tradeable on secondary markets. The U.S. leveraged loan market traded $1.2 trillion in 2021, with public-market transactions accounting for about 70% of the volume, providing fairly good liquidity to investors and making it easier to sell off these investments when prices fell by as much as three pennies upfront on many larger loans amid sell-offs before recovering by at least a point or two by February (according to data from existing mutual funds and hedge funds).
Differences in Investment Strategies and Management Approaches
Private equity funds typically have ambitious goals and adopt a highly active management strategy. Fund managers provide more than just capital; they influence corporate governance, identify strategic opportunities, and implement operational improvements that guide a company’s growth. For example, The Carlyle Group purchased Neptune Company in 2012. Through business-wide restructuring, operational efficiency improvements, and market share expansion, Carlyle sold the company in 2017 for $1 billion. On the other hand, private debt funds focus mainly on credit analysis and interest rate management for their debt instruments with a more passive approach to management. The average default rate in 2021 for U.S. high-yield bonds was only 2.4%, according to Moody’s. In contrast, private debt funds, with their diversified investments and strict credit screening, had an overall default risk below 3%, which is much lower compared to other high-risk (and highly leveraged) debt instruments.
Market Size and Trends
According to Preqin, global private equity funds raised $920 billion in 2021, representing an 18% increase from 2020. This increase was largely fueled by investments in technology and healthcare, as global private equity funds poured over $300 billion into technology alone last year, accounting for 33% of the total investments. Meanwhile, private debt funds also set a record in 2021 by securing a total of $127 billion across all types and strategies, up 14% from the previous year. With interest rates so low, private debt funds have been able to offer higher returns at lower risk, which many institutional investors, such as pension funds and insurance companies, find attractive.
