Why Private Credit During Turbulent Markets?
These are difficult times for investors. Major banks are failing. The stock market is declining. Bond values are dropping. Overall, the market is volatile and will likely continue to be for the foreseeable future. In times like these, where else could you invest your money? One option is private credit. Here’s what you need to know about it.
What Is Private Credit?
When a business wants to grow or expand, they need to raise capital. There are a variety of ways they can go about it, but the two major sources of capital are equity investments or loans. Both are fairly straightforward. As an equity investor, you give the company a certain amount of money, and as a result, you own a portion of the company. If the company does well and profits go up, you reap the benefits. If the company struggles, you could lose your investment. With loans, instead of owning a portion of the company, you become a creditor. The borrowing company pays you back the amount you provided with interest over time.
Equity investments are traditionally done on the public market, through the issuing of stocks. When an equity investment occurs outside of the public markets, it is called private equity. Loans can also be issued through the public market as bonds. Outside the public market, loans are typically taken out from a bank or other financial institution. However, especially during periods of financial chaos, more and more companies seek loans privately.
Privately issued loans are called private credit. Also known as private debt or direct lending, money is obtained from an individual or organization that’s not a bank or other traditional financial institution—often a business development company.
Unlike in private equity, private credit lenders don’t own a piece of the company. Rather, they simply have the loan repaid with interest. However, they do typically hold collateral: some tangible asset that they can take possession of in the event that the loan cannot be repaid.
Types of Private Credit
There are a number of ways to lend money to an organization. The most common is standard direct lending. This is private credit in its most stripped down form: one party lends money to another, without any type of financial institution such as a bank or brokerage as an intermediary. These are typically asset-based loans, where either the physical or financial assets of the company are offered as security against repayment.
A somewhat riskier avenue is distressed debt lending. Take a company that’s currently in financial distress but has a good business model and a viable product or service with significant demand. You loan them the money to pay off their debts and restructure their company. You then get paid back when the company becomes profitable under its new business model.
The highest risk in private credit comes from mezzanine lending. A hybrid of credit and equity, it’s common in leveraged buyouts, wherein you typically lend money to a private equity firm so they can purchase a company whose price tag exceeds what they have in their fund. While this is the riskiest type of private credit, it also comes with the highest potential return—often targeting between 12% and 20% per year.
The Rise of Private Credit
Private credit has been growing steadily since about 2009. In that time, it’s grown around 14% per year—twice the amount that public credit has grown. In just over a decade, private credit has more than tripled, swelling to more than $1.2 trillion.
Why is private credit becoming so popular? There are a variety of reasons, but the long and short of it is, it can provide great returns. Private debt has one of the highest yields of any asset class, and can be up to 6% higher than public loans. Typically, they’re easier to obtain than loans through traditional financial institutions, making them appealing for borrowers whom banks might deny. This does make them a riskier investment, but it also offers higher potential returns. Borrowers will pay a higher rate to a private credit firm than they would to a bank because of the increased ease of approval as well as other benefits not typically afforded to them by public financial institutions.
Private lenders typically do extensive due diligence on borrowers in advance, so they can invest in companies with the highest likelihood of repayment.
Private credit also becomes a more appealing investment when interest rates are on the rise. Private loans typically have a floating interest rate, which is adjusted periodically according to the federal interest rate, the prime rate, or another major benchmark. The more the interest rate goes up, the more money you stand to make.
Currently, interest rates have been rising steadily, and the Federal Reserve Chair has publicly expressed their intention to continue raising them in an effort to combat inflation. So investing in loans with a floating interest rate could net you an increasing amount of money over the course of the next few years.
Private Credit Fund
So how do you invest in private credit? You personally aren’t likely to be providing loans to companies directly. Instead, like many private investments, you put your money into a fund. A private credit fund collects money from a variety of investors, and the fund manager seeks out borrowers to lend it to. When you invest, you can choose what kind of credit you want to invest in: whether you want a more stable option, or prefer one of the higher risk, higher reward investments we discussed.
If you’re looking for an investment with a high target rate of return during these turbulent financial times, we can help you find a private credit fund that meets your objectives.
Contact us to learn more!
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