Private Credit: Definition, What It Is & vs. Private Equity

March 15th, 2024
8 minutes read

Private credit is a type of loan or debt financing that is not traded on the public markets. This type of credit is usually provided by non-bank lenders as opposed to traditional bank loans or publicly traded bonds.

Private Credit illustrating financing taking place in the private markets

What is Private Credit?

Private credit is an essential component of the financial ecosystem, offering alternative sources of capital to businesses and individuals while providing financing solutions outside of traditional banking channels. This form of credit is provided by entities such as private equity firms, hedge funds, or specialized lending institutions.

In simple terms, private credit is lending and borrowing money from sources other than banks. These lenders go to the private markets where they extend loans to businesses or individuals who may not qualify for traditional bank loans. Private credit comprises various types of loans, including direct lending, mezzanine financing, and distressed debt investing.

Private credit offers advantages because it often provides more flexibility regarding loan structures and repayment schedules compared to traditional bank loans. However, it may also come with higher interest rates or additional fees for borrowers, as these lenders assume more risk by extending credit to individuals or businesses whom banks may consider too risky.

Key Takeaways

  • Private credit involves funding alternative loans via various methods like direct lending, debt funds, BDCs, and ETFs.
  • Private credit investments fund debt for private companies, including senior, junior, mezzanine, distressed, and specialty finance.
  • Private credit funds offer alternative lending options to mainly accredited investors and institutions, targeting specialized markets for potentially higher returns.

Private Credit vs. Private Equity

Private credit and private equity serve different functions, yet they complement each other. Private credit provides flexible loans to businesses, supporting various growth stages, while private equity involves buying stakes in companies.

CharacteristicPrivate Credit (PC)Private Equity (PE)
Investment StrategyLends funds with the expectation of receiving interest payments in return.Buys into private companies to make them better and earn profits when they are sold or go public.
Risk and ReturnExhibits lower risk, with profits primarily coming from interest payments and fees.Carries a higher risk and may benefit from superior returns.
Ownership and ControlHas no ownership or control rights; investors are creditors.Owns stakes in invested businesses with significant control and influence.
Duration of InvestmentHas shorter investment horizons, often with fixed terms.Has longer investment horizons, requiring years for operational improvements.
LiquidityOffers more liquidity, with opportunities to sell debt holdings.Investments are less liquid and typically require longer lock-up periods.

How to invest in Private Credit

Investing in private credit involves allocating funds to non-traditional lending opportunities outside of the conventional banking system. This typically includes providing loans to companies or individuals not served by traditional financial institutions, to generate returns through interest payments and potentially capital appreciation.

  • Direct Lending Funds: An investment vehicle that directly provides loans to businesses or individuals, bypassing traditional banking institutions.
  • Private Debt Funds: A financial instrument that raises capital from investors to provide debt financing to companies, typically outside the domain of traditional bank lending.
  • Business Development Companies (BDCs): BDCs are publicly traded firms that provide capital and support to small and mid-sized businesses.
  • Lending-based Crowdfunding: Also known as peer-to-peer (P2P) lending, this concept refers to facilitating loans between borrowers and lenders through online platforms or digital marketplaces.
  • Real Estate Debt Funds: These funds provide financing for real estate projects through debt instruments such as loans or bonds.
  • Private Credit ETFs and Mutual Funds: These are funds, pooling investor’s money to invest in private credit securities, offered either as exchange-traded funds (ETFs) or mutual funds.

Private Credit Investments

Private credit investments refer to debt funding directed towards private companies or non-public entities, offering an alternative to conventional financing channels such as bank loans or public bond issuances.

  1. Senior Direct Lending: This financial instrument refers to providing loans directly to established businesses or individuals focusing on higher credit quality and lower risk.
  2. Junior Debt: This debt instrument comes second in line with senior debt in case of bankruptcy or default.
  3. Mezzanine Debt: This is a hybrid form of financing that typically combines elements of debt and equity, often used to fund growth or acquisitions.
  4. Distressed Debt: This category of debt comprises securities or loans issued by financially troubled companies or those facing bankruptcy.
  5. Specialty Finance: This type of financing is a niche sector focused on providing non-traditional financial services tailored to specific industries or market segments.

Private Credit Funds

Private credit funds pool money from accredited investors and institutions to offer alternative lending options. They focus on various areas like direct lending, mezzanine financing, distressed debt, and special situations, targeting specialized markets for potentially higher returns than typical fixed-income investments. These funds operate with more flexibility and fewer regulatory constraints than traditional banks, allowing them to quickly adapt to market conditions and borrower needs. The managers structure deals creatively to address unique requirements while managing risks effectively, often providing capital to companies during transitional phases or financial distress, which contributes to economic stability and growth.

The private credit funds market witnessed significant growth in 2023, as private lenders accumulated a global total exceeding $307 billion. Since 2008, total private credit has steadily expanded to nearly $1.7 trillion, with direct lending making up about half of this market at $800 billion. Key players in the sector include Oaktree, Ares, Goldman Sachs, HPS Investment, and Blackstone.[1]

Public Credit vs. Private Credit

Credit plays an important role in the bond markets, making up $13 trillion of all fixed-income investments worldwide. It offers a diverse range of opportunities for investors, including improved returns, diversification, and income.[2] There are two main types: public credit, traded publicly, and private credit, negotiated privately. Each type carries distinct levels of risk and return.

AspectPublic CreditPrivate Credit
InstrumentCorporate bonds, government bonds & municipal bondsSenior debt, junior debt, mezzanine debt, distressed debt & specialty finance
Typical size$200 million to more than $5 billion$2 million up to more than $2 billion[3]
LiquidityPublicly traded and typically high liquidityUsually illiquid and not easily traded
RatingDetermined by rating agenciesOften not rated

What is an example of private debt?

Over the past decade, the private debt market skyrocketed tenfold to $412 billion by 2020.[4] Projections indicate it will reach $2.8 trillion by the end of 2028.[5] This growth is driven by its flexibility, risk-adjusted returns, and low correlation to public markets, attracting investors.

  • Bank loans: Loans extended by commercial banks to businesses or individuals for various purposes, such as working capital, expansion, or acquisition financing.
  • Private placements: Debt securities sold directly to institutional investors, such as pension funds, insurance companies, or high-net-worth individuals, without the need for public offering.
  • Direct lending: Loans provided by private equity firms, hedge funds, or specialized lending institutions directly to companies, often in situations where traditional bank financing may be unavailable or insufficient.
  • Mezzanine financing: Junior debt with equity-like features, often used to fund growth, acquisitions, or recapitalizations, and typically offered by private equity firms or specialized mezzanine funds.
  • Peer-to-Peer lending: A form of crowdfunding investment, peer-to-peer lending platforms connect individual investors with borrowers seeking personal or business loans, circumventing traditional financial intermediaries such as banks.

Who buys private credit?

Private credit is usually pursued by institutional or accredited investors. seeking superior returns in contrast to conventional fixed-income investments such as government or corporate bonds. Among the most notable and influential purchasers in private credit are pension funds, insurance companies, asset managers, hedge funds and private equity firms.

  • Pension Funds: Investment entities providing financial support for retired individuals.
  • Insurance Companies: Financial institutions that offer risk management by providing policies that offer compensation for specified losses.
  • Asset Management Firms: Entities that manage investment portfolios on behalf of clients to optimize returns and achieve financial goals.
  • Hedge Funds: Investment pools, typically reserved for accredited investors that aim to generate high returns through various strategies.
  • Private Equity Firms: Entities that invest in privately held companies, typically to increase their value over time and eventually sell them for a profit.

Why do investors like private credit?

Investors like private credit because it offers higher yields compared to traditional assets such as stocks or bonds. Additionally, private credit contributes to portfolio diversification, while offering the flexibility to customize risk and return preferences. Private credit outperformed public loans, with 10% annualized returns versus 5%.[6]

Article Source

  1. U.S. Federal Reserve: “Private Credit: Characteristics and Risks
  2. PIMCO: “Across the Spectrum: Understanding Public and Private Credit
  3. S&P Global: “Private Debt: A Lesser-Known Corner Of Finance Finds The Spotlight
  4. Preqin: “Private Debt
  5. EY: “Private Debt – An Expected But Uncertain “Golden Moment?
  6. Goldman Sachs: “Understanding Private Credit