Small and medium-sized companies have long relied on banks to fund their growth. But in recent years, regulatory capital pressures have forced companies of this size to look outside the conventional banking system for alternative sources of credit. While private equity gets most of the headlines these days, private credit has become a $1.5 trillion market and is expected to grow to $3.5 trillion by 2028, according to BlackRock.
That’s great news for privately held companies. However, investing in private credit is also a great way for your clients to diversify their fixed-income portfolios and offset the impact of low returns on a traditional 60/40 allocation.
As with bank loans, most private credit lending is a form of floating-rate debt that adjusts to interest rates change. This gives investors real-time interest rate mitigation compared to fixed-rate bonds and mark-to-market risks.
Let’s clear up some misconceptions about private credit and how you can best utilize it for your clients.
What Is Private Credit?
Simply, private credit refers to lending to privately held small and midsize businesses through non-bank financial institutions. These businesses are often highly leveraged and generally cannot borrow in corporate bond markets. Private credit gained prominence in the wake of the 2008-2009 Global Financial Crisis, when banks essentially froze credit for all but the most stable customers.
In the private credit market, lenders work directly with borrowers (typically companies) to negotiate and originate privately held loans not traded in public markets. Borrowers have also flocked to private credit because the loans have faster execution, greater flexibility and limited disclosure requirements compared to bank lending and the public markets.
Although private credit is a small slice of overall business financing, its rapid adoption has taken market share away from banks that traditionally lend to small businesses. Regulators have expressed concern about private credit’s risks to the financial system's stability. Memories of the 2008 subprime mortgage crisis, triggered by poor underwriting, are still fresh in many people’s minds
Since private credit debt is riskier than traditional bank loans and publicly traded bonds, it must pay lenders/investors more than the investment-grade debt of high-quality borrowers. The potentially higher return is the main appeal for investors, particularly institutional investors.
Another appeal of private credit is that such loans are at the top of a borrower’s capital stack. This means the company’s assets are pledged as collateral. Private credit funds form the largest class of lenders in the space, followed by business development companies—see below. Investor redemption risks are low because most private credit funds have a closed-end structure and typically lock up their investors' capital for extended periods.
Common examples of private credit include:
- Direct Lending: Provides credit primarily to private, non-investment-grade companies. Typically, this refers to investing in the senior most part of a company’s capital stack, which may provide steady current income with relatively lower risk.
- Mezzanine, Second Lien Debt and Preferred Equity: These types of private credit (aka “junior capital”) provide borrowers with subordinated debt. These loans are riskier for investors because they’re not secured by assets. Thus, they rank below more senior loans for repayment in the event of a default or bankruptcy. In exchange for this credit risk, junior capital often comes with equity “kickers.” These incentives can support attractive total returns—often on par with equities—while still being a debt claim in the payment waterfall.
- Distressed Debt: When companies enter financial distress, they work with existing distressed debt investors to improve their prospects through operational turnarounds and balance sheet restructuring. Distressed debt is highly specialized. The prevalence of opportunities tends to coincide with economic downturns and periods of credit tightness. Here, investors take on a higher level of risk in exchange for lower prices and potentially high returns.
- Special Situations: Any type of non-traditional corporate event that requires a high degree of customization and complexity. This may include companies undergoing M&A transactions or other capital events, divestitures or spinoffs, or similar situations that are driving their borrowing needs.
How to Help Clients Invest in Private Credit
Your clients who meet the test for “accredited investors”—$1 million+ net worth excluding primary residence and annual income over $200,000 ($300,000 couples) – may invest directly in private credit. But there are other ways to invest in private credit, even if not an accredited investor:
- Private credit funds: Some asset management firms offer private credit funds that are open to individual investors. These funds pool money from multiple investors to invest in various private credit instruments.
- Business Development Companies: BDCs are publicly traded companies that invest in private companies, often through debt instruments. Individual investors can buy shares of BDCs on stock exchanges. Just know that BDCs can be required to distribute 90% of taxable income to shareholders and can be more volatile than the underlying investments.
- Interval funds: These are a type of closed-end fund that invests in collateral loan obligations and less liquid assets, including private credit. They offer limited liquidity to investors at specific intervals and may limit redemptions to 5% to 25% of fund assets.
- Crowdfunding platforms: Some platforms allow individuals to participate in private lending to businesses or real estate projects. Also, because hold times can be lengthy and because investors cannot exit their position as easily as they can with stocks and bonds, make clients are in good health and have plenty of liquidity from other sources before investing.
Where Does Private Credit Fit Into My Client’s Portfolio?
Investors have increasingly added private credit to their portfolios as a potentially higher-yielding alternative to bonds and other fixed-income strategies. Here are five attractive attributes of private credit:
- Current income: Like bonds, private credit generally offers potential for current income from interest payments and fees.
- Illiquidity premium: Private credit may provide a yield spread above public corporate bonds to compensate investors for illiquidity.
- Historically lower loss rates: Private credit has demonstrated lower loss rates relative to public credit over time.
- Hedging: Private credit is generally less correlated with public markets than stocks and bonds are. This can help reduce portfolio volatility and improve risk-adjusted returns.
- Customized portfolio construction: It may be possible to create highly customized portfolios of strategies to blend risk-adjusted returns across a variety of private-credit strategies.
Private Credit’s Performance in High-Rate Environments
Direct lending has outperformed bonds in high interest-rate environments like today. When measured over seven different periods of high interest rates between the first quarter of 2008 and the third quarter of 2023, direct lending yielded average returns of 11.6%, compared with 5% for leveraged loans and 6.8% for high-yield bonds.
Make sure clients understand that private credit investments often come with higher risk and less liquidity than public market investments. Also be sure to review fees with your clients. A private fund may charge significant fees for its services, including acquisition fees, annual management fees based on the investment amount and more. There may also be higher minimum investments. If working through a private-credit fund, your client will likely have to put up substantial cash to get in the door. This is why I like interval funds, discussed above.
Conclusion
For clients in good health who have ample liquidity from other sources, private credit can be an excellent hedge to their stock, bond and real estate holdings, especially in volatile interest rate environments. Private credit can also offer higher returns. Just make sure they know their investments can be locked up for several years, that there’s a higher default risk compared to public bonds, and that there’s less transparency than with public company investments. Also, ensure you and your clients do sufficient due diligence on the manager’s track record, fee structure, valuation policy and risk management safeguards. Finally, there are tax considerations. Income from private credit is often taxed as ordinary income, although some structures like BDCs can offer tax advantages. That’s where you come in.
Dr. Guy Baker is the founder of Wealth Teams Alliance (Irvine, CA).
