I hope you have found value in this alternative investment series. Like many things in life, if you head down a rabbit hole it can often be deeper than expected, and such was the case with alternative investments. There are many more categories that we could explore, such as hedge funds or structured notes, but I tried to focus on some core ideas throughout the series.
However, all good things must come to an end, so today we are going to wrap up our alternative asset series with this post on Private Credit. As always, I encourage you to check out the previous posts in this series if you missed any: [Part 1 – The “Why” of Alternatives / Part 2 – Private Equity / Part 3 – Real Estate]
What is Private Credit?
Private credit also referred to as private debt, is essentially the inverse of private equity. Whereas private equity means an investor purchases shares of a private company, private debt is where an investor lends money to a private company and negotiates the term of the loan, much like any other loan. These loans are not done through traditional channels such as banks or public funds, hence the term private credit. Private credit expanded greatly after the 2008 credit crisis as banks tightened their lending standards. So companies, especially small and mid-size companies, had to look elsewhere for funding, and in stepped private credit. According to Preqin, an alternative asset data platform, assets under management in private debt have now surpassed $812 billion, with over 4,000 active investors.
Why Private Credit?
1. Yields – According to JPMorgan’s 1st Quarter Guide to Alternatives, direct lending, which is a form of private credit, has an average yield of 9.5%, compared to commercial grade bonds at 5.5%, and 10-year US Treasuries at 3.9% (data as of 9/30/22 and 2/28/23.)
2. Better looking J-Curve – In our real estate post, I referenced the J-Curve, which is the idea that alternative investments, especially real estate, tend to have early negative returns as management costs, debt costs, and other costs are incurred early in the fund years. In most cases, there is little to no j-curve in private credit since interest payments to investors usually begin right away.
3. Risk and Diversification – As we all know, no investment is risk-free. However, when it comes to alternative investments, private credit is considered one of the least risky investments. Additionally, as has been a consistent theme throughout this series, private credit is a great way to diversify a portfolio. According to information from Blackstone, direct lending has a negative correlation to traditional corporate investment-grade bonds.
Types of Private Credit
Private credit comes in many different forms, below are three types, all with many sub-categories:
1. Direct Lending – This is the largest type of private credit and the most straightforward. This is where companies negotiate loan terms directly with investors and the loan is often backed by the future cash flows of the company. In the case of a real estate company, the loan may be collateralized by physical properties.
2. Distressed Debt – This is where investors buy the debt of a company facing financial hardship such as bankruptcy. Why would anyone want to purchase the debt of a bankrupt company? The lender is hoping that when the distressed firm comes out of bankruptcy, the debt they purchased will be valued higher after they restructure the company.
3. Specialty Finance – A manager may pursue a niche strategy to focus loans on a specific industry that requires special expertise. These funds can often be the hardest to perform due diligence on because of their specialization.
How to Invest in Private Credit
Just like we discussed with real estate in our previous post, private credit has come a long way in terms of access for investors. Below are three general ways to invest in private credit, each with its pros and cons:
1. Publicly Traded Funds – Most of what you will find in the private credit publicly traded space will be in the form of mutual funds, though we are seeing a few ETFs starting to emerge. Obviously, the advantage here is that these funds can be bought and sold daily on a public exchange. However, they may be susceptible to general market fluctuations due to their publicly traded nature.
2. Interval Funds – An interval fund is a type of closed-end fund, meaning it cannot be bought and sold on a public exchange. Usually, shares of the fund can be purchased daily from the fund directly, but they will only periodically buy the shares back, usually quarterly and usually limited to 5% of the outstanding shares. Obviously, the lack of liquidity is one of the drawbacks to this fund structure, but the “illiquidity premium” may make up for this disadvantage. The illiquidity premium is simply the fact that funds recognize they need to pay a higher yield to investors if they are going to make the fund less liquid for those same investors.
3. Business Development Companies (BDC) – BDCs are a type of closed-end fund, but they come with the requirement that 70% of their holdings must be invested in private or thinly traded public companies with the goal of generating income for investors. BDCs can be either publicly traded or privately traded and must distribute 90% of their taxable income to shareholders.
Things to Keep in Mind
1. Capital Structure – While generally speaking, all lenders fall above equity stakeholders when things go bad, within debt investments, there is still a hierarchy that matters when it comes time to pay the lenders. It is important to understand what type of debt the private credit fund is choosing to pursue. For example, senior debt sits at the top of the “food chain” and would be repaid first in the event of a liquidation, so a fund that focuses on this type of debt would be considered a lower-risk fund. On the other hand, a fund that focuses on subordinated debt, sometimes called junior debt, may come with a better yield but would be considered higher risk because senior debt must be paid before junior debt in the event of a liquidation. So, if there is not enough money to “go around” in the event of a liquidation, junior debt holders may not get all their investments back.
2. Fees – Another recurring theme throughout the alternative investment series has been the fact that they tend to have higher fees than public, liquid investments. This does not make them bad per se, just make sure you are comfortable with the fee structure and costs. In addition, especially in the private credit space, some funds will also charge a performance fee on top of their management fees.
3. Leverage – Some funds may seek to increase their return by utilizing leverage. If this is the case, it is important to understand how much leverage they are taking and the effect a declining market may have on the portfolio.
As with all my other posts in this series, this post is not a recommendation to purchase a private credit fund, but rather meant for educational purposes; one of our core tenants of “walking with you on your journey,” is education.
I hope you have enjoyed this series and as always, if you have any questions about this information or wish to see if alternative investments make sense in your financial plan, please do not hesitate to contact our firm.
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