Credit information that is not publicly listed: Understanding it and strategies for investment
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Investing in private credit has become an increasingly popular avenue for both individual and institutional investors. This form of fixed-income investment offers unique opportunities, but it also comes with its own set of risks and considerations.
One of the key advantages of private credit is the access it provides to off-market investments. Unlike traditional bank-based lending, private credit funds can offer senior-secured loans to a variety of borrowers, often extending to riskier entities that may not meet banks' stricter criteria. This diversification can lead to higher returns over a lengthy period of time.
However, private credit investments carry higher risks compared to traditional bank-based lending. These risks include illiquidity, higher default risk, lower credit quality, less regulation, and adverse selection in deal quality. These factors often translate into higher yields but also increased potential for loss and volatility.
Illiquidity is a significant concern in private credit, as these instruments cannot be easily sold or redeemed and may trade at prices significantly different from their initial investment amount. Credit risk is another major factor, with issuers potentially defaulting on payments, especially since private credit often involves lower-rated or unrated securities with speculative characteristics.
Deteriorating underwriting standards, such as a rise in covenant-lite loans and loans with deferred payment structures like payment-in-kind (PIK) interest, also increase the risk of borrower distress. Furthermore, private credit is subject to fewer regulations than banks, which can lead to looser underwriting standards and higher risk-taking.
Despite these risks, private credit has become popular due to the void left by traditional bank-based lenders after the financial crisis of 2008-2009. Investors can access private credit through various channels, including private equity funds, Business Development Companies (BDCs), and other investing platforms like Yieldstreet, Percent, and Fundrise.
It's crucial for investors to understand the specific strategies of private credit funds and the potential risks, especially during economic downturns. The risks associated with private credit should be carefully considered, and investors should weigh these against the potential for higher returns.
Investors should also be aware that participation in the private-credit market requires them to lock their money in the funds for a lengthy period, often 5 to 10 years. Additionally, private credit funds may charge significant fees, and investors may lack liquidity with these funds.
To qualify as an accredited investor, an individual must have a net worth of over $1 million, or an income of $200,000 or more over the last two years. Professionals with certain certifications, SEC-registered investment advisors and broker-dealers, financial firms, entities with investments over $5 million, and knowledgeable employees of a private fund also qualify as accredited investors.
Small and mid-size businesses involved in private credit have a historically low default rate. However, the debt in private credit is typically higher risk and pays higher rates than investment-grade debt. Despite these risks, adding private credit to a portfolio may increase diversification and reduce portfolio risk.
In conclusion, private credit presents a unique opportunity for investors seeking higher returns. However, it's essential to understand the risks involved and carefully consider the suitability of private credit within one's portfolio. As with any investment, due diligence and a thorough understanding of the underlying assets and strategies are crucial.
[1] Investopedia. (2021). Private Credit. [online] Available at: https://www.investopedia.com/terms/p/privatecredit.asp
[2] Investopedia. (2021). Adverse Selection. [online] Available at: https://www.investopedia.com/terms/a/adverse_selection.asp
[3] Investopedia. (2021). Regulatory Oversight. [online] Available at: https://www.investopedia.com/terms/r/regulatory_oversight.asp
Investing in private credit presents a unique opportunity for individual and institutional investors to access off-market investments with higher potential returns over a lengthy period due to diversification, but it is important to be aware of the higher risks involved, such as illiquidity, higher default risk, lower credit quality, less regulation, and adverse selection in deal quality.
Participation in the private-credit market requires investors to lock their money in the funds for a lengthy period and may charge significant fees, leading to potential loss of liquidity. Therefore, it is crucial for investors to understand the specific strategies of private credit funds, the potential risks, and the suitability of private credit within their portfolios before investing.
