Introduction to private credit

Key takeaways

• Private credit involves non-bank lenders providing loans directly to companies outside of public markets, often with more structural protections.
• Private credit can be a compelling alternative to traditional fixed income investments while also presenting historically lower risk than other alternative asset classes.
• Investors seek to trade off lower liquidity and higher complexity to enhance yields and total returns relative to public markets.

What is private credit?

Private credit is a form of debt in which non-bank lenders, such as asset managers, loan capital directly to borrowers who cannot access financing from banks, or want more flexible, customized solutions that public markets do not offer. These loans are not traded in public markets.

Private credit has grown significantly after the Global Financial Crisis (GFC), when regulatory changes caused banks to pull back from leveraged lending. Now, with more companies staying private for longer and needing capital to support their growth, acquisitions and leveraged buyouts, private credit managers are stepping in to help fill the financing void.

How does private credit work?

In private credit markets, companies access financing directly from lenders. This differs from companies transacting in syndicated high-yield or bank loan markets, where financing is obtained with the help of a bank or intermediary.

Private lending happens through direct negotiation; lenders partner with borrowers to create bespoke solutions that address companies’ unique needs. By working directly with borrowers, private credit lenders have more flexibility to negotiate terms, covenants and pricing. This can lead to better protections and higher yields for investors relative to public credit markets. Borrowers can work with lenders to craft loan terms for their specific needs and access flexible capital faster and more easily.

Private credit loans typically use a floating rate structure, where the cash coupon of the loan is reset as interest rates change. These loans are often structured with reference interest rate floors that provide additional yield protection in very low-interest rate environments.

What are the primary categories of private credit?

Private credit strategies cover a range of risk and return profiles and private credit funds can differ by strategy, the type of debt provided, and position in the capital structure. Capital structure refers to the way a company is financed based on the proportion and type of debt and equity on its balance sheet. This determines how, and in what order, capital is repaid in the event of bankruptcy. For example, senior debt is at the top of the capital structure and repaid first, making it lower risk, while junior or subordinated debt sits near the bottom of the capital structure just above equity, which is repaid last. Strategies with lower risk typically provide lower return than those with higher risk.

Three common private credit strategies are:

Direct lending. Provides senior debt financing, often in the form of secured loans, to “middle market” companies with enterprise values between $100 million and $2.5 billion. Returns are driven primarily by income. Historically, direct lending has been the most widely used strategy in the private credit space.

Opportunistic credit. Focuses on debt investments driven by corporate transformations or market disruption. Returns are typically higher than in direct lending but lower than in special situations and distressed investing.

Special situations and distressed debt. Targets companies facing unique circumstances, including businesses showing signs of stress or distress as well as healthy, growing businesses that face legal complexities, time-sensitive capital needs, or other factors that make conventional financing unavailable. These strategies may involve a broader range of instruments and risk profiles. Returns are typically driven by income, price appreciation or equity participation.

Private debt investments are less liquid and more complex than traditional assets, which can create hurdles for individual investors. That said, illiquidity and complexity premiums (the compensation for these higher risks, in the form of higher return potential or attractive negotiated rates) can be a useful tool in portfolio construction to offset more traditional risk exposures

Why invest in private credit?

Private credit can be a compelling alternative to traditional fixed income investing and has historically demonstrated lower risk compared to other alternative asset classes, such as private equity, given its higher position in the capital structure.

Potential benefits of private credit investing include:

1. Higher income and return potential. Historically, private credit has offered higher income and total return than traditional loans and high yield investments, as illustrated in the chart below.
2. Diversification through an expanded opportunity set. With more companies staying private for longer and needing capital to support their growth, private credit can offer access to opportunities unavailable in public markets. Investing across public and private markets can offer portfolio diversification through exposure to differentiated income and return drivers.
3. Structural protections. Fixed income investments often involve lender protections known as covenants; private credit typically relies on more covenants than public fixed income, and covenants can be flexibly negotiated and renegotiated.

Individual investors often have less exposure to private credit than institutions, but new structures such as interval funds, business development companies (BDCs), and managed accounts are making access easier.

What are the risks of private credit investing?*

Private credit investments involve market, credit and operational risks. Private loans are typically less liquid than publicly traded bonds and may offer limited transparency given that they are not subject to public reporting and regulatory requirements. Because private credit investments are not actively traded, investors expect higher returns as compensation for reduced liquidity and increased complexity.

Private credit offers investors a differentiated way to access income and diversification by lending directly to companies outside of public markets, often with stronger structural protections than traditional credit. While these investments involve lower liquidity and greater complexity, investors have historically been compensated through higher yields and attractive risk-adjusted returns. For those able to tolerate these trade-offs, private credit can play a valuable role alongside traditional fixed income in a diversified portfolio.