- Private credit has grown eightfold since 2008, and can offer benefits such as higher yield potential, diversification and less volatility to investor's portfolio.
- Key strategies in the private credit universe include direct lending, distressed debt, and mezzanine debt.
- Endowus Hong Kong offers curated Best-In-Class private credit strategies managed by Apollo, Ares, Blackstone, Caryle, HPS, Oaktree and more for our Professional Investor clients. Contact us to learn more.
What is private credit investing?
Private credit — also known as private debt — refers to loans and bonds provided by a non-bank investor, typically a fund. It is the alternative to debt financing from traditional lenders such as commercial banks and bank-led syndicates, and from the public markets such as bonds.
Investing in private credit does not involve owning shares in the target company or running its business, unlike private equity investing.
Private debt forms an important part of the alternative investment (alts) umbrella, and is often considered lower risk than other alts asset classes. For investors, here are its benefits:
- Lower volatility and diversification benefits
- Better yields than traditional investment-grade debt securities; better risk-adjusted returns
- A good alternative and complementary to traditional fixed-income investing
How does it work?
Private credit investors essentially act as lenders. Deals are negotiated and transacted directly between the borrower and the non-bank lender, and the loans or bonds are not traded publicly.
Much like most loans, private debt borrowers repay lenders the principal plus interest over a certain period of time, according to specified terms.
Rise of private credit: from alternative to strategic asset class
Private credit markets continue to increase in size and importance. The overall size of private credit stands at around US$1.6 trillion, including US$500 billion of dry powder, according to PitchBook data.
The US market accounts for the lion’s share, around US$1.1 trillion, with Europe accounting for most of the remainder.
Private credit AUM has grown eightfold between 2006 and 2023, spurred by high-level macro trends including:
- The retrenchment at banks and a declining supply of credit from banks, in the wake of stricter regulation after the Global Financial Crisis (GFC) in 2008
- The growth of companies owned by private equity investors, which favour the bespoke nature, speed, and flexibility of privately negotiated loans
- Investors’ hunt for yield when interest rates were falling to ultra-low levels
The growth of private credit (US$billion)
Senior loans or junior debt — the capital structure
Before investing in any type of debt, it’s important to understand the capital structure of the company. If the borrower goes bankrupt or defaults, the type of debt and equity held will determine the repayment order and proportion.
Senior debt sits at the top of the capital structure, which means senior creditors will be repaid first if the company defaults (followed by junior creditors and shareholders), making it lower risk. These loans are usually secured — that is, backed by assets that can be sold to repay creditors if necessary — but their interest rates tend to be lower than those of junior debt.
Subordinated debt is often unsecured and is more risky than senior debt, so its interest rates are higher. These creditors will only be repaid after the senior secured creditors’ claims have been met.
Within the private credit space, there are different types of debt sitting across the capital structure. Investors can seek for private credit strategies that matches with their risk appetite.
Different types of private credit
Private debt funds can employ an array of investment strategies, varying in deal structure, risk and return profile, tenor or duration, seniority, security, sector, and geography.
Broadly, the main strategies are as follows:
1. Direct lending
The most popular option among investors is to lend money directly to companies, without an intermediary. These corporate loans often carry floating rates, and are senior and secured against the borrower’s assets and earnings, although some funds may opt for subordinated debt depending on their investment approach.
Direct lending represents the largest category in private credit, at 44% of the total market, according to BlackRock.
Interesting to note, direct lending’s main target market — middle market borrowers, have demonstrated lower default rates and loss ratios compared the large corporate market for syndicated loans, based on data compiled by Morgan Stanley.
Investment returns from direct lending are largely generated from income. The annualised historical return of direct lending from 2014-2023 stands at 8.8%, compared to 4.6% for high-yield bonds in the same period, according to data compiled by JP Morgan.
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2. Asset-based lending
Private debt can also finance real assets such as real estate and infrastructure.
Real estate debt often involves direct lending for acquiring properties. The risk profile varies depending on the underlying asset’s characteristics.
Infrastructure debt is used for developing new projects or improving existing assets. The debt tenor or term is generally longer, up to around 30 years, because the assets have an extended useful life.
3. Credit opportunities
Private debt investors may also seek opportunities to benefit from dislocations in the credit markets, such as in special situations and distressed debt. Returns here can be generated from both income and capital appreciation.
Historical returns from credit opportunities have surpassed 12% during and after periods of market volatility. This strategy could be more appealing as a return-enhancer within growth portfolios opportunitistically, and in the wake of broader market volatility.
Distressed debt
The debt of companies that are likely to become bankrupt or are already bankrupt can be bought at a significant discount. Investors that buy distressed debt expect the value of the company to improve afterwards. Given that there is a high chance of liquidation, investors focus on senior debt, which sits high in the capital structure.
Special situations
Aside from the underlying company fundamentals, a specific event — like a merger, buyout offer, or company spin-off — can affect the value of a company. Investors may therefore extend loans based on a special situation. Not all special situation funds invest exclusively in debt; many also make equity investments.
4. Mezzanine
Mezzanine debt is a hybrid of equity and debt financing, containing “embedded equity options” such as stock call options or warrants. It is usually unsecured. If the borrower defaults, the loan can be converted into shares.
The risk and return profiles depend on the strategy and the debt’s position in the capital structure, among other factors. Lower-risk strategies yield lower returns, just as higher-risk strategies can deliver higher returns.
Why invest in private credit
Private credit can be a good addition to investors' portfolios, offering an attractive risk-return profile, diversification benefits, resilience from its income-generating abilities and lower volatility.
1. Higher returns potential
Most of the returns are generated from income, instead of capital gains. Investors can receive a reliable income stream, with predictable and contractual returns based on the interest rate charged. Furthermore, the bulk of loans in the private market have floating rates, allowing investors to benefit from rising and high interest rates environment.
Private credit is also able to deliver returns that are higher than those in traditional fixed income and equity markets. Investors may use private debt as a yield-enhancer within a broader fixed income portfolio and/or as a diversifier within an overall growth portfolio.
Private credit offers attractive returns vs other asset classes
2. Diversification
Allocating capital to private credit helps to further diversify your overall portfolio, as the asset class has a lower correlation to listed stocks and bonds. Private credit offers exposure to unique drivers that differ from those in traditional, public markets.
It can give investors access to a wide variety of industries and borrower profiles, such as smaller companies and those with unique assets. Some fund managers also take a thematic approach to identify companies that are in non-cyclical sectors or are riding on transformative trends. These traits enable investors to express a specific investment view or strategy while achieving diversification.
3. Lower volatility
Another plus point is the lower volatility that accompanies private credit, in comparison with public bond markets.
For example, the 10-year annualised volatility is 7.2% for investment grade bonds ,as compared to 2.9% for direct lending in the same comparable period, as seen from the earlier chart by JP Morgan.
4. Lender protection
Private credit lenders also have the flexibility to set their preferred lending terms, and can have direct and greater influence when it comes to negotiating and structuring the loan.
Often, lenders will arrange for collateral to protect against defaults, and put in place financial covenants to prohibit the borrower from taking certain actions that could increase the risks for lenders.
Moreover, in the event of a default, the recovery value has generally been much higher for secured private debt instruments than in the public markets or for broadly syndicated loans.
The chart below shows a recovery value of about 80% for private corporate debt — simply put, the investors managed to get back $0.80 for every $1 they invested when there was a default. For unsecured public corporate bonds, the recovery value stood at roughly 50%.
Recovery levels for public debt (grey bars) versus private debt (blue bars)
One way individual investors can approach private credit investing is through the core-satellite method.
The smaller, satellite allocations of your portfolio can include allocations to private debt funds and other alts. These will then complement your portfolio’s largest, core component, which should be globally diversified, have a strategic passive asset allocation, and come at a low cost.
What to note before investing in private debt
Illiquidity is one of the key risks of allocating capital to private credit.
To compensate investors for the inability to quickly exit their investments, private debt carries an “illiquidity premium”, offering higher yields over comparable traditional liquid fixed income assets such as public bonds.
This excess spread is driven by the complexity in originating, underwriting, and structuring private loans. The premium should be high enough to compensate you for the illiquidity.
While it can vary depending on the type of loan or investment strategy, the return premium has been durable and robust over the last decade, as the following chart by Mercer shows.
All-in yield at entry — US senior private debt vs US broadly syndicated loans
In the public markets, credit rating agencies assign ratings to indicate the creditworthiness or quality, and hence riskiness, of the instrument and borrower. In contrast, most private debt borrowers are unrated.
Investors should ideally invest only with experienced through-the-cycle managers with the expertise to underwrite thorough credit assessments. Extensive due diligence should be conducted to screen out borrowers that are too risky and focus on downside protections.
Unlock exclusive access to private credit with Endowus Hong Kong
Endowus offers exclusive access to private credit opportunities with global private credit investment giants including Apollo, Ares, Blackstone, Carlyle, HPS, Oaktree and more to our Professional Investor clients.
We keep fund-level fees as low as possible by working with fund managers to access their lower-fee share classes and we do not charge any upfront subscription fees or redemption fees.
If you are not yet a Professional Investor, opt-in today and to unveil private credit and other leading alternative strategies. Conntact us for a consultation. or email us at privatewealth.hk@endowus.com if you have any questions.
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Read more:
- As the Fed cuts rates, what can we expect from private credit?
- How alternative investments can fit into one’s portfolio
- Why become a professional investor in Hong Kong
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