Contemplating Private Credit? Consider these Pros and Cons

In no other area of the economy have the effects of the 2007-2008 financial crisis lingered as stubbornly as in the credit market. Banks’ willingness to lend capital to consumers and small businesses has yet to return to pre-crisis levels, to the degree that a 2013 report from the Small Business Administration called the lack of access to capital “one of the biggest policy issues in the United States today.” (1)

In the absence of available capital from banks, a variety of nonbank lenders have emerged to fill the void. “Private credit” refers to any loan offered by an entity that is not a bank, and it comes in many flavors—from peer-to-peer (“P2P”) lending platforms like Prosper, Lending Club and On-Deck to multi-billion dollar asset managers like The Blackstone Group. Private credit returns are achieved by investing in predetermined, contractual streams of cash flows at an attractive price.  Returns are more or less locked in at the time of purchase.  Risk mitigating structures can also be put in place to further reduce downside risk, such as recourse agreements, first-loss capital protection and reserve accounts.

The steady demand for private credit has created a strong wave of opportunity for investors to generate returns providing capital to small businesses or individual consumers in the form of P2P loans or other non-bank lending platforms—particularly at a time when traditional fixed income returns are lagging many investors’ expectations.

As with any investment, there are pros and cons associated with private credit:

 

The case for private credit:

Non-correlated assets

Private credit investments rely on a stated stream of principal and interest payments for their return, as opposed to public market fixed income investments whose values fluctuate in part with changes in sentiment, interest rates and macro-economic influences. Because they are uncorrelated with traditional asset classes, private credit investments are a valuable tool for diversifying investment portfolios. 

 

Cooperative versus competitive investment strategy

Private credit investing is a cooperative versus competitive/zero-sum investment strategy.  Private credit investors don’t have to rely on outsmarting Wall Street to obtain alpha. Rather than being on the other side of someone else’s trade, private credit investors are providing financing where it is needed the most in return seeking potentially higher returns.

 

Potentially higher yields than fixed income

Public market fixed income funds generated returns between one and three percent in Q1 of this year (2), continuing the pattern of low yields in the persisting low interest-rate environment. In contrast, the average annual return on investments made through P2P lending platform Prosper average 6.87 percent (3), and some yields can be as high as 15 to 25 percent (4). Accredited investors looking for a higher level of income than their fixed income holdings are currently providing may find private credit opportunities an attractive alternative. In addition, rates of default on nonbank loans are at historic lows, which means that investors would have to take considerably more risk to generate comparable yields through traditional fixed income investments.

 

Investment in the “real” economy

A recent study by Spectrem revealed that 40 percent of mass affluent investors value social responsibility in their investments (Spectrem, Affluent Market Insights, 2014). Private credit investors fund loans for purposes like hiring new employees to grow a business, building a new hospital in a growing community, paying down an individual consumer’s personal debt, and other means of contributing to a healthy economy. In addition to the “feel-good” benefit of investing in a vehicle that supports a small business or helps individual borrowers, private credit lenders are often first in line among creditors to be repaid in the event of a default.

 

Variety of duration options

Thanks to a wide variety of investment vehicles and lending platforms, advisors and investors can select from long or short-term investments based on the duration that suits their needs.

 

Potential Drawbacks

 

Lack of liquidity

Investors in private credit must be willing to hold their investments until maturity. Whereas traditional fixed income investors can count on liquidity because of the market for government and corporate bonds, private credit investments do not offer this flexibility.

 

Barriers to entry and potential for loss

While individual “everyday” investors can participate in P2P lending via platforms like Lending Club and Prosper, many other private credit opportunities are available only to accredited investors through an advisor—which means not everyone can access them. Additionally, as with any investment, the risk of loss of principal does exist.

 

The allure of the trend

Private credit is the latest alternative investment trend generating buzz in the financial community. The P2P space occupied by Lending Club and Prosper is particularly hot right now, potentially contributing to the illusion of a “sure thing” in the minds of investors who fail to do their homework. Technology makes it increasingly easy to match lenders and borrowers via an algorithm, and the marketplace is growing increasingly crowded with options. Prudent advisors and investors should carefully examine investment opportunities and focus on those that provide analysis beyond the algorithm.

The private credit marketplace presents a variety of exciting options to advisors and investors and illustrates that when it comes to funding needed loans for small businesses and individuals, where there’s a will, there’s a way.