Private credit refers to lending from non-bank financial institutions. Also referred to as direct lending, private credit allows borrowers (typically smaller to mid-sized businesses) to seek financing through avenues other than a standard bank loan.
This type of arrangement can remove barriers to funding for businesses while creating opportunities for investors, as a type of alternative investment. Private credit funds allow institutional and individual investors to pool capital that is used to extend loans and generate returns through interest on those loans.
What Are the Different Types of Private Credit?
Private credit investments can adhere to various investment strategies, each offering a different level of risk and rewards. Within a capital structure, certain types of private credit take precedence over others regarding the order in which they’re repaid.
Senior Lending
In a senior lending arrangement, secured loans are made directly to non-publicly traded, middle-market companies. These loans sit at the top of the capital structure or stack and assume priority status for repayment should the borrowing company file for bankruptcy protection.
Senior debt tends to have lower interest rates than other types of private credit arrangements since the loan is secured by business collateral. That means returns may also be lower, but the preferred repayment status reduces credit risk for investors.
Should the borrowing company fail, senior loans would hold an initial claim on the business’s assets. Those may include cash reserves, equipment and property, real estate, and inventory. That significantly reduces the risk of investors losing their entire investment in the event of bankruptcy.
Junior Debt
Junior or subordinated debt is debt that follows behind senior lending obligations in the capital stack. Loans are made directly to businesses with rates that are typically higher than those assigned to senior debt. Junior debt is most often unsecured though lenders can impose second lien requirements on business assets.
Investors may generate stronger returns from junior debt, but the risk is correspondingly higher. Should the borrowing business go bankrupt, junior debts would only be repaid once senior financing obligations have been satisfied.
Mezzanine Debt
Mezzanine debt is a private credit term that’s often used interchangeably with junior debt, but it has a slightly different meaning. In mezzanine lending, the lender may have the option to convert debt to equity if the company defaults on repayment. There may be some collateral offered but lenders also consider current and future cash flows when making credit decisions.
Compared to junior or senior debt, mezzanine debt is riskier but it has the potential to produce higher yields for investors as the interest rates are usually higher. The risk to borrowers is that if the company defaults, they’ll be forced to give up an ownership share in the business.
Distressed Credit
Distressed credit is extended to companies that are experiencing financial or operational stress and may be unable to obtain financing elsewhere. The obvious benefit to investors is the possibility of earning much higher returns since this type of private credit generally carries higher rates. However, that’s balanced by a greater degree of risk.
Risk may be mitigated if the company can effectively utilize private credit capital to restructure and stabilize cash flow. Should the company eventually file for bankruptcy protection, distressed debt investors would take precedence over equity holders for repayment.
Special Financing
Specialty financing refers to lending that serves a specific purpose and doesn’t fit within the confines of traditional bank lending. This type of private credit is also referred to as asset-based financing since lending arrangements typically involve the acquisition of an asset that is used as collateral for the loan.
Equipment financing is one example. Say that a construction business needs to purchase a new backhoe. They could get an equipment loan to buy what they need, using the backhoe they’re purchasing to secure it.
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Potential Benefits of Investing in Private Credit
Private credit investing can be an attractive option for investors who are interested in diversifying their portfolios with alternative investments. Here are some of the primary reasons to consider private credit as an asset class.
Income Potential
Private credit can provide investors with current income if they’re collecting interest payments and fees on an ongoing basis. The more private credit investments someone holds in their portfolio, the more opportunities they have to generate regular cash flow.
Return Potential
Investing in private credit may deliver returns at a level well above what you might get with a standard portfolio of stocks, bonds, and mutual funds. The nature of private credit is such that borrowers may expect to pay higher interest rates than they would for a traditional bank loan. That, in part, is a trade-off since private credit offers lower levels of liquidity than other investments.
Investors benefit as long as borrowers repay their debt obligations on time. The exact return profile of any private credit investment depends on the interest rate the lender requires the borrower to pay, which can directly correspond to their risk profile and where the debt is situated in the capital stack.
Diversification
Like other alternative investments, private credit can introduce a new dimension into a portfolio, allowing for greater diversification of that portfolio. Private credit tends to have a lower correlation with market movements than stocks or bonds, which may help insulate investors against market volatility, to a degree.
Additionally, investors have an opportunity to diversify within the private credit segment of their portfolios. For example, an investor may choose to invest in a mix of senior lending, mezzanine debt, and specialty financing to spread out risk and generate varying levels of returns.
What Are the Risks of Investing in Private Credit?
Like any other investment, private credit can present certain risks to investors. Weighing those risks against the potential upsides can help determine whether private credit is the right investment for you.
Borrower Default
Perhaps the most significant risk factor associated with private credit investments is borrower default. Should the borrower fail to repay their debt obligations, that can put the value of your investment in question. In a worst-case scenario, you may be forced to wait out the resolution of a bankruptcy filing to determine how much of your investment you’ll be able to recover.
Again, it’s important to remember that borrowers who seek private credit may have been turned down for traditional bank financing elsewhere. So, your credit risk has already increased. If you have a lower risk tolerance overall, private credit may not be the best fit for your portfolio.
Illiquidity
Private credit investments are less liquid than other types of investments since they operate on a fixed term. It can be difficult to exit these investments ahead of schedule without facing the possibility of a sizable loss if you’re forced to sell at a discount.
In that sense, private credit investments are similar to bonds which also lock investors in for a preset period. For that reason, it’s important to consider what type of time frame you’re looking for when making these investments.
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Underwriting
While banks often have strict underwriting requirements that borrowers are expected to meet, private credit allows for more flexibility. Lenders can decide who to extend credit to, what collateral to require if any, and what terms a borrower must agree to as a condition of getting a loan.
That’s good for borrowers who may have run into trouble getting loans elsewhere, but it ups the risk level for investors. If you’re investing in private credit funds that are less transparent when it comes to sharing their underwriting processes or detailed information about the borrower, that can make it more difficult to make an informed decision about your investments.
Ways to Invest in Private Credit
Private credit has traditionally been the domain of institutional investors, though retail investors may be able to unlock opportunities through private credit funds.
These funds allow investors to pool their capital together to make investments in private credit, similar to the way a traditional mutual fund or hedge fund might work. You’ll need to find an investment company or bank that offers access to private credit investments, including private credit funds, funds if you’re interested in adding them to your portfolio.
One caveat is that private credit investments may only be open to selected retail investors, specifically, those who meet the SEC’s definition of an accredited investor, who is someone that fits the following criteria:
• Has a net worth of $1 million or more, excluding their primary residence
• Reported income over $200,000 individually or $300,000 with a spouse or partner for the previous two years and expects to have income at the same level or higher going forward
Investment professionals who hold a Series 7, Series 65, or Series 82 securities license also qualify as accredited.
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Who Should Invest in Private Credit?
Given its risk profile, private credit may not be an appropriate investment choice for everyone. In terms of who might consider private credit investments, the list can include people who:
• Are interested in diversifying their portfolios with alternative investments.
• Can comfortably assume a higher level of risk for an opportunity to generate higher returns.
• Understand the time commitment and the risks involved.
• Would like to support business growth through their investments.
• Meet the requirements for a private credit investment (i.e., accredited status, minimum buy-in, etc.)
Private credit investments may be less suitable for someone who’s hoping to create some quick returns or is more risk-averse.
How Does Private Credit Fit in Your Portfolio?
If you’re able to invest in private credit, it’s important to consider how much of your portfolio you’d like to allocate to it. While you might be tempted to devote a larger share of your investment dollars to private credit, it’s wise to consider how doing so might affect your overall risk exposure.
Choosing a smaller allocation initially can allow you to test the waters and determine whether private credit investments make sense for you. That can also minimize the amount of risk you’re taking on as you explore new territory with your investments.
When evaluating private credit funds, it’s helpful to consider the fund manager’s track record and preferred investment strategy. A more aggressive strategy may yield better returns but it may mean accepting more risk, which you might be uncomfortable with. Also, take a look at what you might pay in management fees as those can directly impact your net return on investment.
The Takeaway
Private credit is a form of financing sought outside of traditional bank loans. For investors, it may be classified as an alternative investment, and it has its pros and cons in an investor’s portfolio.
Private credit can benefit investors and businesses alike, though in different ways. If you’re an accredited investor, you may consider private credit along with other alternative investments to round out your portfolio. Evaluating the risks and the expected rewards from private credit investing can help you decide if it’s worth exploring further.
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FAQ
Is Investing in Private Credit Worth It?
Investing in private credit could be worth it if you’re comfortable with the degree of risk that’s involved and the expected holding period of your investments. Private credit investing can deliver above-average returns while allowing you to diversify beyond stocks and bonds with an alternative asset class.
What’s the Difference Between Private Credit and Public Credit?
Public credit refers to debt that is issued or traded in public markets. Corporate bonds and municipal bonds are two examples of public credit. Private credit, on the other hand, originates with private, non-bank lenders and is extended to privately-owned businesses.
Why is Private Credit Popular?
Private credit is popular among businesses that need financing because it can offer fewer barriers to entry than traditional bank lending. Among investors, private credit has gained attention because of its return potential and its use as a diversification tool.
What Is the Average Return on Private Credit?
Returns on private credit investments can vary based on the nature of the loan agreement. When considering private credit investments it’s important to remember that the higher the return potential, the greater the risk you may be taking on.
Is Private Credit a Loan?
Private credit arrangements are loans made between a non-bank entity and a privately owned business. These types of loans allow companies to raise the capital they need without having to meet the requirements that traditional bank lenders set for loans.
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