"Investing in confidential credit: A guide on understanding its nature and techniques"
In the wake of the financial crisis of 2008-2009, banks have scaled back their business lending activities, creating a gap that private-credit investors have stepped in to fill. This type of investment, less regulated than publicly traded securities, offers potential benefits but also carries significant risks.
Who Qualifies as an Accredited Investor?
To participate in the private-credit market, investors must typically be accredited individual investors, institutional investors, or investment professionals. To become an accredited investor, an individual and/or a spouse must have a net worth of more than $1 million, not including their main residence, and an income of $200,000 or more over the last two years, or a couple must have had $300,000 or more. Other entities that qualify include professionals with certain certifications, SEC-registered investment advisors and broker-dealers, financial firms such as banks, investment companies or business development companies, and entities with investments over $5 million.
The Appeal of Private Credit
Private credit funds can produce steady returns over a lengthy period of time, and adding private credit to a portfolio may increase diversification and reduce portfolio risk. These funds invest in the debt of small and medium-sized companies, which may be higher risk and therefore pay higher rates than investment-grade debt. This riskier nature can lead to higher yields, making private credit an attractive option for income-seeking investors.
Private credit represents a growing and distinct segment of the fixed income market with different risk-return drivers than public bonds or bank loans. It offers greater diversification potential and structural protections like stronger covenants and bespoke loan terms in some investment-grade private credit deals, which can reduce risk relative to public equivalents.
The Risks Involved
However, private credit securities are typically illiquid and not easily sold or redeemed at the original invested value, making them less suitable for investors who need quick access to capital. Private credit borrowers may default on payments, especially those with lower credit quality or speculative characteristics. Defaults can cause losses and increase volatility in the investment.
Lower-rated or unrated private credit issuers are more vulnerable to adverse economic changes, which can deteriorate credit quality and reduce liquidity further. Private credit investments generally carry higher management fees and require sophisticated analysis. Their use of leverage and speculative techniques can amplify both gains and losses.
Additionally, these alternative investments may not be tax efficient, so accredited investors are advised to consult tax advisors before investing.
Accessing Private Credit
Investors can access private credit through private equity funds, business development companies (BDCs), or other investing platforms like Yieldstreet, Percent, and Fundrise. Private credit funds may charge significant fees for their services, but they often provide access to off-market investments that offer attractive yields and diversification benefits.
In summary, private credit can offer accredited investors enhanced income potential and diversification benefits compared with traditional fixed income but requires accepting higher credit risk, illiquidity, and complexity. It is suitable mainly for sophisticated investors who can withstand potential losses. Private investors and credit funds now often replace banks in providing loans to small and medium-sized companies.
Investing in private credit funds, such as those offered by private equity firms, business development companies (BDCs), or platforms like Yieldstreet, Percent, and Fundrise, can appeal to accredited investors seeking attractive yields and diversification benefits, as these funds invest in debt of small and medium-sized businesses that often pay higher rates due to their higher risk. However, private credit securities are typically illiquid and carry significant risks, including potential losses from borrower defaults, exposure to adverse economic changes, higher management fees, and complexity, making them more suitable for sophisticated investors who can withstand potential losses.
