What is private credit?

Private credit is, broadly speaking, an investing strategy where money is lent to companies which don’t have, or want, access to the public credit markets. Oftentimes, these are smaller companies or private-equity backed firms which don’t want to deal with the disclosures and expenses associated with issuing more widely-available debt.

There is one other key detail present in most private credit funds: leverage. Typically, private credit managers borrow money against their portfolio in order to make more loans than they would be able to with just the cash invested in their fund. When there are many opportunities to lend money at a higher rate than you are paying to borrow it, this can enhance returns.

How risky is it?

We expect the returns of private credit over a long period of time to be comparable to the returns associated with similar equity markets. Since the returns you earn on an asset are roughly in line with the risk you take, one way to think about private credit is that it’s about as risky as equities over the long term. However, since private credit funds don’t get marked-to-market as often, this risk may not show up over shorter periods in the same way as it does in equities. The returns of the asset classes over the past ~20 years shows this dynamic; the full-period returns are comparable, but private credit has a smoother path:

Source: Bloomberg. Private Credit is the Cliffwater Direct Lending Total Return Index. World Equities is the MSCI World Index. Returns are gross of fees. Past performance is not indicative of future results. Data from September 2004 - December 2022.

When considering the specific risks that drive the return of a private credit fund, the most important one is the creditworthiness of the companies being lent to. Since the strategy relies on making loans to generate income, if a company is unable to make interest payments or goes bankrupt, missed interest payments and/or loss of principal can occur. 

Private credit managers take different steps to mitigate this risk, including securing a higher priority in the capital structure (i.e., getting paid before equity holders in bankruptcy), negotiating information rights and/or a role in management, and trying to find companies which will remain creditworthy under a variety of economic conditions. 

Historically, credit losses in middle market private credit and syndicated bank loans have been lower than losses in the high yield bond market. Loans that are part of a private credit portfolio typically have better metrics than broadly-available fixed income of comparable yields along dimensions like loan-to-value (LTV), which measures the amount of debt relative to the value of the company; interest rate coverage, which measures how much income companies generate relative to their interest payments; and “turns” of debt, which measures how much debt the company has relative to its income. 

Another key risk of private credit is liquidity risk; since the underlying loans in a private credit fund aren’t publicly-traded, there is no market for them. Private credit funds can’t handle the same amount of inflows and outflows that a highly-liquid portfolio like an ETF can, so investors sometimes face restrictions around withdrawals in periods of stress.

One risk that is commonly associated with fixed income investments that is not a first-order risk of private credit is interest rate risk. Although rising interest rates can affect the ability of underlying companies to make their interest payments and affect their creditworthiness, it does not directly impact the principal value of private credit funds, since they hold “floating rate” loans, which are benchmarked to central bank interest rates. So, unlike the rest of your bond portfolio, interest payments will rise when interest rates rise and principal value is unaffected.

What is its role in a portfolio?

Good portfolio construction consists of combining risky assets that have fundamentally different drivers of performance. Private credit can perform well at different times than other common assets, and offers a high yield for clients who want their portfolio to distribute significant amounts of cash. That said, it is a risky asset and is not not a substitute for cash or cash equivalents because of its lack of liquidity and potential for loss. 

If you have any questions about private credit, you can reach out to one of our Portfolio Managers with any questions.