Private Credit

Understanding Private Credit

As global financial markets continue to evolve, savvy investors are exploring alternatives outside traditional equities and bonds. One such opportunity gaining significant traction is private credit. Private credit offers an attractive solution for expats seeking to diversify their portfolios and potentially increase their income streams. But what exactly is private credit, and why should it be on your radar?

What is Private Credit?

Private credit refers to non-bank lending provided directly to companies, often bypassing traditional financial institutions like banks. This form of lending can take many shapes, including direct loans, mezzanine financing, or even distressed debt opportunities. It’s typically provided by private investment funds or specialized lenders that aim to offer more flexible financing solutions compared to conventional banks.

Unlike public debt, which is traded on exchanges, private credit involves negotiated loans that remain off-market. Investors gain access through private funds, direct lending platforms, or institutional investments, typically in exchange for higher yields.

Why Do Private Credit Investments Offer Higher Yields?

One of the main reasons private credit investments can offer higher yields is due to the liquidity premium. In simple terms, because these investments typically require your capital to be locked up for a fixed term, investors are compensated with a higher return. This means that because your money is not easily accessible during the investment period, you are rewarded with a higher return.

This “illiquidity” is a key characteristic of private credit. Private credit loans are less liquid than public bonds or stocks, where investors can sell their holdings relatively quickly. This means you can’t quickly access your money during the loan term. To account for this lack of liquidity, borrowers pay a liquidity premium, increasing investors’ overall yield.

In addition to the liquidity premium, private credit deals often come with credit risk premiums. Since many companies seeking private credit are either smaller firms or firms that don’t meet the strict lending criteria of traditional banks, they are willing to pay higher interest rates to access capital. This creates an opportunity for investors to earn greater returns than conventional fixed-income investments like corporate bonds or government debt.

Private Credit in Specialist Sectors

One of the most exciting developments in the private credit space is the rise of specialist lenders. These lenders focus on niche industries, providing financing to sectors where traditional bank lending may be unavailable or unattractive. These sectors can range from technology startups to renewable energy projects, offering a wide range of investment opportunities.

In litigation finance, for example, private credit lenders offer loans to law firms, particularly those involved in high-stakes litigation. This is especially popular in the UK and other developed markets, where the legal landscape often requires large amounts of upfront capital to fund lawsuits. By lending to law firms or plaintiffs in need of financing, specialist private credit providers help unlock the potential returns from successful cases while diversifying their own portfolios.

Similarly, the UK real estate sector has seen a boom in private credit. Private lenders often step in to provide development financing, bridging loans, and mezzanine debt, all of which are crucial for developers who may not meet the strict lending criteria imposed by traditional banks. The flexibility private credit offers in structuring these loans makes it an attractive option for investors and borrowers.

The Importance of Private Credit for SMEs

It’s worth noting that 50% of the world’s economy comprises smaller companies that either cannot access traditional bank finance or choose not to go public. These businesses often seek private credit to meet their financing needs while retaining control over their operations. A great example of a company that has remained private is Mars, Inc., the global confectionery and food company. Despite its size and success, Mars has chosen to remain privately owned, allowing the company to grow without the pressures of public markets or the need to conform to regulations imposed on publicly traded companies.

This trend underscores the growing importance of private credit in supporting the backbone of the global economy—small and medium-sized enterprises (SMEs). These SMEs represent a significant opportunity for private credit investments for expats, especially in emerging and frontier markets where bank lending is scarce or expensive. By providing these businesses with the capital they need to grow, private credit plays a crucial role in economic development.

Asset-Backed Options and Loan Notes in Private Credit

One attractive feature for many private credit investors is the availability of asset-backed options. These loans are secured by physical assets, such as real estate, equipment, or even intellectual property. Asset-backed loans provide an additional layer of security to investors because if the borrower defaults, the lender can seize the asset to recover some or all of the investment.

This security helps mitigate credit risk, making asset-backed loans a compelling option for investors who want the higher yields associated with private credit but are concerned about the potential for defaults. Real estate and receivables-backed loans are two of the most common types in this category. In the UK, real estate-backed private credit is a popular investment strategy, particularly in the form of bridging finance for property developers and investors.

Another option in the private credit market is loan notes, which are debt instruments issued by a borrower in exchange for capital from the lender. These notes typically come with a fixed interest rate and are repaid over a set period, often ranging from two to five years. Loan notes can be secured or unsecured, with the secured option providing more protection to investors through collateral.

  • Secured Loan Notes: These are backed by assets, meaning that if the borrower defaults, the assets can be sold to repay the debt. They offer lower risk to the investor.
  • Unsecured Loan Notes: These do not have specific collateral attached, making them riskier but potentially offering higher interest rates.

Loan notes are particularly useful for private companies looking to raise capital quickly without giving away equity or going through the lengthy process of public debt issuance. For expats seeking more predictable income streams, secured loan notes offer an appealing combination of higher yields and manageable risk.

Private Credit vs. Public Credit: Key Differences

  • Access to Deals: Private credit deals are generally available to institutional investors or high-net-worth individuals, making it a less accessible option for the average retail investor.
  • Transparency: Public bonds are typically rated by agencies, and their pricing is transparent. Private credit lacks this level of transparency, meaning more due diligence is required from investors.
  • Liquidity: Since private credit loans are not publicly traded, they tend to be illiquid. Investors should be prepared for their money to be tied up for extended periods.

Opportunities for Expats

For expats, particularly those with international networks, private credit offers the chance to invest in growing businesses across various markets. Many private credit funds focus on opportunities in emerging markets, where traditional bank lending is often limited. This can be a great way to capitalize on growth trends in regions with less developed financial sectors while still benefiting from solid yields.

Additionally, expats with ties to growing industries such as real estate, renewable energy, or technology may have unique insights that can inform better private credit investment decisions.

Risks to Consider

While the potential for higher returns is appealing, it’s crucial to weigh the risks:

  • Credit Risk: As with any loan, there’s a chance the borrower will default, resulting in partial or complete loss of the investment.
  • Liquidity Risk: Given the illiquid nature of private credit, expats need to consider their liquidity needs before committing capital.
  • Due Diligence: Conducting thorough due diligence is essential, as these deals are often less regulated than public investments. This can be time-consuming and may require professional support to navigate effectively.

How to Access Private Credit Investments

Expats interested in private credit can access these opportunities through specialized private debt funds, direct lending platforms, or by partnering with wealth managers who have access to private credit markets. It’s crucial to work with advisors familiar with the nuances of private credit, especially in the context of international taxation and regulatory considerations.

Summary

Private credit is an increasingly attractive option for expat investors seeking higher yields, portfolio diversification, and a hedge against market volatility. Its growing popularity in sectors like real estate and litigation financing demonstrates its versatility and potential. The higher yields offered by private credit are mainly due to the liquidity premium, compensating investors for locking up their capital over extended periods. Asset-backed options and loan notes provide additional security and predictable income streams for those seeking reduced risk. However, the illiquid nature and associated risks mean this type of investment should be considered as part of a broader, long-term strategy. If you’re an expat looking to enhance your portfolio, private credit might be worth exploring with the proper guidance.

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