Table of Contents
Why invest in private credit?
Potential risks of private credit
How to invest in private credit
The bottom line
Oct 18, 2022
5 min read
Private credit refers to loans made to borrowers who don’t meet the qualification for traditional bank loans. In return, investors expect to receive market-beating returns.
Private credit, or private debt, refers to private loans made to companies or individuals that are unable to qualify for traditional bank loans. These borrowers often have below-standard credit grades and usually pay above-market interest rates to make up for the increased risk of default. Investors sometimes choose to add private credit to their portfolios because the returns usually are higher than those of public markets.
The private credit industry, part of the broader universe of alternative investments, has boomed over the past two decades, growing from $42 billion in global assets under management in 2000 to $1.1 trillion in 2021, according to consulting firm PwC. Much of the growth has been in reaction to the more stringent lending standards that regulators forced on banks after the 2007-09 financial crisis. Institutional investors such as pension funds and endowment in particular have flocked to private credit, as have some retail investors. Private credit investment products attracts investors for several reasons, including:
Many investors use private credit as a way to diversify their holdings. Private credit investments can take several years, if not decades, to fully mature. Because of the long-term nature of the investment, private credit tends to be less correlated with the short-term ups and downs of public markets.
Borrowers and lenders usually agree on a set repayment plan with predetermined interest rates when arranging a private credit agreement. This means that as long as the borrower does not default, lenders know the returns they will receive.
. In the event that a borrower declares bankruptcy, the company is almost always obligated to pay its creditors before it pays its equity holders. This can make private credit less risky than private equity.
The private credit industry has boomed during the past two decades. There are now more ways than ever for individuals who are interested in investing in private credit.
Investing in private credit comes with several risks, including:
Private credit funds are inherently illiquid because contracts take several years or even decades to mature and investors usually are barred from cashing out prematurely.
Most investors in private credit retain an asset management firm that specializes in private credit. These firms often charge management fees as high as 2% of the assets under management. These fees can chip away at returns.
Sometimes, when an asset class undergoes a sudden boom, there is a risk that people are paying more for the asset than it is worth. This could lead to a correction in private credit markets, causing returns to suddenly decline.
Private credit is traditionally dominated by institutional investors. However, there are some ways that a retail investor can gain exposure.
High-net-worth individuals may be able to invest in private credit by hiring a wealth management firm. Some well-known firms that have private credit funds include Blackstone and Ares Management, both of which also engage in private equity. Professional wealth managers can be attractive because of their decades of experience in investing. However, investors may be required to pay fees of as much as 2% of the assets under management and 20% of any profits to these wealth managers.
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Another way for a retail investor to gain exposure to private debt is through a business development company. These companies focus on lending to distressed businesses that cannot easily access capital. The expectation is that by extending or leveraging credit, the borrowers will be more likely to succeed and repay their debts. Some business development companies are publicly traded, which means that investors can easily buy their shares. As of late September 2022, there were 48 business development companies listed on U.S. stock exchanges, with a total of almost $100 billion in assets under management.
These are retirement accounts that are allowed to invest as much as 15% of their assets in illiquid securities like private credit. Target-date funds are heavily regulated by the Securities and Exchange Commission and are designed to be a relatively low-risk vehicle to help individuals optimize saving and planning for retirement. Private credit is usually only a small percentage of a target-date fund’s portfolio.
Sometimes, small businesses seek extremely small loans to get started. This is one of the easiest ways an individual can begin investing in private credit. Several platforms exist to help facilitate these microloans, including:
. This is a microcredit platform that lends to fledgling businesses. It requires a minimum investment of $100 and offers returns of between 10% and 25%.
GroundFloor is a website that offers investors the opportunity to invest in real estate-backed private debt. The minimum investment is just $10.
PeerStreet isanother organization that provides real estate-backed private debt investment opportunities to the public. PeerStreet has a higher minimum investment of $1,000.
Some other microcredit opportunities might require a higher initial investment, but nevertheless are available to the public. Examples include:
Actium is a Dutch-based asset manager that offers microcredit investment opportunities in emerging markets to retail investors. Many of these loans are designed to assist individuals creating businesses that reduce poverty.
The SDG Investor platform, run by the United Nations Development Fund, also offers opportunities for high-net-worth retail investors to lend money to businesses involved in infrastructure, education, and financial services in emerging markets.
Private credit refers to loans made to borrowers who don’t meet the qualification for traditional bank loans. In return, investors expect to receive market-beating returns because of the risk that borrowers will default and the lack of liquidity. Although the market is dominated by institutional investors, retail investors can gain exposure by hiring wealth managers, buying shares of business development companies, or using websites that make microloans.
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