Private credit is a type of financing that non-bank financial institutions or private investors provide to entities that are not publicly traded, including companies and individuals. It can be used for acquisitions, expansions, capital expenditures, or short-term liquidity needs.
Private equity firms, hedge funds, and other alternative investment managers typically offer these strategies, which can include senior secured loans, mezzanine debt, distressed debt, and direct lending. Compared to traditional bank loans, private credit often involves higher interest rates and fees, as well as fewer regulatory requirements, making it a popular option for borrowers who do not meet strict traditional lending criteria.
Private credit investors aim to generate attractive returns by providing financing to borrowers who have limited access to traditional sources of credit or who seek more flexible terms. Private credit investments have become increasingly popular, as investors search for diversification, with low correlation to other asset classes such as stocks and bonds. However, private credit also carries risks, such as fraud or default due to a lack of regulation and oversight. Investors should carefully evaluate the creditworthiness of borrowers and the terms of any private credit investment before committing capital.
Benefits and Risks of Private Credit Investing
Yield: one of the key benefits of private credit investing is the potential for higher returns than traditional fixed-income investments. Private credit investments typically offer higher yields than publicly traded debt securities, as they are often riskier and less liquid.
Diversification: private credit investments can also provide diversification benefits to a portfolio, as they are not correlated with traditional equity and fixed-income investments. This can help to reduce overall portfolio volatility and provide downside protection in times of market stress.
Risk Management: private credit investing is the ability to negotiate the terms of the investment, such as covenants and collateral, which can provide additional protections for the investor.
Despite the potential benefits of private credit investing, there are also risks involved that investors must carefully consider.
Credit: one of the main risks of private credit investing is the credit risk associated with the underlying borrower. Private credit investments are typically made to privately held companies that may have weaker credit profiles than publicly traded companies. As a result, there is a higher risk of default and loss of principal.
Lack of liquidity: these investments are often held to maturity and cannot be easily bought or sold on public exchanges, which can make it difficult for investors to exit the investment.
Complexity: private credit investments are often complex and require specialized knowledge and expertise to underwrite and manage. As a result, investors must be able to conduct thorough due diligence and work with experienced managers to properly assess and manage the risks involved.
Historical Return and Risk
The average return target and risk for private credit can vary depending on the specific strategy and underlying investments. However, according to a report by Preqin, a leading provider of data and intelligence on alternative assets, the net return for private credit funds over the past 10 years has been 7.0% annually, with a range of 5.5% to 9.5% depending on the fund size and vintage year.
Also, a study by Cambridge Associates found that private credit as an asset class had an annualized return of 7.9% over the 15-year period ending in 2020. This compared favorably to the annualized return of 6.0% for U.S. high-yield bonds and 5.2% for U.S. investment-grade bonds over the same period.
In terms of standard deviation, the same study found that private credit as an asset class had a standard deviation of 5.6% over the same 15-year period, compared to 8.0% for U.S. high-yield bonds and 4.0% for U.S. investment-grade bonds.
In terms of default risk, private credit investments can be riskier than traditional fixed-income investments, as they are typically made to privately held companies with weaker credit profiles. The default rate for private credit investments can vary depending on the specific strategy and underlying investments, but it is generally higher than that of publicly traded debt securities. According to a report by S&P Global Market Intelligence, the 12-month trailing default rate for private credit investments in Q4 2021 was 3.4%, compared to 1.1% for publicly traded high-yield bonds.
Navigating Complexity: Why Working with a Best-in-Class Manager is a Must
To mitigate the risks associated with private credit investing, it is crucial for investors to seek out experienced managers who possess a track record of successfully managing such investments. These managers can assist in identifying appealing investment opportunities, conducting comprehensive due diligence, negotiating favorable terms with borrowers, and managing credit risk to minimize losses and safeguard investors' capital. The IIM Alternatives Platform has been designed to facilitate these activities for its clients.
IIM Alternatives Platform
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The IIM Alternatives Platform offers qualified clients an unparalleled opportunity for access to marquee funds in which some of the highest caliber institutional investors, such as the Ivy League endowments, participate. We seek to improve the risk-return profile of our client’s traditional investment portfolios through an allocation to private funds, including hedge funds, private equity, and private credit. Through the firm’s partnership with Crystal Capital Partners (CCP) clients have access to many of the industry’s largest and most well-recognized alternative investment funds, at significantly lower minimums.
The CCP investment team conducts an initial screen to identify institutional private fund managers that have displayed their ability in navigating multiple market cycles, have proven track records, enhanced risk management frameworks, and deep teams. The investment committee, which has been intact for over 25 years, then reviews the recommendations on an ongoing basis.
IIM provides a final layer of client specific analysis, delivering a custom recommendation based on current holdings and unique objectives. The result is a sophisticated and highly customized investment solution comprised of top institutional investment managers.
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Preqin, "2021 Preqin Global Private Debt Report," (https://www.preqin.com/insights/reports/2021-preqin-global-private-debt-report/37468)
Cambridge Associates LLC. Private Credit as a Growing Component of Institutional Portfolios. February 2021.
S&P Global Market Intelligence, "US Private Credit Default Rates and Recoveries: Q4 2021," (https://www.spglobal.com/marketintelligence/en/news-insights/research/us-private-credit-default-rates-and-recoveries-q4-2021)