Interested in investing in private credit? Benzinga’s guide will help you decide if this alternative investment option is right for you.
Banking has been around for centuries for one reason: Lending money and collecting interest on the loan is profitable. Because most traditional bank lending is secured by an asset such as a house, lending is not only profitable, it’s a pretty safe bet for most banks.
Securing bank lending is more complicated for businesses, startups or small companies without assets to pledge as security. This is especially true since the global financial crisis roiled the credit markets. In many cases, startups and middle-market companies are prevented from raising capital through stock sales because they don’t meet the Securities and Exchange Commission’s (SEC) requirements to qualify for public trading. So, where do they turn to raise money? Private credit.
Private credit, sometimes known as alternative financing, is exactly what it sounds like. Private companies and businesses that need financing can secure it through private credit funds, which operate as direct lenders. This led to private credit becoming its own asset class, and its popularity is growing.
For investors, the allure of private credit is obvious. Because private funds take a larger credit risk on the loans they make, the interest payments are considerably higher and the loan terms are much shorter than traditional loans. This creates the kind of high-yield, short-term investment opportunity that institutional investors are taking notice of.
Private Credit Investments Can Generate Income Beyond Interest Rates
In private equity, an investor will buy shares of a company with the money they pledge to it. If the company is a success, the investor ends up with a large share of equity in relation to their original investment. In private credit, the investor (or lender) gets interest instead of equity, but they can also attach certain covenants and terms to the loan that allows them to generate profit in other ways.
First, private credit funds are, by definition, illiquid because the loan shares are not sold on any public exchanges. So, private credit lenders can attach a liquidity premium to their loan terms, which requires the company to pay them money above the interest rate for tying it up. That premium translates into fixed income the fund can earn above and beyond the loan interest.
Additionally, private credit funds can tie their loan to certain assets at the company they are financing, which offers them a degree of collateral security. For example, a private credit fund that lends to Lordstown Motors Corp. can stipulate it will take possession of the machines and technology that Lordstown uses to build its cars in the event of a default. If Lordstown doesn’t pay, the private lender could seize those assets and sell them to another electric vehicle (EV) manufacturer.
If one private credit loan can generate income from multiple streams and gain control of valuable business assets, imagine how much income a private credit fund can generate with a diversified portfolio that includes hundreds of loans at a time. These extra revenue streams and high potential returns are one reason private credit is such a rapidly growing asset class.
Private Credit Investment Strategies
As is the case with all investment vehicles and offerings, different private credit funds and lenders take different strategies to building wealth. These different strategies have different risk profiles and rates of return. Generally, a private credit fund or lender will adopt a strategy that is dictated by the fund manager’s area of expertise or professional experience. Below are the most common private credit investment strategies:
- Direct lending: In direct lending, private credit funds buy senior debt for less than the value of the debt and reap profits when the debt is paid back. The interest rate on direct lending is usually fixed, but it can be tied to a variable interest rate, such as the prime rate set by the federal reserve or the London Interbank Interest Rate (LIBOR).
- Mezzanine funding: Mezzanine funding typically involves private credit funds or fund managers making subordinated loans to borrowers in the low- to middle-income range. Examples of these subordinated loans would be home equity lines of credit (HELOCs) or other lines of credit on hard assets that are secured by another loan.
Because these loans are subordinated, meaning the dominant or first loan will take priority for repayment in the event of borrower default, the risk is much higher for the lender. That translates to high interest rates. Interest on subordinated loans often reaches or exceeds 10%. Needless to say, a large portfolio of loans paying back at between 10% to 15% annually can be lucrative.
- Distressed debt: In distressed debt or distressed credit investment strategies, lenders and funds buy large amounts of secured debt at a discount. The loans are often available at a discount because the borrowers are severely delinquent or at high risk of default. This allows private credit lenders to make highly leveraged buyouts and get a lot of loans for a relatively low price in relation to their total value.
- Capital appreciation: In a capital appreciation strategy, the private credit lender or fund will target loans or other agreements like simple agreements for future equity (SAFE) notes that convert the amount financed to equity in an emerging company or startup. If the company is successful, the equity the private fund manager secured will represent a significant appreciation of the original investment capital used to buy the debt.
Pros and Cons of Private Credit Investments
The most obvious benefit of private credit investments is that they can generate incredibly high returns in a short period of time. Depending on the investment strategy and market conditions, private credit funds and managers can make an extraordinary amount of money for their investors.
However, that upside is not without risk. Almost all private credit investments are illiquid, meaning there is no way for you to get your money out before the end of the hold period. Once you commit funds to the offering, you are along for the full ride. You have to be 100% sure you can handle both the risk and the illiquidity that comes with the investment.
The other knock on private credit investments is that the risk profile and illiquidity means they are usually only available to qualified investors. In most cases, you must have a net worth of more than $5 million to participate in a private credit investment offering.
Should You Invest in Private Credit or Private Credit Funds?
The public capital market is lucrative but usually only over the long haul. Bank loans and secured debt offer slow and steady returns for an extended period of time. They should be part of your portfolio, but if you want to diversify into something more lucrative, should it be private credit?
Assuming you meet the investment qualifications, and you can handle the risk factors, private markets represent a great opportunity to add wealth to your portfolio in a short period of time. The key is to make sure you don’t have all your eggs in the private credit basket. As part of a diversified portfolio, private credit is a great way to bolster its value.
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