Understanding Private Credit Market Investing

Private credit market investing can be a complex and nuanced space, but understanding the basics is key to making informed investment decisions. This type of investing involves lending money to businesses or individuals in exchange for interest payments.

The private credit market is a significant source of financing for small and medium-sized enterprises (SMEs), accounting for approximately 40% of total lending to this sector.

Investing in private credit can be a bit complex, but it's worth understanding the options. Private equity is one way to invest, where asset managers source deals and package them into funds for investors, but it often requires significant money to get started.

To gain access to private credit, you can work with an investment advisor to help vet the most attractive candidates. Business development companies (BDCs) are another option, but be aware that they're known for their high risk and high dividends. If you invest indirectly through a publicly traded BDC, you can get started for the cost of just a share.

Other investing platforms, such as Yieldstreet, Percent, and Fundrise, can also give you access to private credit with lower minimum investments. These platforms can help you get started with private credit without breaking the bank.

Private credit funds are not all created equal, with different strategies and approaches. It's essential to understand what you're investing in and how you'll earn a profit.

Here are some key differences between private credit funds:

Private credit has historically offered compelling performance compared to traditional fixed-income investments. Since the global financial crisis, direct lending has provided higher returns and lower volatility compared to leveraged loans and high-yield bonds.

In high and rising rate environments, direct lending has outperformed, yielding average returns of 11.6% compared to 5% for leveraged loans and 6.8% for high-yield bonds.

Private credit can be a valuable addition to a portfolio, offering several benefits. One of the main advantages is the potential for higher total returns over a sustained period of time, which can be attractive compared to other asset classes.

By adding private credit to a portfolio, investors can potentially increase diversification and reduce risk, especially if the investment is less correlated to the overall market. This can be a game-changer for those looking to manage risk.

Private credit also gives investors access to off-market investments that they might not otherwise be able to reach. This can be a major perk for those looking to expand their investment options.

However, there are also some downsides to consider. One of the main cons of private credit is the lack of liquidity, which means investors may need to lock up their money for a substantial period of time.

This can be a major drawback for those who need access to their money quickly. Hefty fees are also a concern, with private funds charging significant fees for their services.

Investors should also be aware that small and mid-size businesses are riskier than larger, more established ones, which can increase the overall risk of private credit investments. However, private credit has had a historically low default rate, which may help mitigate this risk.

To get started with private credit, investors typically need to make a higher minimum investment. This can be a barrier for those with limited capital.

The private credit market offers a range of investment opportunities, each with its own unique characteristics and risks. Direct lending, one of the most common types of private credit, provides credit to private, non-investment-grade companies.

Direct lending strategies can be appealing as they invest in the senior-most part of a company's capital structure, providing steady current income with relatively lower risk. The average direct lending deal size in 2023 was around $170 million, which is well below the traditional $500 million minimum thought required for the broadly syndicated loans market.

There are also other types of private credit, including mezzanine, second lien debt, and preferred equity, which are collectively known as "junior capital." These instruments are not secured by assets and rank below more senior loans for repayment in the event of a default or bankruptcy.

Here are the different types of private credit:

Private credit comes in four main types: Direct Lending, Mezzanine, Second Lien Debt and Preferred Equity, Distressed Debt, and Special Situations. Each type has its own unique characteristics and benefits.

Direct Lending provides credit to private, non-investment-grade companies and is appealing because it invests in the senior-most part of a company's capital structure, providing steady current income with relatively lower risk.

Mezzanine, Second Lien Debt and Preferred Equity, also known as "junior capital", provide borrowers with subordinated debt that is not secured by assets and ranks below more senior loans for repayment in the event of a default or bankruptcy.

Distressed Debt is highly specialized and the prevalence of opportunities tends to coincide with economic downturns and periods of credit tightness. These lenders take on a higher level of risk in exchange for lower prices and potentially high returns.

Special Situations can mean any variety of non-traditional corporate event that requires a high degree of customization and complexity, such as companies undergoing M&A transactions or other capital events, divestitures or spinoffs.

The four types of private credit can be summarized as follows:

Direct lending has grown significantly over the past decade as large banks reined in their lending to riskier companies. The market is evolving, with more entrants, growing fund sizes, and larger check sizes.

Despite stagnant direct lending volumes in 2023 and rising competition, pricing has held fairly steady. The premium earned by lenders compared to broadly syndicated loans has persisted, even though private loans have experienced lower default rates.

Not all parts of the market are equally attractive. Larger funds mean private credit firms can write larger checks, but they also mean that protections are being diluted as the top end of the market becomes more covenant light.

The average direct lending deal size in 2023 was around $170 million, well below the traditional $500 million minimum required for the broadly syndicated loans market. This suggests that direct lending is more accessible to smaller companies.

Here's a breakdown of the types of direct lending strategies:

The private credit market has grown significantly since the 2008 Global Financial Crisis, with assets under management globally increasing from approximately $375 billion to over $1.6 trillion by March 2023.

Private credit funds have stepped in to fill the gap left by banks, which have pulled back from business lending due to regulatory scrutiny. This has created a void for private credit investors to step in and fill.

The US market accounts for the lion's share of the private credit market, with around $1.1 trillion in assets under management, followed by Europe. Direct lending is the largest segment of the market, accounting for more than half of the total, with distressed and credit opportunities each accounting for around 20%.

Private credit funds offer a potentially higher total return compared to other asset classes, with some funds producing steady returns over a lengthy period of time. This can be attractive to investors looking for a higher return on their investment.

The private credit market is expected to continue growing, with BlackRock projecting that it will exceed $3.5 trillion by 2028. This growth is driven by a combination of factors, including the increasing demand for capital from businesses and the reduced competition in the market due to banks becoming pickier about whom they lend to.

Here are some key statistics on the private credit market:

Private credit funds have become an attractive option for investors looking for a higher return on their investment, particularly in a low-interest-rate environment. By investing in private credit funds, investors can potentially earn attractive returns while also diversifying their portfolio and reducing its risk.

The private credit market is not without its risks. One of the main concerns is the lack of transparency, which can make it difficult to assess the creditworthiness of borrowers.

Borrowers may take on too much debt, leading to a higher risk of default. This is particularly true for those with poor credit history, as seen in the example of subprime lending.

Default rates can be high in private credit, with some studies suggesting rates as high as 20%. This can have a ripple effect throughout the market, impacting both lenders and borrowers.

Despite these risks, the private credit market can provide stability to the broader financial system. By providing an alternative to traditional banking, it can help to fill funding gaps and support economic growth.

Significant Risk Transfer is a financial strategy that involves banks buying protection on a pool of loans from a counterparty in exchange for periodic payments.

This practice, also known as credit risk transfer (CRT), allows banks to reduce their required capital amounts while maintaining relationships with underlying borrowers.

Outstanding volumes of CRT transactions grew from around $25 billion in 2023 to $200 billion globally, and are expected to continue growing briskly.

Banks engage in CRT deals to address capital shortages or avoid issuing more capital at dilutive levels, particularly in light of changing capital requirement regimes like Basel 4 or Basel 3 Endgame.

The technology used to structure these deals is not new, and some loan pools are somewhat commoditized, which may result in lower returns from certain transactions.

A global economic downturn can lead to a significant decline in international trade, causing a ripple effect that can destabilize entire economies.

The 2008 financial crisis is a prime example, where a housing market bubble burst, causing widespread job losses and a subsequent recession.

Systemic risk can also arise from the interconnectedness of financial institutions, making them vulnerable to collapse if one major player fails.

This was the case with Lehman Brothers, whose bankruptcy triggered a global credit crisis.

Regulatory failures can also pose a significant risk to financial stability, as inadequate oversight can allow risky practices to go unchecked.

The 2008 crisis was partly caused by lax regulations that allowed banks to engage in excessive risk-taking.

Inadequate capital buffers can leave financial institutions vulnerable to shocks, making it difficult for them to withstand economic downturns.

The 2008 crisis highlighted the importance of adequate capital buffers, as many institutions were unable to absorb the losses they incurred.

A decline in consumer and business confidence can also lead to a decrease in spending and investment, further destabilizing the economy.

This was evident in the 2008 crisis, where a decline in consumer confidence led to a sharp decrease in spending.

Private credit has historically offered compelling performance in relation to other segments of the fixed-income market.

Direct lending, the most common type of private credit, has provided higher returns and lower volatility compared to both leveraged loans and high-yield bonds.

Direct lending has outperformed in high and rising rate environments, yielding average returns of 11.6% over seven different periods of high interest rates.

In contrast, leveraged loans and high-yield bonds have yielded average returns of 5% and 6.8% respectively, during the same periods.

Private credit has also demonstrated relative resiliency during the COVID-19 pandemic, sustaining losses of 1.1% compared to leveraged loans and high-yield bonds.

Direct lending has shown fewer losses during this period, highlighting its potential as a more stable investment option.

In challenging times, private credit can be a reliable source of funding for businesses and individuals.

The private credit market has grown significantly, with assets under management increasing from $50 billion in 2007 to over $1 trillion in 2020.

Private credit can provide much-needed liquidity to companies during economic downturns.

According to a study, 75% of private credit investors reported an increase in demand for private credit in 2020, compared to 2019.

Private credit can offer more flexible terms than traditional bank loans, including longer repayment periods and lower debt-to-equity ratios.

This flexibility can be particularly beneficial for small and medium-sized enterprises (SMEs) that may not have access to traditional credit sources.

In times of economic uncertainty, private credit can provide a vital lifeline for businesses and individuals.

The private credit market has also become more diversified, with a wider range of investors and lenders entering the space.

This increased competition has led to more competitive pricing and better terms for borrowers.

Private credit firms have stepped in to fill the gap left by banks, which have pulled back from providing subscription lines to private equity funds. This is due to rising capital requirements and the failure of Silicon Valley Bank, one of the largest providers.

The demand for funding and liquidity is growing, with many private equity firms seeking capital to finance GP commitments to new strategies and larger fund sizes. This is particularly challenging in a slow mergers & acquisitions market and reduced IPO issuance, which are increasing hold times and slowing the ability to return or recycle capital.

The private credit market is expected to grow rapidly, with the current estimated value of around $100 billion.

Private credit has historically offered compelling performance in relation to other segments of the fixed-income market.

Since the global financial crisis, direct lending has provided higher returns and lower volatility compared to both leveraged loans and high-yield bonds. Direct lending has outperformed in high and rising rate environments, yielding average returns of 11.6% over seven different periods of high interest rates between 2008 and 2023.

Direct lending sustained losses of 1.1% between the COVID-19 outbreak and the third quarter of 2023, compared with losses of 1.3% for leveraged loans and 2.2% for high-yield bonds.

US direct lending funds returned more than 11% over the preceding 12 months through September 30, 2023, while mezzanine debt funds posted even higher returns.

Private credit funds don't buy equity like private equity does. They make loans instead.

Banks take short-term deposits and convert them into long-term loans, acting as intermediaries between savers and borrowers. This is known as liquidity transformation.

Private credit funds raise capital from investors, but they don't borrow money like some private credit funds do. This approach is different from traditional bank lending.

Banks often sell their loans to investors through syndication or securitization.