Private Credit: What is it and why has this US$1tn market become such a popular investment option?

Private credit is a US$1 trillion (A$1.49tn) market and $200bn in Australia alone. It is clearly worth knowing about and paying attention to. Stocks Down Under provides a lowdown of what private credit is, and why it has become so popular.

What is private credit?

Private credit refers to non-bank lending provided by private investment firms or funds, rather than traditional banks. It includes loans made to companies that are not publicly traded or to individuals, typically involving higher risk and potentially higher returns compared to traditional bank loans. Private credit can include a variety of financial products such as direct lending, mezzanine financing, distressed debt, and other forms of private lending.

It is important to note that investors don’t have to invest directly in these types of loans. They can turn to companies like Ares, Blackstone and Apollo that specialise in these. In the 5 years to July 1, 2024, these companies all returned over 250% to investors.

Why has it become popular?

There are several reasons. The most important is the higher yields that come with it. Private credit often offers higher returns compared to traditional fixed-income investments. This is due to the higher risk associated with lending to less creditworthy borrowers or more complex financial structures.

Moreover, private credit offers a way to diversify away from traditional equities and fixed income, towards an asset less correlated with either stocks or bonds. This can help spread risk and provide a stabilising effect in times of market volatility.

Of course, it is not just popular to invest in, but popular amongst borrowers. As regulatory changes have made it more challenging for banks to lend, particularly to smaller and mid-sized companies, private credit has stepped in to fill the gap. This growing demand for alternative lending sources has expanded the market.

Private credit deals are often tailored to the specific needs of borrowers and investors. This customisation can include bespoke terms, covenants, and structures that might not be available in public markets. These investments are typically actively managed, meaning investors can benefit from the expertise and experience of fund managers who have specialised knowledge in assessing and managing credit risk. With the ability to negotiate terms and covenants, private credit investments can potentially offer a more attractive risk-return profile. Investors often have more control over the risk they’re taking on and the return they’re expecting.

But it is not without risks

Many investors may immediately think of the GFC when they hear the word ‘risk’ in relation to private credit. The private credit we are talking about here is corporate lending rather than lending to mortgagees who would quickly be unable to afford paying them. It was the GFC that provided the opportunity for this market to rise, because the major banks retreated from corporate lending due to increased regulations on them.

However, the lack of regulation gives rise to potential risks with private credit. Most prominently, the risk that there could be regulations on providers and this could harm investment. For now it appear the worst that could happen would be providers needing to give better disclosures to investors, which shouldn’t be too much of an ask for them.

Still, there is the risk that the ultimate borrowers may not be able to repay. there is a reason why there is a higher yield…high interest rates. And why are interest rates higher? Because the borrowers are riskier, being unable to obtain traditional finance from the big banks. It is also important to note that the ability to compare performance across managers is difficult, given the private nature of lending and the differences between the loans.

Conclusion

All investors should be aware that private exists, that it has grown in popularity and why. Even if you stick with equities, your company may rely on finance provided by private credit loans. If you choose to invest in it, you need to be aware of the risks and of the potential for more regulation to come to an asset class that has virtually none – for now.

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