How to Invest in Private Credit: Maximizing Your Returns
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Private credit investments have recently garnered significant attention. In essence, private credit entails investing in a company through a loan, which is subsequently repaid within a defined timeframe and at a prearranged interest rate. This investment avenue presents investors with consistent distributions and a path to returns within a relatively short time frame.
Now might be the right time to take advantage of private credit.
Understanding the benefits of private credit investing is only one aspect. To optimize returns, one must also acquire the knowledge to invest in private credit.
Key Highlights
- There are numerous private credit investment strategies, with the most common being senior secured loans, asset-based lending, distressed credit, and mezzanine.
- Investors interested in gaining exposure to this fast growing asset class may invest through an experienced fund manager, a platform that specializes in private credit or directly into a single company opportunity.
- Finding the right partner is critical to ensure optimal returns and a prudent risk approach.
Private Credit Background and Investing Strategies
The private debt market has grown almost six-fold since 2010, to approximately $1.4 trillion in 2022 (Preqin). This once-considered nascent asset class has gained popularity driven both by the unique value proposition it can offer borrowers (flexibility, customization, and critical support to name a few) and increased appetite from investors seeking to diversify their portfolio and increase their allocation; as evidenced by the growth in AUM fund sizes specializing in Private Credit.
Even when analyzing the return profile, this asset class has outperformed public loans over the past decade, having delivered 10% annualized returns compared to an annualized 5% for public loans. According to another recent study conducted by Wells Fargo in June, direct lending in particular, demonstrated an approximately 8% annualized return throughout the rate-hiking cycle until mid-2023. Concurrently, other public fixed-income products experienced negative or nearly zero returns during the same period.
Private credit has become more sophisticated as it has evolved, covering an array of strategies that span capital structure and borrower type of loans, which can generate different types of returns commensurate to the risk profile. The most common strategies include:
- Senior secured loans - Typically the least risky form of private credit as they are secured by collateral and have the highest priority claim on assets in case of default. While senior loans tend to offer lower yields, higher recovery rates in default scenarios make this instrument appealing to investors seeking a more conservative approach.
- Asset-based lending – A form of financing that involves providing loans backed by tangible assets, such as inventory, equipment, and receivables. This approach adds a layer of security for lenders, as the loan is collateralized by specific, identifiable assets. Our Crowd has invested in asset-based lending funds like Upper90.
- Distressed credit – The purpose of the distressed credit strategy is to find struggling companies with still viable goods that desperately need financing. The goal here is to fund such businesses to help them restructure and increase their value. It’s a more risky private credit strategy, but it can provide very high returns. For instance, Our Crowd has invested in the Arrow Credit Opportunity fund specializing in the non-performing loans (NPL) space.
- Mezzanine – This approach combines private equity and credit investments. Such a strategy allows investors to secure returns through private credit and yield potentially higher returns through private equity financing if the company performs well.
- Venture Debt - Involves debt financing tailored for high-growth technology companies. These loans are designed to meet the needs and challenges of the technology sector, which often experiences rapid growth but may face cash flow fluctuations. OurCrowd has invested in this area through a specific medical device company, Momentis Surgical. OurCrowd has also invested in funds like the Genesis II Venture Debt Fund.
Understanding the Risks of Private Credit
Although investing in private credit is considered less precarious than investing in, for instance, private equity, it still comes with some level of risk, and one should carry out due diligence before investing in private credit.
Therefore, it is important to take into consideration the following potential pitfalls:
- Credit risk – There is always a probability that a borrower will fail to comply with the loan repayment schedule or skip an interest payment. This risk might be higher for private credit investments than for public investment grade bonds, as private borrowers are typically smaller and less financially stable.
That is why it’s crucial to implement mitigants and safety measures such as covenants and liens over the company’s assets providing investors recourse in the event the company is unable to repay. Additionally , one should analyze the financial profile of a potential borrower and their ability to generate cash with sufficient runway to determine whether they will be able to repay the loan in full.
- Asset illiquidity – Although private credit is considered more liquid than private equity, it is still an illiquid investment, meaning that it might be challenging to sell or redeem.
- Interest rate risk – Most private credit investments are tied to floating interest rates (such as Wall Street Journal [WSJ], Secured Overnight Financing Rate [SOFR], etc) which might decrease depending on the interest rate environment. Some investors opt for fixed rates to mitigate this risk, although it may result in lost opportunities if the rate increases significantly when setting the loan terms.
How do you Find the Right Private Credit Manager or Platform?
Although investing in private credit can be highly profitable, its complex nature can be a barrier to some investors, and especially for individuals. The problem here is that such investments need vast expertise and knowledge, and navigating through them can be challenging.
To maximize your chances of success and minimize potential risks, it’s best to find a trusted manager who will provide you with access to the best private credit opportunities, utilizing all the array of tools at their disposal. The range of outcomes can vary based on the skill and experience of the manager, even within sub categories.
What to seek from such a firm? Initially, consider partnering with a seasoned firm boasting proven long term and a compelling track record. Secondly, emphasize the manager's expertise. You want to collaborate with experienced professionals who have the tools and knowledge in private credit investments. It is critical to select an experienced dedicated team having executed numerous deals and navigated through multiple economic cycles.
Experienced investment managers strive to craft a well-balanced portfolio through selective deal origination, maximizing negotiated terms and conditions, and employ defensive pillars to mitigate risks. Lastly, ensure the firm provides you with a transparent defined investment process and thorough reporting. A structured investment process not only makes it repeatable and scalable but ensures all necessary checks and balances are in place.
Private Credit Due Diligence - “Behind the Scenes” Look
Whether you decide to invest in private credit directly or through a fund, it’s always important to understand what measures are taken and established through an exhaustive due diligence process, with the purpose of reducing potential risks and maximizing returns. First and foremost, conducting an exhaustive financial analysis on the company is essential.. This involves examining the borrower’s financial statements, cash flow, leverage metrics and more. This way, you’ll be able to determine the financial state of the company and its capacity to repay the capital with a degree of certainty.
Then, run a background check on the borrower’s performance, assess the quality of management and review their future business and growth projections. At this stage, engage with different stakeholders in the investor community supporting the company to gain insight on their perspective. Lastly, when signing a term sheet with a target company try to strike the right balance to structure a deal which ensures sufficient collaterals, covenants and remedies to back the loan in case of a downside scenario.
By applying these steps, you’ll be able to significantly reduce the potential risks. It’s easier said than done, though. As a private investor, acquiring the necessary data and ability to conduct the process might be challenging.
OurCrowd also intends to launch several direct private credit opportunities into single companies, a differentiated offering which traditionally is not readily available to investors and are difficult to access.
Final Word
In conclusion, private credit offers investors a unique landscape of opportunities. With a comprehensive background in private credit and a strategic approach to investing, individuals can tap into higher yields, diversify their portfolios, and access niche sectors not readily available in public markets. In essence, private credit presents a compelling option for those seeking a balance of risk and reward in today's dynamic financial landscape.
However, to get the most out of your investment and enhance your chances of success,you need to work with a trusted and experienced fund manager or platform such as OurCrowd, who will guide you through the meanders of private credit investing, helping you find promising opportunities and choosing the right approach.
FAQs
Is private credit a good investment?
That depends on how you look at it. In theory, private credit offers investors more certainty when it comes to their expected returns. You lend a company money at a given interest rate and expect them to repay within a set period. It makes things much less risky than when investing, for instance, in private equity.
On the other hand, private credit also comes with decreased returns compared to some other asset classes. It also has a level of risk attached to it that any potential investor must consider. There’s also the case of high entry requirements for single-deal opportunities, as well as the legal complexity surrounding such investments and limited access for private investors .
Is private credit the same as private equity?
No, although both are classified as alternative asset classes they are two different types of investment. Private credit is when an investor loans a company money at a given interest rate. That debt must be repaid in a predetermined period, with returns generated by the interest rate.
Private equity involves acquiring a minority ownership in a privately held business. The difference here, though, is that they do it in exchange for an ownership stake in the company, which can be later sold for a profit.