What to Know Before You Invest
There’s been a lot of chatter lately about private credit, which refers to lending activities by institutions other than banks. In fact, the size of the private credit market has rapidly expanded over the last few years from $1 trillion in 2020 to $1.5 trillion at the start of 2024 — and it’s expected to grow to $2.8 trillion by 2028.1
Despite its rapid growth, private credit as an asset class has only recently gained the attention of investors. If you’re considering an investment in private credit, here’s what you need to know.
What is private credit?
Private credit, also referred to as direct lending, is a type of lending that takes place outside the traditional banking system. Most often, rather than a bank as the lender, an asset manager or private equity firm is the lender. The borrower is most often a small- to medium-size enterprise that can’t find financing through traditional banks, due to regulations and restrictions imposed following the 2008-2009 financial crisis. Since the financial crisis, the need for private credit has risen sharply, and as a result, private asset managers have entered the space to provide capital where banking is no longer a resource, becoming an important source for business funding.
Benefits of investing in private credit
Many investors are interested in private credit opportunities because they offer the following benefits:
- The potential for higher yields – Private loans are typically issued with higher interest rates than traditional bank loans, which can lead to higher yields for investors compared to traditional credit investments.
- Short-term investment opportunities – Private credit investments typically have short-term durations, which can allow for enhanced liquidity, reduced interest rate risk, enhanced flexibility and reduced risk of default.
- A history of low default rates – Private loans are typically backed by borrower collateral, which can provide investors with a level of protection if borrowers default on their loans.
- Low correlation with overriding market trends – One of the main reasons investors incorporate an allocation to alternative investments, such as private credit, is that the value of these investments tends to fluctuate independently of overall market trends. This reduced correlation can help buffer your portfolio against market volatility because it offers an opportunity to access returns that perform separately from traditional investments, such as stocks and bonds.
Drawbacks of investing in private credit
Of course, along with the benefits of investing in private credit, there are also downsides such as:
- Added complexities – Some private credit investments have complex investment structures that can be difficult to understand. These complexities can also lead to significant tax implications if not properly planned for.
- Illiquidity – Depending on the specific investment, it can be difficult to sell private credit on the secondary market. This means you may not be able to access your money for a period of time once it’s invested. Before investing in private credit, it’s important to understand the specific terms of the investment to make sure you’re comfortable locking up your assets for the duration of the loan.
- A lack of transparency – Because they’re privately managed, private credit investments aren’t held to the same pricing and reporting standards as publicly traded investments. It’s vital that you, together with your wealth manager, conduct an in-depth due diligence analysis of any potential investment prior to investing.
- Concentration risk – Private credit investments are generally sold in large sums to a small group of investors. The requirement to invest a large sum of money may mean that your portfolio becomes overly concentrated in private credit, placing your assets at risk should something go wrong. When considering an allocation to private credit, make sure the investment’s risk profile matches your risk tolerance, time horizon and investment objectives.
