If you are anywhere near the banking industry, you probably know they have continued to be on a “risk-off” mode and not wanting to get involved in extra lending. Private credit is a directly negotiated loan offered by non-bank institutions. These loans are also not issued or traded in traditional public markets, hence the label “private credit.”
Why Banks Might Choose Private Credit
Why would a business want to borrow from a company that is not a bank? Banks are lending less, so we can start there. In addition, these relationships between the lender and the business offer flexibility and execution certainty that banks tend not to provide when there are challenging market conditions.
Like all loans, the borrower will pay interest, typically at a spread above a floating rate until they return the principal. Private debt agreements often include covenants that offer greater protection to the lender.
When done correctly, private credit offers higher yields and lower volatility than other options like U.S. high-yield leveraged loans or even investment-grade bonds. Most private credit funds focus on the middle market, which is big enough to be selective about who you borrow from, but not large enough to be competing against the banks that are lending.
Evaluate Private Credit Track Record
When working with a private credit manager, you want to evaluate their track record, expenses, and the diversity of their lending portfolio across companies, industries, and company sizes. Some funds have been operating for over 50 years, attracting institutional and high-net-worth investors.
Not all loans are the same. The safest private loans focus on senior secured loans, providing the lender with a first lien against an asset. These loans offer a degree of protection, as the asset acts as collateral.Obviously, you never want to take ownership of an asset, but you also never want to lose the money you like. As long as the manager is doing diversification across different portfolio companies, industries, and timeframes of transaction, you can have a very balanced portfolio with much less risk and much higher returns than other fixed income alternatives.
Be cautious with hybrid funds. Some mix private credit with other exposures, which reduces the benefits of a pure private credit fund. While these hybrid funds might provide more liquidity, they also introduce volatility linked to the public market. Complexity in private credit structures is increasing, with some funds incorporating various loan types and even private equity within the same fund.
If you’re looking for private credit funds, make sure they are doing private credit lending, and not using public funds to build out the portfolio. As the demand for these funds increases, just like we’ve seen in mutual funds and ETFs, the complexity of these funds will also increase. Currently, there are funds that have multiple types of loans between senior debt, debt, and even private equity within a private credit fund. There has been over $35 billion invested in middle market businesses with a very little loss ratio. The US middle market needs new money, and banks are not in that space like they used to be. If they are in that space at all, they are not as easy to work with, and bank loans tend to not have the protective covenant that you would get when you borrow on the private credit site. Of course, these funds have liquidity lock-up since your money is out on the street in private loans. But they tend to have quarterly liquidity up to 5% of the value of the fund, and as long as it’s planned for in your portfolio, the liquidity lock could be seen as a benefit since it also includes the reduction of market exposure.
Pros and Cons of Private Credit
Private credit isn’t for everyone, but it’s a useful alternative for fixed-income investors who want to avoid public market volatility. With the banking sector pulling back from business lending and healthy private companies in need of money to expand, private credit presents opportunities worth considering for investors.
Securities are offered through Arkadios Capital. Member FINRA/SIPC. Advisory services are offered through Creative Capital Wealth Management Group. Creative Capital Wealth Management Group and Arkadios are not affiliated through any ownership.
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