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Private credit has become a popular investment, as investors seek out above-average returns. Private credit allows investors a way to buy into off-market loans that they might not have been able to access before, giving them an alternative investment that could diversify their portfolios.
Here’s what private credit is, how it works and what risks it poses to investors.
What is private credit and how does it work?
Private credit is a kind of fixed-income investment that allows investors – typically accredited investors and institutional investors – to purchase off-market debt of private companies. Private credit funds are originated by non-bank financial institutions, such as private equity shops or alternative asset managers. These institutions then sell stakes in the fund to partner investors.
Private-credit funds invest in the debt of small and medium-sized companies, which may be higher risk and therefore less attractive to a typical bank. Because this debt is higher risk, it pays higher rates than the investment-grade debt of high-quality borrowers. The potentially higher return is the main appeal for investors, especially if they can find strong returns for relatively less risk.
Investors have piled into a market that’s been ceded by traditional bank-based lenders for years.
“Since the financial crisis of 2008-2009, banks have pulled back from business lending and have applied more stringent requirements to give loans,” 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 lending market has grown substantially.”
So, private investors and credit funds step in to replace the banks when it comes to putting up this money.
“Instead of banks making senior-secured loans to sponsor-backed companies, they are now offering subscription credit facilities to private credit funds that are then taking those funds and making those senior-secured loans,” says Trevor Freeman, head of fund finance for Axos Bank.
To participate in the private-credit market, investors are typically required to lock their money in the funds for a very lengthy period of time, perhaps as long as five to 10 years.
Who can invest in private credit?
Private credit is not immediately accessible to everyone, and would-be investors must usually be accredited individual investors, institutional investors or investment professionals.
To be an accredited investor, an individual and/or a spouse must have a net worth of more than $1 million, not including their main residence. An individual must also have an income of $200,000 or more over the last two years or a 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 firms such as banks, investment companies or business development companies
- Entities with investments over $5 million
- Knowledgeable employees of a private fund
Some investors may work through a financial advisor to gain access to private credit funds, though other more accessible options may be available.
Pros and cons of private credit
Pros
- Potentially higher total return: “Private credit funds can have produced steady returns over a lengthy period of time,” says Freeman. “Compared to other asset classes over a sustained period, those 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 their portfolio’s diversification and reduce its risk, especially if the investment is less correlated to the overall market.
- Access to off-market investments: Private credit can give investors access to investments that they might not otherwise be able to reach.
Cons
- Lack of liquidity: Because investors may need to lock up their money for a substantial period of time, they may not have liquidity when they need to access their money, as they would with a publicly traded investment.
- Hefty fees: 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 in excess of what investors could find in the best index funds.
- Greater investment risk: Small and mid-size businesses are simply riskier than larger, more established ones, so investors are running higher risks generally here. The question really is: Are they making up for that risk with a high enough return? However, Robinson emphasizes that private credit has had a “historically low default rate.”
- Higher minimum investments: If you’re working through a private-credit fund, you’ll likely have to put up some substantial cash to get in the door.
How to invest in private credit
Investors who are interested in accessing private credit have a few options, starting with private equity funds and moving to more available options.
- Private equity: These asset managers can source deals and package them into funds for investors, who then buy into them. Work with an investment advisor to help gain access and vet the most attractive candidates. Generally, it will take significant money to get started on 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 risk, and you’ll need to investigate each company’s portfolio to see if it’s investing in debt securities that you may be interested in. If you invest indirectly through a publicly traded BDC, you can get started for the cost of just a share.
- Other investing platforms: Other broadly available investing platforms may also give you access to private credit, and may do so with small to mid-size minimum investments. Platforms such as Yieldstreet, Percent and Fundrise can help investors get started in private credit with lower amounts of money.
However you decide to invest, it’s vital to understand what exactly you’re investing in and how you’re going to earn a profit. The term “private credit” is a large umbrella covering many areas.
“Not all private credit funds are created the same, as they all may have different and some more bespoke strategies,” says Freeman.
Bottom line
Private credit may offer investors the potential for better overall returns even when factoring in the extra risk of investing in small companies. But investors looking into this off-market area must be fully attuned to the potential risks, especially when the economy weakens since small companies are likely to have less solid financial stability than more established firms.
Editorial Disclaimer: All investors are advised to conduct their own independent research into investment strategies before making an investment decision. In addition, investors are advised that past investment product performance is no guarantee of future price appreciation.
