Private credit can play a strategic role in an investor’s portfolio, primarily as part of an alternative investment allocation within the fixed income sleeve of a portfolio for investors with a higher risk tolerance and no need for immediate liquidity.
Private credit refers to non-bank lending to private companies that takes place via loans that are privately negotiated, rather than syndicated or traded in the public markets. This market began to emerge in the early 2000s, and growth accelerated after the 2008 global financial crisis due to regulatory reforms. The private credit market has grown from under $100 billion in 2000 to about $2 trillion today.
According to the U.S. Small Business Administration, there are over 33 million small businesses (those with fewer than 500 employees) in the United States that employ nearly half of all American workers and contribute roughly 43.5% of U.S. GDP. Private credit plays an increasingly important role in the U.S. economy, acting as a major alternative to traditional bank lending and public debt markets for these smaller companies. Companies backed by private credit tend to be small and mid-sized businesses that often face barriers to traditional financing. More recently, however, larger companies have also been turning to the private credit markets due to the favorable financing terms they can receive versus the public markets. This will likely lead to even further growth of the asset class in the coming years.
The growth of private credit has accelerated even more in recent years as access for investors has grown. Traditionally, private credit was accessible only for institutional investors who would invest millions at a time. However, as regulations change, private credit has become accessible to retail investors, primarily through the use of interval funds. Just like mutual funds, interval funds are registered under the Investment Company Act of 1940. However, liquidity is limited (often to a quarterly basis with capped redemptions), and fees can be high.
The benefits of private credit investing may include:
- Higher yields because of the lower liquidity and the lending to higher-risk borrowers
- Inflation hedge – most private credit loans are floating rate, which can help protect against rising interest rates
- Diversification – returns on private credit are generally uncorrelated with the public equities and bond markets, which may serve to reduce overall portfolio volatility
- Senior in the Capital Structure – most private credit debts are senior secured loans, meaning they rank at or near the top of the capital structure of a company
The risks of private credit investing may include:
- Illiquidity – most private credit investments are locked up for a period of time and provide only limited liquidity
- Increased Credit Risk – private credit loans tend to be made to smaller, lower credit quality companies
- Valuation Transparency – because of the illiquidity in the private credit markets, loan valuations can be difficult to assess and sometimes result in mispricing of securities
- Prepayment Risk – like most loans, private credit loans can typically be repaid early, subjecting investors to unexpected reinvestment risk
Because private credit has evolved from a closed, illiquid institutional market into a mainstream alternative investment with growing retail participation through the use of interval funds, it may be worth reviewing with your advisor. In certain cases, we believe private credit may enhance a portfolio’s diversification and therefore risk-adjusted returns for investors with a higher risk tolerance level who don’t require liquidity.