Investors are almost always looking for ways to increase their returns and hedge against risk, often through diversification. One asset class that has increasingly been used to achieve these goals is private credit, a type of lending by investment funds to companies—and in some cases individuals—that can’t secure traditional bank loans.

Many investors see private credit, a type of alternative investment, as a useful hedge because its performance has little correlation with the short-term moves of the stock market. Private credit—sometimes known as private debt—also tends to offer higher returns than investments in public markets.

Private credit strategies

There are multiple strategies that can be used to invest in private credit markets depending on the risk tolerance of the investor.

Capital preservation

Strategies that take a more conservative approach to investing generally are designed to preserve capital. As the term suggests, the goal is to avoid losses, which often entails taking less risk. As a trade off, however, investors usually expect lower returns. There are two main private credit strategies that investors use to preserve capital: 

Senior lending.

The most risk averse way to make a private credit loan is as a senior lender. This debt is considered “senior” because the borrower is obligated to pay these lenders first should it file for bankruptcy. Senior debtors are often entitled to take ownership of collateral like real estate or business inventory if the borrower defaults. An investor may also serve as a secondary lender, which means that the lender would be later in line to receive repayment should the borrower go bankrupt. Senior lenders might receive lower interest rates because their positions are the least risky. 

Mezzanine debt.

This is a hybrid strategy that involves both private credit and private equity, or taking an ownership stake in the borrower. In general, the bulk of returns from mezzanine strategies come from debt, not equity. However, the expectation is that by leveraging credit to give the business more capital, the business will succeed and the investor will also receive returns on the equity. These contracts can last as long as 10 years and are relatively illiquid. Middle market companies are the most likely to use mezzanine structured deals. 

Return-maximizing strategies

Some investors prefer more aggressive strategies that can offer high returns by accepting more risk. There are several private credit strategies that these investors turn to including:

Distressed credit.

In this situation, a private credit fund will seek out a company that is in financial trouble but still provides a valuable service or product. The goal is to either restructure the company to return it to profitability or collect payouts if it declares bankruptcy. Because of their desire to change the borrower’s fundamental structure, private credit managers may have a hostile or competitive relationship with a company’s leadership. Sometimes, a private creditor will buy a company’s debt in small increments to prevent the company’s owners from realizing that the creditor is attempting to take control of a majority of the debt. 

The secrecy and competitive nature of distressed debt investing can make this a high-risk strategy. However, the risk can pay off if the debtor successfully restructures, reducing the chance of a default while still continuing to pay high interest rates agreed upon under the original loan terms. 

Small business credit.

Sometimes small businesses and other smaller middle-market companies are willing to pay significantly higher interest rates to access capital. These companies are usually riskier than larger middle-market companies, so an investor will try to invest in a large number of them. The hope is that the high-interest rate paid by some of the companies will offset some of the businesses that default on their debts.

Other strategies

There are many other strategies that investors can use when it comes to investing in private credit. 

• Opportunistic real estate.

  These are investments in real estate or properties that require significant enhancements. For example, an investor might lend to a developer who wants to buy a plot of land with a plan to build an apartment complex on it.

• Value-added real estate.

  This is a loan to a real estate investor who intends to make improvements to a property and then resell it. 

• Secondaries.

  An investor can sell their stake in a private credit contract to another investor for the sake of liquidity. ‍

• Impact investing.

  Some investors may seek to make loans to businesses that they believe will contribute to the social good of a community. These loans are often made to small businesses in emerging markets or businesses that seek to solve major social problems like climate change.

The investment process

Private credit firms make loans to companies and individuals on behalf of investors. A private credit manager will go through several steps when making an investment decision. 

Step 1: Building relationships 

A private credit manager will build relationships with  asset managers, business owners, and investors. Because private credit opportunities are not open to the public, having a network of people that a manager knows is a key component of finding out which companies might be seeking funding and which investors might be appropriate for participating in a loan. 

Step 2: Research

Once a manager finds an investment opportunity, they must spend a significant amount of time researching the company or individual seeking the loan. This stage is critical because this is when the manager assesses a borrower’s risk of default. Thorough research might show that the company is less risky than its credit rating implies. On the flip side, the manager could also find out that a company is offering an interest rate that is too low to adequately compensate for the risk of default. During the research stage, managers are trying to gain superior insight into risk with the goal of achieving above-market returns. 

Step 3: Underwriting a loan

During this stage, a manager signs a contract agreeing to lend to the borrower using funds supplied by investors. Usually, a manager arranges this agreement on the behalf of several or many different investors. Sometimes, depending on the private credit strategy used, a manager will also agree to invest in the equity of a company or participate in the company’s restructuring. 

Step 4: Following through

Depending on the type of contract signed, a manager may implement changes to a company’s structure. The private credit firm will make sure that payments are being made on time and may intervene if issues arise throughout the duration of the contract. 

The bottom line

There are many different strategies that investors can use when deciding how to approach the private credit market. These strategies range from relatively low-risk senior lending to high-risk distressed credit opportunities. Ultimately, the outcome of any given strategy depends on a combination of both luck and the research conducted by the private credit firm. Most private credit firms want a deep understanding of the borrower to maximize their chances of success.