Understanding Private Credit

Private credit refers to any debt arrangement that takes place outside of traditional public lending institutions such as banks.

This includes direct lending, distressed debt, mezzanine debt, and other types of specialized lending.

In this article, we look at the concept and various aspects related to private credit.

Key Takeaways – Private Credit

• Private credit refers to debt arrangements outside of traditional public lending institutions like banks.
• It includes various types of specialized lending such as direct lending, distressed debt, and mezz debt.
• Private credit is growing as investors seek higher yields than traditional bonds, benefiting from floating rates and direct lending structures.
• Breaking into private credit requires a solid understanding of financial principles, credit analysis, and risk management. Education, experience, and networking in the financial industry can help open doors in this field.
• Private credit attracts a wide range of investors, including institutional investors, high-net-worth individuals, hedge funds, and private equity firms.
• It offers potential for higher returns and diversification, but also comes with risks such as illiquidity and higher lending risk compared to traditional loans.
• Unlike public markets, private credit lacks daily liquidity. Traders must account for longer lock-up periods and limited exit options.
• Focus on borrower quality, deal structure, and covenants to mitigate default risks.
• Monitor interest rate trends and credit spreads to anticipate shifts in risk and return.

What is Private Credit?

Private credit is a type of financing that is not publicly traded.

Instead, these loans are provided by non-bank lenders to businesses and individuals, and usually are tailored to meet specific financing needs.

This sector has grown significantly over the years as banks have pulled back from certain types of lending due to increased regulations, opening the door for private lenders to fill the gap.

Getting into Private Credit

Education and Skills

Breaking into private credit requires a solid understanding of financial principles, credit analysis, and risk management.

Typically, a bachelor’s degree in finance, economics, business administration or a related field is a good starting point. However, more advanced roles may require an MBA or CFA designation.

Experience

Prior experience in credit analysis, investment banking, private equity, or corporate finance can also be beneficial.

Entry-level roles often involve financial analysis, credit underwriting, and portfolio management.

Networking

Building relationships in the financial industry can help open doors.

Attending industry events, leveraging professional networks like LinkedIn, and staying informed about industry trends can be helpful in identifying job opportunities.

Who Invests in Private Credit?

A wide range of investors are drawn to private credit due to its potential for higher returns and diversification.

These include:

Institutional Investors

Institutional investors like pension funds, insurance companies, and endowments have historically been the largest investors in private credit.

High-Net-Worth Individuals

These individuals often invest in private credit via family offices or wealth managers, seeking diversification and higher returns than traditional bonds.

Hedge Funds and Private Equity Firms

Hedge funds and private equity are significant players in the private credit market, often establishing their own private credit funds.

The Rising Interest in Private Credit

From Fed Rates to Spreads: What’s Driving the Conversation?

Over the past decade, investor questions have shifted.

First, it was “When will the Fed raise/cut rates?”

Then came the crisis-driven baseball analogy “What inning are we in?” But for the last two years, the spotlight has turned to private credit.

Now, the focus is heavily on “spreads.”

Why? Since interest rates climbed off historic lows in 2022, credit has become a focal point for portfolios.

Investors are hungry for yield, and private credit – often touted for its high-single or double-digit returns – has surged in popularity.

Like many trading and investing allocation questions, it comes down to relative choices: What makes credit, public or private, compelling in today’s market?

The Allure of Yield in a Post-Zero World

From 2009 to 2021, yields on credit instruments were meager. High-yield bonds offered a paltry 4% in early 2022, with some issuances dipping into the 2% range.

Investors starved for returns turned to private credit, where levered strategies promised ~9% yields. Then came the Fed’s rate hikes.

By late 2022, high-yield bond spreads ballooned to over 4%, pushing total yields to 9% or higher.

The result was a better era for credit: the ICE BofA US High Yield Index delivered 8.2% in 2022 and 13.5% in 2023. But as prices rose, yields compressed.

Today, high-yield bonds yield ~7%, down from their 2022 peak.

The question isn’t just about returns – it’s about risk compensation. How much are you getting relative to the risk?

Understanding Yield Spreads: The Barometer of Risk

What’s a Spread, and Why Should You Care?

A yield spread is the premium investors demand to hold risky debt over safer alternatives (like Treasuries), essentially like an “insurance fee” against default risk.

Historically, high-yield spreads averaged 350–550 basis points (bps).

Today, they sit at ~290 bps – near all-time lows. Skeptics argue this signals complacency, though optimists counter that spreads reflect improved credit quality and central bank safeguards.

Who’s right?

The Math Behind the Spread

If a Treasury yields 5% and a high-yield bond offers 8%, the 300 bps spread must cover expected defaults.

Suppose annual defaults average 3.5%, with a 66% loss per default.

That translates to ~2.3% in annual credit losses. At 300 bps, the spread more than covers historical losses.

But the thing is that defaults aren’t evenly distributed. Crisis periods (like 1990–91 or 2008–09) skew averages upward.

Excluding outliers, the median default rate is just 2.7%. Today’s spread might be tighter, but the risk-reward math still holds – for now.

The Evolution of Credit Quality

Not all high-yield bonds are created equal. Over 25 years, the market’s credit profile has shifted:

• BB-rated bonds now make up 52.6% of the market (up from 32.7% in 1999).
• B-rated bonds dropped from 54.6% to 33.7%.

Higher-rated issuers mean today’s spreads compensate more per unit of risk than in 2007’s pre-crisis “tight spread” environment.

Active managers can further tilt the odds by avoiding defaults and minimizing losses.

Are Today’s Yield Spreads Too Thin?

Lessons from History’s Tightest Spreads

In June 2007, high-yield spreads hit a record low of 241 bps. Then the 2008 Financial Crisis threw a wrench into things.

Investors who bought at the peak saw -1.13% returns in Year 1. But over 15 years, they still earned 6.01% annually – outpacing Treasuries.

Why? Coupons matter.

Even if prices dip, interest payments cushion returns. Spread widening hurts temporarily, but contractual cash flows help.

The Case for Optimism

Central banks have rewritten the crisis playbook.

During COVID-19, unprecedented stimulus averted a wave of defaults. Today’s issuers are healthier, and lenders are savvier.

While spreads are narrow, they’re backed by stronger fundamentals. Talented active management can also sidestep landmines.

For long-term investors, today’s 7% yields still look relatively good against elevated equities’ valuations (i.e., relative to earnings).

The Resilience of Contractual Returns

Why Bonds (Still) Belong in Your Portfolio

Bonds offer something stocks can’t: better certainty.

If you hold to maturity and the issuer doesn’t default, you’ll earn the yield you signed up for – regardless of price swings. This helps smooth volatility.

Even in 2007’s worst-case scenario, high-yield investors eked out positive long-term returns.

The Hidden Engine: Reinvestment Risk

Bond math has a twist: reinvesting interest payments.

If spreads widen and yields rise, then you can compound faster, assuming you have cash to deploy.

Private Credit vs. Public Credit: Weighing the Pros and Cons

The Allure of Illiquidity

Private credit’s appeal is simple: higher yields (8–12%) and leverage. But illiquidity cuts both ways.

Without daily pricing, volatility hides – until it doesn’t.

Private lenders also face “extend and pretend” temptations, delaying defaults via loan modifications.

The Transparency Trade-Off

Public credit’s mark-to-market volatility terrifies some investors. But transparency forces discipline.

Private credit’s smoothed valuations may feel artificially comforting, but they obscure risk.

The Fee Factor

Private credit fees are steep: 1–2% management fees + 10–20% performance cuts. Public credit ETFs usually charge 0.3–0.5%.

Over time, fees erode returns. For example, a 2% fee on a 10% gross return leaves 8% net – barely edging out public markets.

Credit vs. Equities: Where’s the Better Opportunity?

The Case for Credit Over Stocks

High-yield bonds, at 7–8%, can often be better than stock yields and are almost always above Treasury yields.

Even adjusting for defaults, credit’s contractual returns can outshine equities’ uncertain prospects.

Since 1986, high-yield bonds returned 7.83% annually vs. 5.14% for Treasuries – proof that risk premiums pay off.

Volatility’s Double Standard

Stocks can plunge 30% in a bad year. High-yield bonds? Even in 2008, the index fell ~26% – but coupons softened the blow.

For pension funds and retirees, credit’s steadier cash flows can be a positive thing, rather than relying on the appreciation of equities.

Pros and Cons of Investing in Private Credit

Like all investments, private credit has its pros and cons.

Pros

High Potential Returns

Private credit often provides higher returns compared to traditional fixed-income investments due to its illiquid nature and the higher risk involved.

Diversification

Private credit can offer diversification benefits as it is not always correlated with public markets.

Stable Income

In the right opportunities, private credit can provide stable income with a high chance of the borrower paying the loan.

Cons

Illiquidity

Private credit investments are typically illiquid, meaning they cannot be easily sold or exchanged for cash without a substantial loss in value.

Risk

Private credit carries higher risk than traditional lending as it often involves lending to businesses that may not qualify for traditional loans.

In certain cases, there are great opportunities that the banks can’t do for regulatory reasons.

However, there are also the cases where the borrowers’ ability or willingness to pay means they are simply too risky to lend to and it’s unlikely to make a good investment.

How Private Credit Is Like Equities

Some types of loans are structured in a way that makes them much riskier, offering higher returns, and blurring the line between traditional debt and equity investments.

Key Ideas

• Creative Collateral – Lenders are willing to accept a wide range of assets as collateral, not just the typical stuff like buildings or equipment.
• Cash Flow is #1 – If something generates a relatively predictable income stream, lenders can come up with a way to value it, regardless of how outlandish it may seem.
• Less Precision with Debt – While stocks in industries like biotech or space exploration can have uncertain outcomes, those investments at least have potential for unlimited growth. Debt, conversely, has a limit on how much you can make back. This makes lenders demand higher returns when risks are big.
• Weird Deals Mean High Returns – These riskier loans often provide returns that are more typical of leveraged equity investments (mid-teens). This can seem unique because you’re expecting a predictable debt outcome but taking on the riskiness usually seen in stocks.

Analogy

Think of it like lending money to a friend.

• Traditional Loan – You lend your friend money to buy a car. The car itself is the collateral. The loan terms are clear, and you expect your money back plus a bit of interest.
• Risky “Weird” Loan – You lend your friend money to start a lemonade stand. The income is uncertain, so you charge a much higher interest rate to make it worth the risk.

Bottom Line

Lenders are getting creative, which means more possibilities for borrowers but also increased risk for the lenders and potentially higher returns that feel more like investing in a business than traditional lending.

Conclusion: Navigating Credit in Today’s Market

The Bottom Line

Credit isn’t a free lunch, but it’s a compelling meal. Public markets offer liquidity and transparency; private markets promise illiquidity premiums. Both have roles in a diversified portfolio.

A Balanced Approach

Instead of fixating on spreads, focus on total return potential. Today’s 7% high-yield yields and private credit’s 9–12% levered returns beat equities’ shaky forecasts. But tread carefully: avoid overpriced assets, demand lender protections, and diversify across sectors.

Final Thought

As Warren Buffett warns, “Only when the tide goes out do you discover who’s been swimming naked.” Private credit’s test is coming. Until then, let coupons compound, spreads normalize, and fundamentals guide the way.

FAQs – Private Credit

Why is the private credit market growing so rapidly?

The private credit market has grown rapidly in recent years due to a variety of factors.

Traditional banks have become more constrained due to tighter regulations following the 2008 financial crisis.

This has opened up opportunities for private lenders to fill the gap, particularly for middle-market businesses and certain real estate projects that may find it difficult to secure traditional bank financing.

What is the difference between private credit and private equity?

While both private credit and private equity fall within the realm of private capital, they represent different investment strategies.

Private equity involves purchasing equity, or ownership stakes, in companies, often with the aim of improving their performance and selling them at a profit.

Private credit, on the other hand, involves lending to companies, with the loans typically secured by the companies’ assets.

How do private credit funds mitigate risk?

Private credit funds mitigate risk through rigorous due diligence and credit analysis before making a loan.

This can include analyzing a company’s financials, market position, and management team, as well as structuring the loan to include protective covenants.

Additionally, because loans are often secured by the borrower’s assets, the lender may have a claim on these assets if the borrower defaults.

What is the typical duration of a private credit investment?

The duration of a private credit investment can vary significantly depending on the specific type of loan.

Direct lending deals, for example, usually have a term of 3-7 years (sometimes less, sometimes more, depending on the deal). Longer durations are more common in infrastructure or real estate financing.

(Also, the longer the lead times between capital issuance and paybacks, the more likely the public sector will be involved, given they’re less concerned about investment returns relative to private sector participants.

This is why the government tends to be so heavily involved in infrastructure projects.)

Moreover, it’s important to remember that these investments are often illiquid, meaning they can’t be easily sold or exchanged for cash.

What type of returns can I expect from investing in private credit?

Returns in private credit can vary significantly based on the risk profile of the loan, the borrower’s industry, prevailing risk-free rate (i.e., cash and government bonds), and market conditions.

However, because private credit entails higher risk compared to traditional bank loans, investors generally expect higher returns to compensate for this risk.

What are the tax implications of investing in private credit?

The tax implications can vary greatly depending on your personal circumstances, the jurisdiction you’re in, and the specific structure of the private credit investment.

Interest income from private credit is typically taxed as ordinary income. It’s recommended to consult with a tax advisor before making any investment or financial decisions.

Is private credit a good fit for my portfolio?

The answer to this question depends on your individual investment goals, risk tolerance, and liquidity needs.

While private credit can offer higher returns and diversification benefits, it also carries risks and is typically illiquid.

A financial advisor can help determine if and how private credit might fit into your overall investment strategy and what instruments or strategies are available to do so.

Conclusion

Private credit is a significant and growing part of the global financial landscape.

While it presents an opportunity for higher returns, it also comes with unique risks and challenges.

As such, it’s important for both those seeking to enter the field professionally, and those considering investment in private credit, to conduct thorough due diligence and potentially seek advice from financial professionals who have a track record of success in the field.

With the right knowledge and approach, private credit can be a lucrative and rewarding sector.