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 a reason: lending money and earning interest on the loan is profitable. Since most traditional bank loans are secured by an asset such as a house, the loan is not only profitable, it is a safe bet for most banks.
Securing bank loans is more complicated for companies, startups or small businesses without assets to pledge. This is especially true since the global financial crisis rocked credit markets. In many cases, startups and middle-market companies are prevented from raising capital through the sale of stock because they do not meet Securities and Exchange Commission (SEC) requirements to qualify for public trading. So who do they turn to for fundraising? Private credit.
Private credit, sometimes called alternative financing, is exactly what it sounds like. Private companies and businesses that need financing can obtain it through private credit funds, which operate as direct lenders. This has led to private credit becoming its own asset class, and its popularity continues to grow.
For investors, the appeal of private credit is obvious. Since private funds take on greater credit risk on the loans they make, interest payments are significantly higher and loan terms are much shorter than traditional loans. This creates the type of high-yield, short-term investment opportunity that institutional investors notice.
Private credit investments can generate income beyond interest rates
In private equity, an investor will buy shares of a company with the money he has promised. If the business is successful, the investor ends up with a large share of equity compared to their initial investment. In private credit, the investor (or lender) gets interest instead of equity, but they can also attach certain terms and conditions to the loan that allow them to generate profits in other ways.
First, private loan funds are, by definition, illiquid because loan shares are not sold on any public exchange. Thus, private lenders can attach a liquidity premium to their loan terms, which forces the company to pay them money above the interest rate to lock it in. This premium results in a fixed income that the fund can earn beyond the loan interest.
In addition, private credit funds can link their loan to certain assets of the company they are financing, which provides them with some collateral security. For example, a private credit fund that lends to Lordstown Motors Corp. can stipulate that he will take possession of the machinery and technology that Lordstown uses to build his cars in the event of failure. If Lordstown doesn’t pay, the private lender could seize those assets and sell them to another electric vehicle (EV) maker.
If a private credit loan can generate revenue from multiple streams and take control of valuable business assets, imagine how much revenue a private credit fund can generate with a diverse portfolio of hundreds of loans at once. These additional revenue streams and high potential returns are one of the reasons private credit is such a rapidly growing asset class.
Private Credit Investment Strategies
As with all investment vehicles and offerings, different private credit funds and lenders adopt different strategies to build wealth. These different strategies have different risk profiles and different rates of return. Typically, a private credit fund or lender will adopt a strategy dictated by the fund manager’s area of expertise or track record. Below are the most common private credit investment strategies:
- Direct loan: Under direct lending, private credit funds buy senior debt for less than the value of the debt and reap profits when the debt is repaid. The interest rate on direct loans is usually fixed, but it may be linked to a variable interest rate, such as the prime rate set by the Federal Reserve or the London Interbank Interest Rate (LIBOR).
- Mezzanine financing: Mezzanine financing typically involves private loan funds or fund managers who provide subordinated loans to low- and middle-income borrowers. Examples of these subordinated loans would be home equity lines of credit (HELOCs) or other lines of credit on durable assets that are secured by another loan.
Since these loans are subordinated, i.e. the principal or the first loan will have priority for repayment in the event of default by the borrower, the risk is much higher for the lender. This results in high interest rates. Interest on subordinated loans often reaches or exceeds 10%. Needless to say, a large portfolio of loans repaying between 10% and 15% per year can be lucrative.
- Distressed debt: In distressed debt or distressed credit investment strategies, lenders and funds purchase large amounts of secured debt at a discount. Loans are often available at discounts because borrowers are seriously in arrears or at high risk of default. This allows private lenders to make highly leveraged buyouts and obtain many loans at a relatively low price compared to their total value.
- Capital appreciation: In a capital appreciation strategy, the lender or private credit fund will target loans or other agreements such as simple agreements for future equity (SAFE) notes that convert the funded amount into equity into a emerging company or a startup. If the venture is successful, the equity the private money manager has obtained will represent a significant appreciation of the initial investment capital used to purchase the debt.
Advantages and Disadvantages of Private Credit Investments
The most obvious advantage 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 earn an extraordinary amount of money for their investors.
However, this benefit is not without risk. Almost all private credit investments are illiquid, which means you have no way of withdrawing your money until the hold period expires. Once you’ve committed funds to the offer, you’re ready for the full ride. You need to be 100% sure that you can manage both the risk and the illiquidity that comes with investing.
The other impact on private credit investments is that the risk profile and illiquidity means that they are generally 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 offer.
Should you invest in private credit or private credit funds?
The public capital market is lucrative, but usually only for the long term. Bank loans and secured debt offer slow and steady returns for an extended period. 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 requirements and can manage 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 add value.
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