Private credit has become a popular investment as investors look for above-average returns. Private credit offers investors a way to purchase off-market loans that they may not have had access to before, giving them an alternative investment that could diversify their portfolios.
Here you can read what private credit is, how it works and what risks it entails for investors.
What is private credit and how does it work?
Private credit is a type of fixed income investment that allows investors – typically accredited investors and institutional investors – to purchase off-market debt of private companies. Private credit funds come from non-bank financial institutions, such as private equity shops or alternative asset managers. These institutions then sell their shares in the fund to partner investors.
Private credit funds invest in the debt of small and medium-sized companies, which may entail higher risk and are therefore less attractive for an average bank. Because these debts carry higher risk, they pay higher interest rates than the investment-grade debt of high-quality borrowers. The potential higher returns are the biggest draw for investors, especially if they can earn strong returns with relatively less risk.
Investors have piled into a market that has been ceded for years by traditional bank-based lenders.
“Since the 2008-2009 financial crisis, banks have retreated from business lending and imposed stricter lending requirements,” says Brandon Robinson, president and founder of JBR Associates in Plano, Texas. “This created a void for private credit investors to step in and fill. Because banks are now more reluctant to provide business loans, the private credit market has grown substantially.”
So private investors and credit funds are stepping in to replace the banks when it comes to making this money available.
“Instead of banks providing senior-secured loans to sponsor-backed companies, they are now offering subscription credit facilities to private credit funds who then take those funds and provide senior-secured loans,” says Trevor Freeman, head of fund finance for Axosbank.
To participate in the private credit market, investors typically have to lock up their money in the funds for a very long period of time, perhaps five to ten years.
Who can invest in private credit?
Private credit is not immediately accessible to everyone, and potential investors generally must be accredited individual investors, institutional investors or investment professionals.
To be an accredited investor, an individual and/or spouse must have a net worth of more than $1 million, not including their primary residence. An individual must also have had an income of €200,000 or more in the past two years, or a married couple must have had €300,000 or more.
Others who qualify as an accredited investor include:
- Professionals with a Series 7, Series 65 or Series 82 certification
- SEC-registered investment advisors and broker-dealers
- Financial companies such as banks, investment companies or business development companies
- Entities with investments exceeding $5 million
- Expert employees of a private fund
Some investors may work through a Financial Advisor to access private credit funds, although other more accessible options may also be available.
Advantages and disadvantages of private credit
Plus points
- Potentially higher total return: “Private credit funds may have delivered stable returns over a longer period of time,” says Freeman. “Compared to other asset classes over a longer period, these returns stand out and can be attractive.”
- Diversification and potentially lower portfolio risk: By adding another type of investment to a portfolio, investors may be able to increase the diversification of their portfolio and reduce its risk, especially if the investment is less correlated with the overall market.
- Access to off-market investments: Private credit can give investors access to investments they might not otherwise be able to access.
Cons
- Lack of liquidity: Because investors may need to hold their money for a significant period of time, they may not have liquidity when they need to access their money, as would be the case with a listed investment.
- High cost: A private fund may charge significant fees for its services, including acquisition fees, annual management fees based on the investment amount, and more. These fees are well above what investors might find in the best index funds.
- Greater investment risk: Small and mid-sized companies are simply riskier than larger, more established companies, so investors generally face higher risks here. The question is actually: do they compensate for that risk with a sufficiently high return? However, Robinson emphasizes that private credit has seen “historically low default rates.”
- Higher minimum investments: If you go through a private credit fund, you’ll probably have to put up quite a bit of money to get in.
How to invest in private credit
Investors interested in accessing private credit have a few options, starting with private equity funds and moving on to more available options.
- Private assets: These asset managers can source deals and package them into funds for investors, who then buy into them. Work with an investment advisor to gain access and research the most attractive candidates. In general, it costs a lot of money to start this route.
- Business Development Companies (BDCs): Some BDCs are publicly traded, allowing access to anyone who can invest in the public market. BDCs are known for their high dividends and high risks, and you should research each company’s portfolio to see if it invests in debt securities you might be interested in. If you invest indirectly through a listed BDC, you can get started for the price of just one share.
- Other investment platforms: Other widely available investment platforms can also give you access to private credit, and this can be done with small to medium minimum investments. Platforms such as Yieldstreet, Percent and Fundrise can help investors get started with private credit with lower amounts of money.
However you decide to invest, it is crucial that you understand exactly what you are investing in and how you will make a profit. The term ‘private credit’ is a broad umbrella that covers many areas.
“Not all private credit funds are created equal, as they may all have different and more tailored strategies,” says Freeman.
In short
Private credit can offer investors the potential for better total returns, even when taking into account the additional risk associated with investing in small companies. But investors focusing on this off-market area should fully consider the potential risks, especially if the economy weakens, as small companies are likely to have less solid financial stability than more established companies.
Editorial Disclaimer: All investors are advised to conduct their own independent research into investment strategies before making any investment decision. In addition, investors are advised that the past performance of investment products does not guarantee future price increases.
