Private Credit
8 min read

Private credit, lending beyond the bank

Published on
June 13, 2023
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Private credit provides steady returns for investors and the capital necessary for SMB businesses to grow. The private credit industry has grown from $42 billion in global AUM in 2000 to $1.1 trillion in 2021 according to PwC.

Why it Matters: The Great Financial Crisis (GFC) changed the landscape of banking for good.  It opened the door for non-traditional lending and has grown ever since.  

The big picture: Private credit spans a wide spectrum and crosses both public and private markets.  

The low down: Pimco does a great job of defining the private credit market. It is a lot to digest so we will highlight a few of the commons forms of private credit below to help jumpstart the journey.

What is Private Credit?

Private credit is a type of investment where individuals or companies lend money to other companies or individuals. Unlike bonds, which are publicly traded and can be bought by anyone, private credit is not publicly traded and is only available to a select group of investors. The main difference between private credit and bonds is that private credit is typically issued to smaller to midsize (SMB) companies that don't have access to public financing or need additional financing they are unable to secure through banks.

Private credit can come in different forms, such as senior, mezzanine, distressed, and venture  credit. Investors who choose to invest in private credit do so through private credit funds, which are managed by asset managers. These funds pool investments from multiple investors and then direct the money towards private credit investments. Investors in private credit generally do so for the potential of higher returns compared to traditional investments such as corporate bonds.

When investing in private credit, investors typically allocate a portion of their portfolio to private credit funds, which are managed by experienced asset managers. These funds invest in private credit opportunities across different industries and sectors and can offer a range of investment strategies, such as direct origination or secondary market purchases.

Whether an investor seeks higher returns or a way to diversify their portfolio, private credit investments can offer compelling opportunities. However, as with any investment, it is important for investors to carefully consider the potential risks and benefits and ensure that private credit investing is aligned with their investment goals and risk tolerance.

Overall, private credit offers an alternative investment option for those looking to diversify their portfolio beyond traditional options like stocks and bonds.

Examples of the various types of Private Credit Investments

Senior Credit

Senior credit is a type of private credit investment that involves directly loaning money to a private company with the highest priority in the capital structure (our debt fund leverages this strategy)

Senior credit is secured against the assets of a company and typically has priority over other types of financing. It is often used by companies to finance their operations, acquire new assets, improve real assets and make capital investments. Senior credit typically pays a fixed rate of interest, which is usually higher than the rate paid for any other type of loan or security.  

In real estate senior direct lending, investors can lend money to real estate projects, such as commercial or residential properties, bypassing banks. For example, an investor can offer funding directly to a real estate entrepreneur for the rehab of a single family building. This type of investment can provide a steady income stream and potentially high returns.  

In small and medium business senior direct lending, investors can provide loans directly to private companies with the aim of financing their business operations. For instance, an investor can lend money to a restaurant owner to purchase inventory and renovate their establishment. Direct lending in small and medium businesses is a crucial source of funding as these companies often struggle to secure financing from traditional lenders.

Mezzanine Credit

Mezzanine credit is a type of financing that combines features of both credit and equity. It is commonly used in real estate and small to medium businesses when the owner needs additional funding beyond what traditional lenders are willing to provide.

In real estate, mezzanine credit can be used to finance large development projects. For example, consider a developer who wants to build a new shopping mall. The developer may be able to get a loan from a bank or other lender, but the amount may not be enough to cover all the costs. To bridge this gap, the developer might seek mezzanine credit financing. This type of financing would involve an investor providing a loan to the developer that is secured by the property itself. In return, the investor would receive interest payments and potentially a share of the profits from the project.

In small to medium businesses, mezzanine credit can provide the necessary capital for expansion or equipment purchases. For example, consider a small restaurant chain that wants to open a new location. They already have a loan from a bank, but it's not enough to cover the full cost of the expansion. The restaurant chain might seek mezzanine credit financing to cover the remaining balance. In return, the investor would receive interest payments and potentially a share of the profits from the new location.

Distressed Credit

Distressed credit means the borrower is having trouble repaying the loan and the lender is at risk of not getting their money back. This can happen in both real estate and small to medium businesses. In real estate, an example of distressed credit could be a developer who can't make their loan payments on a property. This could happen if the property doesn't lease out as planned or if there are changes in the real estate market. The lender may end up having to take the property back and sell it to get their money back. In small to medium businesses, an example of distressed credit could be a restaurant that is struggling to pay back their loan. This could happen if the restaurant isn't making enough money to cover their expenses or if there is increased competition in the area. The lender may have to restructure the loan or take ownership of the business to try to recoup their losses.

Venture Credit

Venture credit is a type of private credit investment aimed at financing early-stage venture companies with high potential for growth. This type of investment can offer attractive yields, but with a higher degree of risk than direct lending or senior credit.

Advantages and Challenges of Investing in Private Credit

Investing in private credit can offer both advantages and challenges to investors.  One of the biggest advantages of investing in private credit is the ability to generate steady income from interest payments. This type of investment can also offer lower volatility and may be less affected by market fluctuations. However, these types of investments may involve a higher degree of risk when more advanced strategies are deployed (e.g. distressed credit, litigation finance). These advanced strategies may also require significant upfront capital or a longer time horizon for returns.

It's important to carefully consider the advantages and challenges of investing in private credit before making a decision. Private credit investments can be a valuable addition to an investment portfolio and provide investors with steady income and diversification, but they also require a higher degree of research and risk management to find the appropriate credit strategy that fits your risk profile.

The bottom line: private credit is important to consider when building a diverse investment portfolio.  It can provide protection against inflation, income and growth of capital.  

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