Understanding Private Credit

What is private credit? 

Private credit (also known as private debt) has become a prominent alternative investment strategy and refers to debt financing provided by non-bank entities to borrowers, typically private companies or high-net-worth individuals. Private credit has gained traction among institutional investors seeking to diversify their portfolios and achieve attractive risk-adjusted returns.  

Private credit has outperformed traditional fixed income investments significantly and Preqin predicts the market will grow from $1.6trillion (in 2023) to $2.8trillion, with BlackRock forecasting growth to $3.2trillion.  

This article delves into the key drivers contributing to its growth over the years. 

What's driving the growth of private credit? 

The move away from traditional bank lending: Private credit has rapidly grown since the 2008 crisis due to the reduced appetite of banks to lend to smaller or riskier borrowers. 

Direct lending relationship for borrowers: From the borrower’s perspective, private credit comes with greater customisation of loan structures as well as longer maturity profiles to match their financing needs. They are also attracted to the private debt arena by the speed, flexibility and predictability displayed by private lenders in comparison to banks. 

Enhanced Yield Potential: Private credit investments typically offer higher yields compared to traditional fixed-income securities, reflecting the illiquidity premium and the additional credit risk assumed by lenders. A report on Bloomberg notes that loans in the private credit market are usually more lucrative than those to bigger or ‘safer’ companies, with all-in yields of 7%–9%, compared to 3% for the typical investment-grade corporate bond, making it more appealing for lenders. 

Tailored Solutions: Private credit offers borrowers the advantage of customised financing structures tailored to their individual needs, including longer tenures and flexible repayment terms. This flexibility has resonated with borrowers seeking alternatives to rigid bank lending criteria and standardised loan products. 

Types of Private Credit fund Strategies 

Private credit strategies encompass a wide spectrum of investment options tailored to meet varying risk appetites and return objectives of the fund. Some common private credit fund strategies include: 

Direct Lending: Involves providing financing directly to companies, often in the form of senior secured loans. Direct lenders typically conduct extensive due diligence to assess creditworthiness and negotiate terms customised to meet the specific needs of borrowers. 

Mezzanine Financing: Combines elements of debt and equity by offering subordinated debt with equity participation rights. Mezzanine financing provides higher potential returns but entails greater risk, as lenders typically rank below senior debt holders in the event of default. 

Distressed Debt: Involves acquiring the debt of financially troubled companies, often at a significant discount to face value. Distressed debt investors seek to capitalise on restructuring opportunities or asset sales to generate returns as the distressed company improves its financial position. 

Special Situations: Encompasses a broad range of opportunistic credit investments, including financing for mergers and acquisitions, recapitalisations, and growth capital. Special situations strategies require high expertise to identify and capitalise on unique investment opportunities. 

Click here for more private credit strategies you could consider as an investor > https://www.connectioncapital.co.uk/investing-in-private-debt/ 

Considerations for Investors 

While private credit investing presents compelling opportunities, investors should carefully consider the following factors and risks: 

Credit Risk Assessment: Conducting thorough credit analysis is essential to assess the creditworthiness of borrowers and mitigate default risk. Investors should evaluate factors such as cash flow stability, leverage levels, industry dynamics, and management quality. 

Illiquidity Risk: Private credit investments are typically illiquid, with limited opportunities for secondary market trading. Investors should have a long-term investment horizon and adequate liquidity reserves to meet redemption requests or unforeseen capital calls. 

Manager Selection: Choosing experienced and reputable managers is important in navigating the complexities of investing in private credit. Investors should assess track records, investment processes, and alignment of interests to select managers capable of generating consistent risk-adjusted returns. This is a market where experience counts – a manager that has built and managed portfolios through a variety of economic environments is a more attractive prospect than one who has only invested in benign markets. 

Private credit investing continues to gain popularity as investors seek alternative sources of income and portfolio diversification. By understanding the various strategies, opportunities, risks and considerations associated with private credit investing, investors can make informed decisions to effectively deploy capital in this dynamic asset class, potentially enhancing overall portfolio performance over the long term. However, it is important for investors to conduct thorough due diligence and seek professional advice to navigate the inherent risks and complexities of private credit investing successfully. 

At Connection Capital we offer our professional clients the opportunity to gain exposure to private credit either through direct investment in UK SMEs or through specialist private credit investment managers. If you would like access to private credit transactions, you can register to join our syndicate.