Understanding Private Credit

Over the past two years, we’ve shared several viewpoints on private markets and their potential role in a diversified portfolio. While these pieces provide an overview of private markets, they also highlight three key areas of focus for our team: private credit, private equity, and private real estate. If you’re unfamiliar with these categories, you might be wondering what each one entails. Let’s begin by taking a closer look at private credit.

In the simplest terms, private credit is a broad category of lending where the capital comes from private investors rather than public banks or bond markets. 

Since the Global Financial Crisis and the implementation of Dodd-Frank and Basel III, banks have retreated from middle-market lending due to tighter regulations. This has created an opportunity for private lenders to step in, often with the ability to underwrite bespoke loans that are tailored to the borrower’s needs, while providing attractive returns to investors.

Private credit involves non-bank institutions—such as investment funds—lending money directly to businesses or against specific assets. The flexible nature of private credit funds allows them to focus on aspects other than just cash flows when underwriting. These loans are not publicly traded, meaning they are typically illiquid but offer a premium in yield and a flexible structure compared to traditional public bonds or syndicated loans. 

As such, private credit has the potential to play an important role in portfolio construction by creating a further diversified set of exposures with the potential to augment traditional bond yields. Private credit is a diverse asset class, but we focus on three key strategies: sponsor-backed direct lending, asset-backed lending and real estate debt (this strategy will be covered in an upcoming private real estate piece). Each has distinct characteristics, but all three aim to generate consistent, risk-adjusted returns through critical underwriting and private origination.

Sponsor-Backed Direct Lending 

One of the more established forms of private credit is sponsor-backed direct lending. This involves loans to companies owned by private equity firms. In these transactions, private credit funds provide loans—typically senior secured—for the purpose of financing acquisitions, general capital expenditures, or refinancing. These loans are usually negotiated privately, offering flexible terms and faster execution than traditional bank financing. Additionally, they tend to be floating rate and involve covenants to protect the lender.

The involvement of a private equity sponsor is seen as a positive factor, as they often have operational expertise and have a vested interest in the company’s success. Because the sponsor’s equity sits below the lender in the capital structure, they absorb the first losses, providing a cushion to the lender, in the event of a downturn in the business. In addition to credit and liquidity risk, the lender (investor) also faces leverage risk, which is another reason there are higher yields associated with private credit. Put another way, risk and return are inextricably linked. If you are receiving higher yields, you are being compensated for higher risk. This is not necessarily something to be avoided, it just needs to be accounted for in context of the overall portfolio.  

Asset-Backed Lending 

In contrast to lending based on a company’s cash flow, asset-backed lending involves loans secured by specific assets—such as real estate, equipment, receivables, inventory or even intellectual property. A few examples would be financing a company’s heavy machinery fleet, buying accounts receivable from a credit card portfolio or inventory financing for a lower middle market company that doesn’t have access to a regional or super regional bank. If the borrower fails to repay, the lender has recourse through the collateral. This collateralization helps reduce downside risk and can allow lenders to extend credit to borrowers with more complex profiles or niche financing needs. By utilizing a single lender, companies get the benefit of speed and certainty of execution versus utilizing a syndicated bank loan.  

Why Allocate Towards Private Credit? 

Utilizing private credit can complement a traditional bond portfolio in several ways. The first characteristic that catches most people’s eye is the potential for enhanced returns. As previously mentioned, yields are typically higher than those received from publicly traded bonds, compensating for the illiquidity and complexity of the investment. Because we are lending to a different set of businesses and the loans themselves have unique structures, introducing private credit provides increased diversification in your portfolio. Both direct and asset-backed lending exhibit low correlation to stocks and traditional corporate bonds. Because the returns of these products are driven by income, not capital appreciation or projected growth, they have proven resilient and performed consistently across different rate cycles and macro environments.

Evaluating Private Credit 

While private credit can be a good investment for many investors, it is not without risks. Most prominently we highlight the illiquidity, credit risk, and valuation risk; illiquidity is of a primary focus. Private credit funds generally offer quarterly liquidity but only up to 5% of the total fund. So, while a redemption request may be submitted and honored at 100%, it is also possible that it could be a lengthy process to receive your redemption in full. Investors should be aware that these gates serve as protection for both investors and the fund.  

While asset-backed lending funds are often considered investment grade or investment grade equivalent, direct lending is more closely related to high yield bonds and the leveraged loan market. This increased credit risk is what helps drive the higher returns. Because of this, partnering with a manager who exhibits high level selection and underwriting discipline is paramount. Included in this, we seek managers with a documented history of strong sourcing, structuring, monitoring and workout experience.    

For clients looking to diversify their bond holdings and potentially generate enhanced returns, private credit offers a compelling option. Whether through direct lending to established sponsor-backed companies or by utilizing asset-backed financing against specific, tangible assets, private credit can serve as a complement to traditional bonds and stocks within a well-constructed portfolio. 

As always, we want to assess each client’s liquidity needs and risk tolerance before recommending an allocation to private credit. If you’re interested in exploring how private credit might fit into your portfolio, please reach out to your advisor to discuss the opportunities available in more detail.