Over the last 15 years Private Credit has grown in importance and the breadth and depth of investment opportunities have become significantly more mainstream. So, let's dive in to understand what Private Credit is, how it fits into a diversified investment portfolio, and the different types of Private Credit.
Private Credit refers to non-bank lending where investors provide loans to private companies, real estate or even infrastructure projects. This asset class has grown significantly as traditional banks have scaled back their lending activities due to regulatory changes, leaving a gap that has been filled by the private credit market. Private Credit offers a variety of lending structures, terms, and collateral options, often tailored to meet the specific needs of borrowers while providing underlying investors with attractive risk-adjusted returns.
Before we get into the different types of private credit it is useful to understand a company's capital structure. The capital structure refers to the mix of capital a company has to fund its operations and growth. In broad terms it is a combination of debt and equity that makes up a company's total capital.
Note: This graphic is illustrative; only for discussion purposes.
Debt capital is raised by borrowing money through loans, bonds, or other debt instruments. It represents an obligation to repay the borrowed funds, usually with interest. Debt holders do not have ownership rights but are entitled to receive interest payments and the return of the principal loan amount.
In the event of wind up debt holders are paid out before equity owners with senior secured creditors paid first. Senior secured debt ranks highest in the capital stack in terms of payment in a bankruptcy situation. Other forms of debt are subordinated and mezzanine debt, which rank lower than the senior creditors. In return yields are typically higher and they can be bundled with other investment securities to offer additional upside for the risk taken on.
Equity on the other hand represents ownership interest in a company or asset. Equity capital is raised by issuing shares to investors, and shareholders become partial owners of the business. Investors participate in the company's profits through dividends and have voting rights in major decisions. They are the last to be paid when a company is wound up and are the lowest in the capital stack.
Broadly speaking the higher an investor is in the capital stack, the less risky it is and therefore the lower the expected returns.
While offering potentially lower risk than private equity, the world of private credit isn’t a one-size-fits-all solution. It boasts several strategies catering to various risk profiles and borrower types. Moving from the lower to higher end of the risk/return spectrum the types include:
Note: This graphic is illustrative; only for discussion purposes.
While income generation is a key reason that investors invest in private credit it also has the added benefits of offering additional diversification and lower return volatility. In many cases private credit also offers some inflation protection because they are mostly floating rate, as the interest income is tied to a reference rate that is correlated with inflation.
On the investment risk spectrum, private credit might be thought of as lying between equity and riskier types of fixed income. Private Credit is likely to replace some of your other income generating parts of your portfolio like bonds, or core real estate and infrastructure. Some investors may also have income generating focused share strategies and for such investors it could be appropriate to replace those sorts of exposures with private credit.
Whether you are an income-focused investor or looking for diversification, Private Credit offers a spectrum of opportunities with different risk-return profiles, therefore what it replaces will depend on the characteristics of the opportunities you are considering and how it fits against your income or return objectives for your total portfolio.
Given the lack of ownership interest in a company, private credit investors have very little insight into let alone influence over the operations of a borrowing company. Instead, there are a couple of techniques that are used to help manage risk:
