Once again, we delve deeper into the world of alternative investments. So far on our journey, we’ve explored REITs, Structured notes, and private equity in previous articles. If you’d like to read about those products, here are direct links to take you there:
In this post, we’ll explore another unique product, private credit.
The potential is great
I’m keeping this header like last week because private credit has seen a significant upside in this environment. Similar to private equity, private credit investments involve aggregating capital from investors. However, private credit provides a loan instead of acquiring equity from companies for the investment.
Like getting a loan from a bank, there are similar stipulations. Imagine yourself being the bank and receiving a percentage of the interest rate as profit based on the loan provided.
Unfortunately, all of us can’t be a bank (unless it’s Monopoly!). However, we can still reap some of the benefits when investing in the private credit market. Private credit investments are typically made by large private credit firms, which manage funds from institutional investors, high-net-worth individuals, and sometimes retail investors.
Let’s take a look at it in more detail
Private credit investments act as the lender. As you can imagine, the clientele that walks into the bank for a loan can include individuals, startups, mid-sized firms, large companies looking to expand, or companies with liquidity/financial distress. The difference here is the borrowers may have already tried to get a loan from a traditional bank with no success. They may not have well-established credit or good investment grade credit and thus are considered too risky for the banks.
This isn’t always the case, but we’ve seen much stricter lending in the banking sector, leaving the door open for this industry. Private credit can step in and underwrite the loan, which would generally include a higher interest rate to compensate for the increased risk. Many of these loans are written with floating interest rates, and in today’s interest rate environment, this has greatly benefited investors in the private credit market.
I mentioned this last week, but it must be repeated. This market and alternatives as a whole are very complex. This is why finding a manager or financial advisor who knows how to invest appropriately in alternative investments is essential. Our team at Whitaker-Myers Wealth Managers conducts the necessary research and due diligence so you, as the investor, do not need to. Having the proper guardrails and boundaries can be a significant game changer in the private market.
Pros of Private Credit Investments
Potential predictable returns
Loan interest payments function similarly to fixed income payments in your portfolio, with predictable monthly/quarterly payments.
Diversification benefits
Since these assets are poorly correlated to the public markets, they can provide an opportunity to increase diversification and exposure to alternative alpha (yes, we’ll explore this in a post coming soon). To understand correlation better, here is an article to help - Correlation of Assets in Your Portfolio (whitakerwealth.com)
Senior secured loans
One of the most significant risks is default risk. If the loan defaults, the creditor has a senior secured loan that gives them the first payout upon liquidation.
Sub-diversification into sectors/categories
Diversifying by adding alternatives to your portfolio has its benefits. Private credit firms also diversify their risk by investing in multiple sectors and companies.
Cons to Private Credit Investments
Default risk
As mentioned above, this inherent risk is mitigated (primarily) by the underwriting process and loan terms.
High minimum requirements
Including net worth, investment capital, and income.
Illiquidity or semi-liquidity
Some funds may have redemption limitations and have minimum investment time horizons. Some may apply a ‘haircut’ on the investment if taken out before (usually around 2%).
Fees
Including some frontend, backend, and management fees.
Transparency
This is becoming less of a concern as most information is available on the investment company’s website and their fact sheets.
Complexity
Investing in private credit isn’t as easy as the public market and certainly has a learning and investing curve.
How do I know if Private Credit investments are for me?
The best answer here is to discuss it with your financial advisor. Our team at Whitaker-Myers Wealth Managers is always ready to field your questions and guide you with the heart of a teacher.
Private credit investments have gained popularity in today’s interest-rate environment and will likely be around for quite some time. This alternative investment functions as a bank providing loans to companies seeking capital. This investment class, as a whole, can be a great addition to your portfolio diversification strategy. While they offer the potential for high returns, they come with significant risks and require a long-term commitment. As mentioned earlier, there certainly is an opportunity with private credit or any alternative asset investing, but discuss it with your advisor to see if it is a good fit for you.
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