What is Private Credit?
Private credit is an asset class comprised of non-bank lending issued outside of public markets. Instead, the lenders are private investors or investment firms, who lend directly to businesses or individuals, bypassing traditional financial institutions such as banks. Borrowers vary, but include companies in need of capital, real estate projects, and non-traditional cash flow sources such as aircraft leases or music royalties.
The historical performance of the private credit asset class has been strong, with equity-like returns and moderate volatility. Future performance will fluctuate based upon economic and interest rate environments, the credit cycle, and investment manager skill set.
**Return subcomponents may not add exactly to total return due to compounding effects.
What are ‘Middle Market Private Companies?’
Arguably the largest user of private credit is mid-size companies, often referred to as “middle market private companies.” While not household names, these companies are generally comparable in size to smaller public companies but have chosen not to go public for various reasons.
Revenues are often between $10 million and $1 billion per year. In aggregate, these middle market companies comprise one of the largest revenue and asset bases in the world, and represent a significant opportunity set.
How Private Credit Works
Private credit transactions typically involve negotiated loan agreements where the terms are customized to fit the specific needs of both the lender and borrower. The ability to set interest rates, loan terms, loan maturity, and what collateral secures the loan is a significant benefit to both the borrower and the lender. An added benefit for lenders is that private credit often comes with higher yields than public debt. Additional characteristics of private credit are that it is generally floating rate, generally relatively short-term in maturity, and generally structured with protections for creditors.
As with any investment though, there is no free lunch with private credit. So, while the yield the lender earns may be higher, the tradeoffs include illiquidity, lack of transparency, and the complexity of the transactions.
Furthermore, the lack of standardization in private credit means that each deal is unique, so much of the due diligence falls on the investor. These investors typically have a team of professionals who assess the borrower’s creditworthiness, determine the terms of the loan, and monitor the loan’s performance over its life cycle. Because of that, private credit is a market best suited for institutional investors, rather than individuals.
How to Invest in Private Credit
As stated above, private credit is not an asset class in which an individual investor can (or should) directly participate. How then should the average individual gain exposure to this potentially intriguing opportunity set?
Well, the good news is that over the last several years, a growing number of firms have begun to offer investment vehicles that provide individual investors with access to private credit. In addition to the managers investment philosophy and process, and their commensurate odds of success, there are several other important items to consider when evaluating these funds:
- Qualifications: Many private credit vehicles restrict who can invest in them. Common requirements are that the investor be a Qualified Purchaser, a Qualified Client, or an Accredited Investor. Still others require that the individual access the fund through a financial intermediary.
- Minimum Investment: While minimum investment levels have declined in order to make private credit available to individual investors, many vehicles still have minimums of anywhere from several thousand dollars to $10,000,000 or more. The good news around those higher minimums is that the limit usually applies at the firm level, meaning that a financial intermediary can aggregate a number of their clients to meet the multimillion dollar limit.
- Liquidity Provisions: Private credit is not a liquid asset class. And, while many vehicles focused on individual investors attempt to bring liquidity to the asset class, they are not as easily traded as the typical stock or bond. Some can be purchased daily, others monthly or quarterly. And in most instances, the fund can only be sold at periodic intervals, such as once a quarter. Furthermore, some funds have a soft lockup’ which assesses a penalty if investor attempt to liquidate in the first 12 or 24 months.
- Additional Considerations: Other items to consider include whether the fund provides a 1099 or K-1 for tax purposes, whether the vehicle is a traditional ‘draw down fund’ or an ‘evergreen’ offering, and what sort of deal access does the manager have.
Why Invest in Private Credit?
Given some of the unique considerations the asset class presents, the question becomes: Why invest in private credit?
Pros: Well, the reality is that private credit can help investors looking to diversify their portfolios or earn higher returns than what is typically offered by more traditional fixed-income assets like government bonds or investment-grade corporate debt.
- Diversification: Private credit provides exposure to a different type of asset than traditional bonds or equities, which can help investors balance their portfolios and reduce risk. Furthermore, the returns from private credit are typically less correlated with traditional financial markets, which can provide benefits when constructing a diversified portfolio.
- Higher Yields: Because private credit often involves borrowers who are somewhat smaller than those issuing publicly traded debt, as well as the fact that the loans are not very liquid, investors are compensated with higher interest rates, which can result in higher yields.
SOFR – Secured Overnight Financing Rate
Cons: As with any investment, there are risks associated with private credit. These include:
- Credit Risk: While private credit can offer higher returns, it can also carry greater credit risk. Depending on the time period studied, the credit risk from private credit might be considered somewhat similar to that offered by high yield bonds. This means that the ability of a manger to conduct robust credit research and ongoing credit monitoring is paramount to success in the asset class.
- Illiquidity: Private credit investments are generally illiquid, meaning they cannot be easily sold or traded in the secondary market. Newer ‘evergreen’ vehicles attempt to alleviate this problem for individual investors, but the fact remains that money invested in private credit should be considered potentially inaccessible for extended periods, sometimes several years.
The Bottom Line
The bottom line is that private credit is an evolving asset class that may be able to offer investors additional yield and diversification for their portfolios. Furthermore, recent advancements in the financial markets mean that private credit is increasingly available to individual investors. However, the asset class also comes with credit and illiquidity risk, which means that it is vitally important to consider whether private credit is an appropriate investment for you, and if so, how to allocate private credit within the context of your overall portfolio.
Next Steps:
- Learn more about private credit by conducting your own research or talking with a financial professional.
- Analyze your financial plan and investment portfolio to see if an allocation to private credit can help meet your financial goals.
- Take a deeper dive into your overall financial situation using our free Financial Blueprint.
