Private credit is loans extended to projects or companies. Unlike corporate bonds and other types of public credit, private debt is not publicly traded. Individuals can invest in them through funds. It can take several legal forms, such as bonds, private securitisation issues, notes or loans, while also encompassing different strategies, such as distressed debt, real estate debt, direct lending, structured financing and mezzanine financing.
For a long time, investments in private credit was restricted to institutional investors and ultra-high net worth individuals. It has only been in recent times that it has become accessible to retail investors, driven by the increase in individual investor fund structures, like interval funds.
Following the credit crisis of 2008-2009, private debt funds have seen robust growth, rising from about $70 billion in 2006 to hit a record high of $235 billion in 2018, according to a report by Preqin. A large part of this growth can be attributed to the post-recession era, when low interest rates led to premium yields for private credit investments. In addition, with banks scaling back their lending activity, following the restrictions imposed by Basel III and Dodd-Frank, private credit found many more takers.
Although the situation is very different today, with rising interest rates and economic recovery globally, this asset class continues to hold its attraction. In fact, private credit has proven to be a very effective way to diversify investment portfolios. And, given the large variety of choices available for private credit investment today, there is something available at every phase of the credit cycle. This is a way to balance risk and reward, rather than attempting to time the market.
In fact, following the 2008 crisis, private credit gained popularity because it offered better yields than public debt instruments, which suffered due to record low interest rates, kept artificially low by central banks to stimulate consumer spending. Private credit, with low-to-moderate correlation with traditional instruments and market inefficiencies, offered another investment avenue.
According to a 2018 survey by the Alternative Investment Management Association (AIMA), the global assets under management (AUM) for the private credit asset class is expected to reach a whopping $1 trillion by 2020.
The first and foremost reason for investing in these funds is the potential for significantly higher yields than public debt instruments, albeit at a higher risk too. However, returns on private credit have historically been less impacted by changes in interest rates, remaining positive even during times of rising rates. On the other hand, returns on public debt, such as high-yield bonds, tend to turn negative under these conditions.
Another advantage of investing in these funds is that they may provide an opportunity to earn what is known as ‘illiquidity premium’. Since investments in these funds are usually locked-in for a specific period of time, investors may be rewarded for keeping their money through periods of illiquidity, hence the term, illiquidity premium.
Private credit offers quite a broad range of investment choices, from distressed debt to core direct corporate debt, asset-backed, specialty finance and structured finance. Each type of investment tends to do well at different phases of the credit cycle. For instance, mezzanine and core direct debt tend to outperform during the expansionary phase, while distressed debt does better during recession or contraction phases. Investment in private debt, therefore, offers a means to weather different market conditions.
At the same time, it is important to remember that this asset class is not immune to interest rate or credit cycle risks. There could be times when investors receive little or no returns. Also, these funds employ high leverage, which usually means higher risk. So, while investing in such instruments, it is important to do the groundwork and choose a fund managed by a skilled manager, who effectively identifies opportunities, while also efficiently managing risks.