FORECASTS & TRENDS E-LETTER
by Spencer Wright
January 7, 2025

IN THIS ISSUE:

Private Credit and Why It Exists
Traditional Fixed Income vs. Private Credit
Direct Lending Model Returns
The Risks of Private Credit
A Final Thought

This is the latest installment in our series on alternative investments. You can find the original overview here and our last article on hedge fund investing here.

Private Credit and Why It Exists

Private credit funds are debt-like, non-publicly traded instruments provided by non-bank entities, such as private credit funds or business development companies (BDCs) to fund private businesses. These funds typically engage in direct lending to private companies at above market rates.

Private credit exists due to a decades long decline in the number of commercial bank lenders. Consider this graph:

There are several reasons that contributed to the decline in commercial bank loan risk appetite, but banking industry over-regulation in the EU and US is a major factor. With traditional banks exiting the space, private lenders stepped in to fill the void.

The loans provided by private credit are often to “middle-market” firms with annual revenues up to $1 billion. The loans offered are specialized to the borrower and can include features not found in traditional loans, such as a structured equity component, high prepayment penalties, or a role in oversight or management of the company, among others.

Large investors in private credit funds include pension funds, insurance companies, family offices, sovereign wealth funds, and high net worth individuals. In the last ten years, private credit has become more available to a wider range of retail investors. This has fueled considerable growth in the private credit space as this graph illustrates:

Traditional Fixed Income vs. Private Credit

While private credit is frequently managed to total return, it can also be used to provide income like its more traditional fixed income counterparts.

Traditional fixed income investments are usually composed of various fixed rate bonds such as corporate, municipal, mortgage and US treasury. However, private credit funds are portfolios of floating-rate loans, meaning that when interest rates rise, the coupon on a private credit investment also rises, increasing the return profile for the fund. This is an important distinction between traditional fixed income and private credit.

The debt securities in fixed income portfolios are rated by independent agencies while those in private credit portfolios are not. The components in a private portfolio are call protected, meaning that the issuer cannot call the loan back ahead of time while some traditional fixed income assets have call components attached to them. Valuations of traditional fixed income assets are usually daily and market linked while private credit valuations can be infrequent. Importantly, private credit is generally illiquid while fixed income is fully liquid in almost all cases.

Private credit funds can offer diversification benefits and lower cyclicality compared to traditional assets. They provide active management capabilities, allowing for direct influence on underlying debt/assets.

Direct Lending Model Returns

The direct lending model used by private credit has been proven successful over several full market cycles, market environments, and through the vagaries of Federal Reserve interest rate policy. Consider the following graph:

The returns are impressive, with only 2008 showing a loss of 6%. Here is a 10-year return comparison of fixed income investments. The senior loan line is private credit.

This clearly illustrates why private credit is so heavily used by institutional investors. Of course, like all investments, private credit carries risk.

The Risks of Private Credit

There is no free lunch. While private credit has provided solid absolute returns over the years, it is not without risks. Here is a list of the most common risks associated with private credit. There can be other risks that are germane to specific funds. Always read the fund prospectus prior to investing.

Credit Risk: Private credit can carry more risk compared to traditional debt instruments as borrowers generally have higher risk. This means there’s an increased probability of default or non-payment by borrowers.

Liquidity Risk: Private credit investments often require investors to lock up their capital for a period of time. One to three years is common. This lack of liquidity can be problematic if investors need access to their capital quickly.

Market Risk: Higher interest rates can impact companies’ free operating cash flows, potentially exposing private credit investments to increased risk as the portfolio companies may have trouble meeting obligations.

Transparency and Evaluation Risk: Private credit funds are complex investments. The individually negotiated agreements between lenders and borrowers can make it difficult for investors to accurately assess the risk involved in investments. This opacity can also limit regulators’ ability to monitor the financial stability risks associated with private credit funds.

Rollover Risk: In an economic downturn private credit could come under additional pressure leaving highly leveraged firms vulnerable and unable to refinance their debt. This could lead to significant losses for lenders and disrupt the functioning of financial markets.

Regulatory Oversight: Compared to traditional instruments, private credit funds are subject to less regulatory oversight and transparency requirements. This can make it harder for regulators to monitor the financial stability risks posed by private credit funds, especially in times of financial stress.

A Final Thought

Private credit funds are more accessible now and their floating-rate, absolute returns are attractive. A private credit fund could make a useful addition to an income portfolio. Consult with a financial advisor to determine if private credit is right for you.

I just can’t help myself. I asked Microsoft Co-Pilot to render an image from the prompt “A Happy AI New Year”. Behold the result!

Thanks for reading,

[Spencer]

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