Understanding private credit

Private credit in its most basic form - one party loaning another money for business or personal use, with a charge of some kind to account for the risk - has probably been around since humans first started using money. However, the asset class has grown extremely rapidly over the last few years to account for roughly $1.6T in 2023, up from just $200M before the Global Financial Crisis (GFC).

Keri Findley, founder and CIO of Tacora Capital, explains the basics of private credit.

Why you should be excited about private credit

In the wake of the GFC in 2008-2009, tighter US bank regulation caused many traditional lenders to pull back, leaving many businesses stranded in a “lending desert”. Private credit managers stepped in and filled the void (see chart below).

The difficult times for banks are not over, and they continue to struggle with higher interest rates, US regulatory uncertainty, and potentially higher capital requirements. 

So, while the banks cut back on lending, private credit managers continue to evolve - creating strategies and structures to meet new economic and financial challenges. As a result, private credit managers increasingly are becoming the lender of choice for even the most credit-worthy borrowers. Some of these borrowers are looking for better deal terms with quicker execution, while others want a lender/partner who offers special expertise. 

Driven by borrower and investor demand, the global private debt sector is expected to more than double in size to $3.5T by 2028, according to BlackRock estimates.

This rapidly expanding universe of private credit strategies, though they have diverse risk-reward profiles, typically generate regular income and have characteristics that can hedge against inflation, such as floating rates. A floating rate means that when interest rates rise, so does the rate on the loan, unlike with fixed-rate bonds, which would lose value in this scenario.

And perhaps most important from an investment perspective, the median returns from private credit funds have been significantly greater than those generated by their public markets counterparts over the last 15 years (see chart below).

What is private credit?

Private credit is lending that happens outside of the traditional banking system and is untradeable on public markets. 

Borrowers range from startups to blue-chip companies. Lenders and borrowers negotiate private loans that span a company’s “capital stack” (see chart below). The capital stack describes the various layers - or “tranches” - of debt on a typical balance sheet. These range from common equity to senior debt . The level of seniority denotes the sequence in which lenders are paid back in the event of financial distress. So more senior debt commands lower rates of return - reflecting this lower risk - while junior debt in the stack, such as common equity, has higher risk and return potential.

Private credit strategies

Prominent strategies, each with their own risk-return profile, include: leveraged loans, middle-market secured lending, mezzanine lending, asset-based lending, distressed debt, and special situations lending.

• Leveraged loans provide borrowers with generally low- to poor-credit quality, or relatively high existing debt, with the money to finance business activities, such as acquisitions, growth, or leveraged buyouts. Typically these loans have variable or floating interest rates linked to a benchmark and change over time.

• Middle-market secured lending provides loans to middle-market companies that are not traded on public exchanges. Typically, the loan is secured against the borrower’s assets, and is structured to meet specific needs, such as funding for acquisitions or restructuring, or as working capital.

• Mezzanine debt, or mezzanine financing, combines debt lending with equity components. It generally sits in the junior part of the capital stack (so has secondary claims on assets in the event of bankruptcy). The loans may be fixed or floating and, depending on how the deal is structured, there may be warrants or convertible notes that allow the lender to convert the debt into equity under predetermined circumstances. This can potentially provide greater upside in returns.

• Asset-based lending (ABL), as the name suggests, extends loans to companies with specific real assets, rather than financial assets, serving as collateral. This can include assets ranging from brand names and intellectual property to accounts receivable and physical property. In ABL, the lender typically agrees to lend up to a certain percentage of the value of specified assets, called a borrowing base.

• Distressed debt investing involves purchasing the debt of companies that are in financial distress, or are at a high risk for defaulting on their current loans. This debt is typically purchased from the company’s lenders at a deep discount, which reflects the level of risk, and then often restructured to improve the distressed company’s financial health. 

• Special situations strategies are highly niche and structure complex financing solutions. Special situations may include: a distressed company that needs to finance a turnaround; a borrower that needs money to complete a complex merger or acquisition; or a firm looking to fund a unique project that requires specific expertise.

How do I invest in private credit?

For many of the reasons we discussed above, investing directly in private credit is impractical for most people. The simplest investment approach is through a fund.

The active management edge

Investing in a private credit fund is not like investing in a mutual fund. A mutual fund holds a portfolio of publicly-traded securities. Those companies – and the fund - are required by law to disclose uniform information in a specific way. There are no disclosure exceptions and failure to comply with US Securities and Exchange (SEC) regulations carries severe penalties.

Because mutual fund portfolios are filled with publicly-traded securities, they can theoretically be replicated by a competitor.

Given the sheer number of potential investment opportunities, the different types of strategies, the lack of standardized information, and differentiated access to the best deals, it is highly unlikely that any two private credit funds will be identical.

Top-performing private credit managers need skills that go beyond traditional credit analysis. They must be able to evaluate below-investment-grade borrowers, as well as have expertise in workouts and restructurings. In addition, they must be able to source and identify the best deals. This can be particularly tricky in distressed situations because companies do not “plan” to be distressed, and a manager needs to be able to quickly identify and evaluate those cases.

The importance of skill is one of many reasons why investing in debt via private credit funds has a wider range of outcomes than investing in public funds (see chart below). Evaluating private credit managers is challenging (but crucial) and accessing top-performing managers may be difficult.

Returns from private credit funds

While other private markets strategies, such as venture capital and private equity, may take several years to generate returns, private credit strategies begin paying investors more quickly.

As we mentioned earlier, private credit returns are generated largely in the form of regular quarterly income (aka “coupon”). A private credit fund is a portfolio of loans, which typically have floating interest rates. The interest paid on the loans generates the bulk of the fund’s returns and provides regular payments to investors. 

A floating interest rate is typically tied to a specific benchmark rate (often SOFR - the Secured Overnight Financing Rate) and will change in relation to that benchmark. For example, if the US Federal Reserve raises the Federal Funds Rate to calm inflation, a floating-rate loan is protected from the impact of that move, preserving a set margin above its selected benchmark (which would typically move with the Fed’s rate). This is why floating rates are often considered a hedge against inflation and rising interest rates.

In a declining interest rate environment, private credit loans usually have an interest rate floor or minimum, which provides investors with some protection.

While distributions may come earlier than in other private strategies, private credit investments remain long term, and your investment is largely illiquid.¹ You cannot sell your investment in a private credit in the same way you can a mutual fund. However, private funds do not require the entire investment at the start.

They take a “just in time” approach to collecting your money. Committed capital is the money you agree to invest in a fund throughout its life. Called capital is the money the fund manager collects from you as it makes investments. 

You get capital calls throughout the investment period. This means you do not have to provide all the money upfront, but will need to have ready cash when there’s a capital call. These calls can come quickly with little notice and you need to respond immediately.

Fees in private credit

Fees in private credit funds are structured differently from the flat fees you pay for a mutual fund. Designed to incentivize the GP to do their best, there are two types of fees, as well as some general expenses. We talk about this in more depth here, but in short…

Management fees

First, there is an annual management fee that covers most of the fund’s basic operating expenses. This typically includes salaries, office rent, legal and due diligence costs, and other administrative costs. This fee usually ranges from 0.5% to 2% of the capital you committed, with an average around 1.2%.

Performance fees

The fund manager also receives a share of the fund’s profits, commonly called carried interest or just “carry.” The standard carry in private credit is roughly 15%, but it may vary depending on the terms of the fund agreement. 

Carry is typically subject to a hurdle rate. This means that performance fees only start to accrue after investors get their capital back, as well as the pre-approved hurdle rate. At this point, the GP receives 100% of returns until their carry matches what they would have received if the hurdle rate did not exist.

Aligning interests

As this performance fee structure makes evident, there is strong alignment of interests between investors and the fund managers.

Put simply, if a fund is successful, the manager profits. If not, they take the losses alongside their investors. Of course, we should note that management fees provide a small amount of income for the manager throughout the fund life.

Risks…

Risks in private credit strategies are directly related to the economic and financial health of the borrowers, and/or the underlying real assets. An economic downturn can lead to increased bankruptcies and more defaults, as well as a more challenging exit environment.

By their nature, private credit investments are long term and illiquid. Before making an investment, investors need to determine how much money they are willing to lock up for the duration, which may be 10 years or more.

…and the rewards

Nevertheless, with carefully calibrated fund selection and diversification, and by working with the right partners, private credit funds can play a highly constructive role for individual investors.

From distressed companies to blue-chip borrowers, private credit offers exposure to an expanding array of different company profiles. The rapidly evolving and growing range of private credit strategies offer a wide range of possibilities for diversification and potentially enhanced risk-adjusted returns that may usefully augment the income-focused component of a well-balanced portfolio. 

Still curious? Click on the private credit tab on our Insights site.