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What is Private Credit and How Does It Work?

October 18, 2022
6
min

Learn all about how private credit is a type of lending to businesses and individuals who can’t get loans through a traditional bank or public debt markets.

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In 2008, the global financial crisis rocked credit markets. Banks, which had been the go-to source for mortgage and business loans, were suddenly unable to provide funding. So companies and individuals that needed to borrow turned to other lenders, including a type referred to as private creditors. 

With little competition from banks, private credit firms were able to charge both companies and individuals much higher interest rates, making the loans a lucrative long-term investment. From there, the private credit industry has expanded rapidly. In 2000, global private credit investments were worth just $42 billion. By 2019, that number had grown to roughly $1.1 trillion, according to consulting firm PwC. The asset class has one of the highest growth rates in the investing world, ahead of both private equity and venture capital.

What is private credit and how does it work? 

Private credit is an industry that primarily lends to businesses that don’t meet normal credit standards. The industry has rapidly expanded to fill a void that exists because lending standards at banks and bond markets prevent many of these businesses from accessing traditional loans.  These borrowers can be businesses that are in risky markets or those that have blemishes on their credit records that might include a history of not making timely loan repayments or even bankruptcy.  The investment funds that lend to these businesses are referred to as private credit. 

Those who put money into the funds that offer private credit are investing in an alternative investment, meaning that it is a way to invest that does not involve traditional stocks or bonds. It is also sometimes referred to as private debt.

Private credit funds are sometimes housed inside private equity firms although other firms focus exclusively on private credit. 

Who are private creditors lending to? 

There are several different types of borrowers that make up the private credit market. Many of these borrowers turn to private credit because they are considered too risky to receive standard loans from banks, which were subject to tighter regulations after the 2008-09 financial crisis. Some borrowers are companies, while other borrowers are individuals who must tap into their personal credit. The major types of borrowers include:

  • Middle market companies. These are businesses that have annual revenue of $10 million to $1 billion. They make up the largest portion of private credit borrowers, and they typically use the loans to help expand. Middle market companies turn to private credit because they tend to have high debt-to-income ratios and lower cash flows than established large corporations, making it hard for them to get bank loans. Additionally, unlike small businesses and start-ups, they cannot turn to venture capital firms and angel investors for capital.  
  • Small businesses. These are businesses with less than $10 million in revenue and they also sometimes seek out private credit loans. These small companies, including those owned by individuals, usually carry more risk than middle market companies, often because they are newer and don’t have an established operating or credit history. Because of this, a creditor may charge an even higher interest rate as a risk premium. 
  • Distressed businesses. These are companies in financial trouble, but still have the potential to produce a viable product or service. In this case, a private creditor will lend money to the business and they may even become involved in restructuring it. This type of investment requires the creditor to do a lot of research and commit a significant amount of resources to try to minimize the risks involved. 
  • Real Estate. In this case, a private creditor will issue a mortgage loan as opposed to a bank. The private creditor will hold the borrower’s real estate as collateral. If a borrower defaults on the loan, the creditor has legal grounds to seize the property used as collateral. Because these loans are backed with a physical asset, private credit real estate  loans are sometimes less risky. 

Who typically invests in private credit? 

The private credit market is dominated by institutional investors with large sums of money to invest—mostly pension funds, university endowments, and charitable foundations. Institutional investors like private credit because they get paid a so-called liquidity premium. This means that they receive interest rates that are above other market rates because the money they invested is illiquid and not readily available for other uses.

Institutional investors may not be as concerned with liquidity as individual or corporate investors are because their mandate is to invest for the long term. Most pension funds, endowments, and foundations keep the majority of their assets invested, with only a small percentage of assets under management being taken out of the funds each year for payouts. 

Other investors have a harder time investing directly in private credit due to minimum investment requirements and other qualifications, such as accreditation. However, some retail investors are able to gain exposure to private credit through business development companies. These are companies that specialize in investing in small, medium sized, and distressed private companies. Some business development companies focus specifically on private credit and some are publicly traded, making them accessible to retail investors. 

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Potential benefits of investing in private credit

Investing in private credit brings several possible benefits including: 

  • Higher rates. Many borrowers are willing to pay a higher interest rate to make up for the lack of liquidity inherent in private credit. 
  • Diversification. Investing in private credit can be a way for investors to diversify their portfolios. Private credit is often less correlated with public markets—meaning they don’t rise or fall at the same time—because of the long term and illiquid nature of the asset class. 
  • Legal protections during bankruptcy. In the event that a borrower goes bankrupt, the borrower is usually obligated to pay its creditors first, before it pays its shareholders. This can make private credit more appealing to some investors. 
  • Predictable returns. Private credit returns are more predictable than equity returns, since they usually are set at agreed upon interest rates and repayment plans. This is sometimes attractive to investors who value a reliable flow of payments. 

Risks of investing in private credit

Investing in private credit also comes with several potential risks such as:

  • Default. As with any loan, there is always a risk that the borrower defaults. However, with private credit, this risk may be even higher because the borrowers are often considered too shaky for traditional bank loans. 
  • Lots of background work. To make sure a particular borrower will not default, lenders must spend a lot of time and resources to dig into a particular borrower’s financial condition and assess the risk. 
  • Liquidity risk. Private credit loans often take years, and sometimes even decades to mature. During this time, the lender has no way of accessing the money invested. If a lender finds itself in financial trouble and needs to raise cash, this lack of liquidity could become a serious problem. 

The bottom line

Private credit is a type of lending to businesses and individuals who can’t get loans through a traditional bank or public debt markets. These loans are often illiquid, and as a result, the main participants are large institutional investors that can afford to have funds tied up for long periods of time. Private credit also comes with a higher risk that the borrowers will default, so they often pay relatively higher interest rates. Because traditional banks were subject to tougher lending standards after the Great Recession, the demand for private credit has boomed.

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