Understanding private credit investing
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Understanding private credit investing

Updated
5 Sep
2024
published
15 Dec
2022
  • Private debt investments can offer diversification benefits, less volatility, and downside protection
  • Key strategies in the private credit universe include direct lending, distressed debt, and mezzanine debt
  • Sign up to our early access list and let us introduce you to a better way to manage your wealth

​​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. That said, some private equity funds hold a small portion of debt, for diversification purposes.

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 to traditional fixed-income investing

Who are the lenders and borrowers?

The investors essentially act as the lenders. The 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 essentially repay lenders the principal plus interest over a certain period of time, according to specified terms. With bonds, the issuers make regular coupon payments to the investors.

Borrowers of private debt tend to be small and medium-sized enterprises (SMEs) without investment-grade credit ratings. They can be either listed or unlisted companies, and their Ebitda (earnings before interest, taxes, depreciation, and amortisation) range from some US$3 million to US$100 million a year, averaging some US$30 million.

These companies typically use the loans or bonds to finance acquisitions, develop real estate, build infrastructure, expand the business, or improve their operations.

Aside from companies, private credit is also provided to real assets, such as real estate or infrastructure.

The expanding private credit market

Investing in private credit started to gain momentum relatively recently, as compared with other traditional and alternative asset classes. PitchBook estimates that private debt now accounts for about 10% to 15% of total assets under management (AUM) in the private markets. It is the third-biggest asset class by AUM in the alternatives space, behind private equity and real estate.

As banks increased their loan requirements and tightened financing to avoid riskier loans, more borrowers, especially SMEs, have turned to non-bank lenders.

Before the year 2000, almost all loans to small and medium-sized businesses were from banks. But non-bank lending subsequently became more popular — private debt AUM tripled in size between 2008 and 2020, spurred by high-level macro trends such as:

  • 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 debt (US$billion)

Source: Preqin, as of September 2021; Mercer

In these times of stubbornly high inflation, rising interest rates, and volatile public markets, investors have increasingly looked to alternative investments such as private credit.

However, inflation can be a double-edge sword for private credit, creating both headwinds and tailwinds across the corporate, real estate, and consumer segments, as UBS highlights.

On one hand, a big portion of private debt instruments have floating interest rates, which fluctuate according to the benchmark interest rate. As central banks hike interest rates, floating-rate loans become more lucrative, providing some protection to investors against inflation. This exposure can complement a traditional fixed-rate bond allocation.

On the other hand, surging inflation and interest rates will eventually increase credit risks, as borrowers face higher input costs and rising debt-service requirements. In UBS’ view, this could result in a greater dispersion in company fundamentals, making credit selection even more important — investors may wish to focus on sectors and companies that are able to withstand inflation.

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 amount and type of debt and equity on its balance sheet will determine who is repaid in what order and proportion. A debt default occurs when the borrower fails to pay the interest or principal amount when it comes due.

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.

Ways to invest in 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 may be categorised as direct lending, asset-based lending, credit opportunities such as distressed debt and special situations, and mezzanine debt.

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.

More than a third of private debt capital raised in the first half of 2022 was for the direct-lending strategy, according to PitchBook’s global report.

Investment returns from direct lending are largely generated from income. Historical returns stand at about 5% to 8% for senior debt, and 8.5% to 12% for junior debt or leveraged debt funds, according to Mercer’s estimates as of December 2021.

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. In a rising rate environment, commercial mortgage loans in sectors with strong fundamentals can provide inflation-hedged collateral as the property appreciates in value over time and commands higher rents.

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 or equity 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. In Mercer’s view, this strategy is 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.

Private debt: Risk/return by fund type (vintages 2011-2017)

Source: Preqin

Why private debt attracts investors

The asset class can be a good addition to a mature portfolio inclusive of private equity, given the downside protection that private credit offers through an attractive risk-return profile, diversification benefits, and resilience from its income-generating abilities and lower volatility.

Returns

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 interest rates.

Private credit is also able to deliver returns that are higher than those in traditional fixed income and equity markets. The following graph by JP Morgan Asset Management shows the relatively high yields offered by private credit — such as direct lending and commercial real estate (CRE) loans — over public markets.

Asset class yields

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, as Mercer notes.

Diversification

Allocating capital to private credit helps to further diversify your overall portfolio, as the asset class has a low 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.

Resilience

Another plus point is the lower volatility that accompanies these investments, in comparison with public bond markets. Private debt has performed steadily for more than a decade, barring a dip in returns at the height of the Covid-19 pandemic in early 2020. For example, US private debt recorded shallower drawdowns and less volatility during periods of economic growth and turbulence, as seen from the chart below.

Growth of $100 over a decade

Source: Mercer analysis, Thomson Reuters Datastream (ICE BofAML US High Yield Master II, S&P Leveraged Loan) and Burgiss (US Private Debt)

Lender protection

Private debt 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)

Source: Abrdn

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. Lenders often intend to hold the debt to maturity, so the instruments are not typically traded in a secondary market. Shares of private debt funds may not be traded actively or regularly.

To compensate investors for the inability to quickly exit their investments, private debt carries an “illiquidity premium”, offering higher yields over comparable traditional 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

Source: Mercer, S&P LCD

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, weaker credit profiles than speculative-grade companies, and may be highly leveraged — the fund managers will therefore need to conduct a robust ratings analysis.

Investors should ideally invest only in well-structured, professionally managed assets that have undergone a thorough credit assessment, Abrdn suggests. Fund managers have to conduct extensive due diligence to screen out borrowers that are too risky and focus on downside protections.

Start your private debt investing journey with Endowus Private Wealth

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Investment involves risk. Past performance is not an indicator nor a guarantee of future performance. The value of investments and the income from them can go down as well as up, and you may not get the full amount you invested. 

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