For investors, a reliable stream of income is extremely important, and finding it can be as elusive as a shadow in the twilight. Imagine searching for stable returns in a landscape where real yields hover disappointingly low, leaving you frustrated and exasperated. Businesses also need capital for expansion and growth, but banks are not lending as much as they used to. Even if they did, the terms are rigid, and companies may sometimes want terms that are more customizable regarding how they can access capital. The solution to these intertwined dilemmas may lie in private credit.
In recent years, there has been a lot of buzz about private credit—and for good reason, too. The private credit market has expanded significantly over the past few years. From being a $1 trillion industry in 2020, it has experienced phenomenal growth and is expected to reach $2.8 trillion by 2028.
While its growth has been massive, private credit as an asset class has only recently attracted investor attention. By the end of this exploration, you’ll know if private credit fits your risk profile, potentially helping you decide on its suitability for your portfolio. So if you’re wondering what all the chatter about private credit is really about, keep reading.
What Is Private Credit?
Private credit, or direct lending, is a type of lending that takes place outside the traditional banking system. Unlike most bank loans, private credit solutions are more flexible in how they can be tailored to align with borrowers’ needs, based on the type, size, and timing of transactions. Instead of a bank being the lender, in private credit, an asset manager or private equity firm is the lender.
Usually, the borrower is a small- to medium-sized business unable to obtain financing from traditional banks due to the restrictions and regulations imposed after the 2008-2009 financial crisis. For instance, from 2008 to 2010, bank lending to small businesses declined by more than 20%, creating a challenging environment for these companies. In fact, following this economic downturn, demand for private credit has grown exponentially, and private asset managers have seized the opportunity to provide capital when banks do not offer the desired options.
Benefits Of Investing In Private Credit
While private credit has a unique structure, it offers four key benefits that make it an excellent alternative to traditional fixed-income investments. Let’s explore them below.
Better Yields
The defining factor for private credit borrowers is the higher yield they offer lenders to gain capital. Usually, private loans are issued at higher interest rates than bank loans, so for investors, this can mean higher yields than traditional credit investments.
Opportunities For Short-term Investment
Private credit investments typically have short-term maturities, ranging from 3 to 5 years. This feature helps reduce interest rate risk, improve liquidity, offer greater flexibility, and reduce the risk of default.
Low Default Rates
Since private loans are often collateralized, this gives investors a cushion in case the borrower defaults.
Less Correlation With Market Trends
Nowadays, investors prefer allocating a percentage of their money to alternative investments, such as private credit, to enhance the stability of their portfolios. Since private credit investments are not actively traded on secondary exchanges, investors are not subject to the daily volatility seen in publicly traded fixed-income portfolios.
Disadvantages Of Investing In Private Credit
As with most things, advantages are shared with drawbacks too. Here are some downsides of investing in private credit:
Complex Structures
Some private credit investments have complicated investment structures that can be difficult to navigate and understand. As a result, this leads to significant tax implications if there is no proper plan in place.
Lack Of Liquidity
Based on the investment, it can be challenging to sell private credit on the secondary market. Therefore, you may not be able to access your money for some time after you invest. Accordingly, you must be knowledgeable about the terms of the investment so you are confident in your decision to lock up your assets for the duration of the loan.
Limited Transparency
Since private credit investments are privately managed, they are not liable to the same reporting standards and pricing as publicly traded investments. This makes it all the more important for investors to conduct due diligence and in-depth market analysis before investing.
Concentration Risk
Usually, private credit investments are sold in significant amounts to a small group of investors, often accounting for 5-10% per deal. Needing to invest a considerable amount of money means that your portfolio is now concentrated in private credit, thereby placing your assets at risk in case something should go wrong. Before deciding to allocate your money into private credit, ensure that the investment’s risk profile aligns with your objectives, risk tolerance, and time frame.
Regulatory Risks
In private credit, the regulatory landscape is still evolving, so regulatory changes can affect the operations and profitability of private credit funds. It’s essential to comply with tax regulations, local laws, and reporting requirements.
How To Invest In Private Credit
If you’re looking to add private credit to your investment portfolio, then here is how you can do it.
- Determine how much of your portfolio you wish to allocate to private credit. According to statistical research, high-net-worth households should ideally allocate about 30% to alternative assets, with 10% of that to private credit. However, for most investors, this is most likely to be on the high end.
- Next, you will need to register with a platform that allows you to invest in private credit. Some popular choices are Willow Wealth and Percent.
- After you have decided on the platform, determine which investments to make based on the available listings and your personal financial goals.
- Now is the time to purchase by investing in your first private credit deal.
Final Thoughts
Private credit is undoubtedly growing in popularity, and this propulsion is expected to continue. This trend is a strong testament to the growing demand for private credit in the global financial landscape. Fuelled by institutional demand, attractive returns, market flexibility, and the need for alternative financial options, private credit has indeed reshaped the traditional lending models. As the financial sector continues to evolve, there is no doubt that private credit will play a pivotal role in providing businesses with the capital they need, supporting economic growth, and offering investors attractive investment options.
But investing always comes with a level of risk, and you have to be well aware and comfortable with these risks. Yes, the historical performance of private credit has been excellent thus far, but the concept is still considered somewhat new. Plus, it’s regarded as a speculative asset class, so you need to weigh the pros and cons and be totally confident in your choice to invest in private credit.
