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Key Points
- Private credit refers to non-bank lending where investors provide loans to private companies, real estate or even infrastructure projects.
- Investors seek private credit for strong income generation. Private credit is broadly less risky than private equity, however, there are all sorts of strategies within private credit that range across the risk/return spectrum, with some generating more cash income than others.
- Borrowers seek funding from private credit because they cannot issue public bonds and/or need loan terms that banks are not willing to be flexible on. To manage risk, private credit lenders use techniques such as credit underwriting, covenants, and debt workout programs.
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.
What is 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.
Capital Structure
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.
Navigating the Options: Different Types of Private Credit
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:
- Real Asset Debt: These are loans secured by real estate or infrastructure assets, providing capital for development, acquisition, or refinancing of those types of assets.
- Direct Lending: This is the most common type of private credit, where investors lend directly to medium-sized companies (often portfolio companies of private equity sponsors). These loans are usually senior secured and offer regular interest payments, providing a steady income stream for investors.
- Mezzanine Debt: Mezzanine loans are subordinated to senior debt but senior to equity. They often include equity-like features, such as warrants or options, providing a higher yield potential due to their riskier position in the capital stack.
- Distressed or Special Situations Debt: This involves investing in the debt of companies facing financial difficulties or borrowers that require very specific or flexible loan agreements. In the case of distressed debt, investors aim to profit by acquiring debt at a discount and potentially taking control of the company during a restructuring. While special situations debt providers offer financial solutions that are very bespoke and because of the bespoke nature can demand a premium as there are typically few players willing to be flexible on the terms of the loans.
Note: This graphic is illustrative; only for discussion purposes.
What role does Private Credit play in a diversified investment portfolio?
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.
What techniques are used to manage risks in private credit?
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:
- Credit underwriting: because the borrowers will not have a credit rating from an agency such as S&P or Moody’s, credit underwriting is the process to evaluate the borrower's ability to make the loan repayments. It is a similar but more complex process you go through when you hand over all sorts of financial information to the bank when you are taking out a loan to purchase a house. It involves a thorough examination that incorporates both qualitative and quantitative analysis and understanding of the company's operations and financials.
- Covenants: A covenant is a set of conditions imposed by a lender upon a borrower as part of the debt issuance. Covenants serve to protect the interests of the lender by defining certain parameters and restrictions that the borrower must adhere to throughout the term of the loan, for example they must notify the lender if revenues fall below say 1.5x the interest repayments, or the Debt/Equity ratio increases above say 1.0x. Debt covenants are designed to mitigate the lender's risk and ensure that the borrower maintains financial stability.
- Debt workout: this is a process in which the borrower and lender negotiate and agree on modified terms of the debt. This typically occurs when a borrower is facing financial distress and is struggling to meet its debt obligations and could have been a result of a covenant being breached. A debt workout attempts to find a mutually acceptable solution that allows the borrower to manage its debts while addressing the concerns of the creditors, it could be an action like requiring an equity injection, increasing the interest rate, requiring cash payments than capitalising interest payments, thereby recalibrating the risk/return profile of the deal.
