Savvy investors are always looking for ways to diversify and strengthen their portfolios. However, finding profitable investments can be particularly challenging when the economy experiences inflation and recession-like conditions. Fortunately, private credit has emerged as a high-yield investment in the last decade. Private credit is an asset class of debt financing and privately negotiated loans. If you’re interested in investing and not sure how much to put into this type of risk, consider working with a financial advisor who can help you work it into your overall investment strategy.
Private Credit, Defined
Private credit is an asset that provides returns through interest payments on loans for small businesses or individuals looking to fund something specific like litigation. The debt is private because banks and public entities don’t provide the loans. Instead, private investors and investment companies finance the debt because of the potential for sizable returns.
When you invest in a company’s equity, you purchase and own stock in the company. You buy a position in the company because you expect the company to turn a profit, raising the stock value. Similarly, private credit also bets on the financial reliability of the borrower. However, instead of stock, private credit is a loan with a high interest rate. Investors rely on the borrower’s ability to repay the loan plus interest.
How Does Private Credit Work?
Let’s say a business wants to raise capital but cannot acquire a loan from a bank. Additionally, the business doesn’t want to dilute ownership by selling stock to investors. So, it turns to an investment firm that issues private debt and obtains a loan, usually for tens of millions of dollars.
These loans are much more intricate than consumer loans and can take weeks or months to negotiate. In addition, private credit agreements typically contain legally binding requirements called covenants that borrowers must adhere to for funding to come through.
For example, a private credit contract might include a condition that a borrowing business provides quarterly financial updates to demonstrate the business’ continuing fiscal stability. If the business fails to provide an update, the investment firm might cut off funding.
Advantages of Investing in Private Credit
In recent years, private credit investment opportunities have become more accessible to individuals as investment opportunities. You may want to consider include private credit in your portfolio for the following reasons:
Quick Maturity: Private credit often matures in nine months, providing substantial returns more rapidly than other assets. Plus, the short time horizon allows investors to turn a profit without waiting years to get their money back.
Favorable Returns: The government does not impose heavy regulations on private credit as it does with other loans, especially in the post-2008 market. In addition, private debt often has a variable interest rate, which rises along with market rates. As a result, private lenders charge high-interest rates on debt, meaning a better return on investment.
Resilience Against Downturns: Financial data demonstrates that market downturns don’t impact private credit as harshly as other asset types. Resilience in tough markets makes private credit an excellent choice as a pillar in a diversified portfolio. Plus, when markets are tight, private credit can help stabilize the economy by injecting capital when traditional lenders hesitate to provide loans.
Default Payment Priority: Senior direct lending is a characteristic of some forms of private debt. The debt is referred to as senior because if a business goes bankrupt, it will likely default, or stop making debt payments. However, when the failed business begins selling its assets or negotiating an acquisition, profits from such actions will first go toward repaying private debt before any other financial obligations.
Downsides to Investing in Private Credit
All investments come with risk and private credit certainly isn’t any different. That said, it’s wise to beware of the following pitfalls of private credit before deciding to move forward:
Low Liquidity: Although private credit has become more liquid recently, it is illiquid relative to most other assets. As a result, if you invest in private credit, you may be unable to access the funds until the loan matures. This condition could put you in a bind if you have a financial emergency or want to reset your portfolio allocations. However, investors earn extra money through liquidity premiums for their increased risk.
Increased Risk: If the private debt is not senior direct lending, investors incur more risk if the business fails. Furthermore, even with senior direct lending, there’s the chance a failed business can’t repay the debt in full, causing a loss on investment.
Untradeable: Investors cannot buy or sell private credit positions in the stock market. Therefore, once you invest money in a private debt fund, you’re along for the ride, win or lose.
How to Invest in Private Credit
You can invest in private credit through a private debt investment platform. Investors with assets of at least $1 million or an annual salary of $200,000 or higher can create an account with a company like Percent. Through this type of platform, you’ll get access to a number of different debt deals that you can invest in. Each deal will have a minimum investment amount and a hold period that your money will be invested for. Other platforms may have fewer financial requirements to start investing.
The Bottom Line
Private credit is an investment that creates returns through business loans instead of stock trades. It provides higher potential returns than other assets, weathers market volatility and matures quickly. However, it can be a high-risk investment that lacks liquidity, meaning you might tie up your money in a losing venture with no option to sell.
Tips for Investing in Private Credit
Navigating private credit platforms can be daunting. A financial advisor can help you pick the best investments for your goals. SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
When investments pay off, you will need to figure out how much you owe in taxes. SmartAsset’s capital gains tax calculator will help you estimate the taxes you’ll incur in your location.
If you want to borrow money privately or want to know more details about private lending, read this guide to private lending.
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