Private Credit

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Today I want to talk about one of the Highest growing areas of Alternative Investments market which is Private Credit. Understanding private Markets may have direct relevance for many of us who might be leading and helping businesses in Strategic Transformational Business and Data Architectures of buy-side Asset Management industry. More often I have observed that, due to the siloed nature of alternative markets and specialized Asset servicing platforms, have fractured Business, Data and Technology architectures. They are always hard to consolidate. Having said that, there will always be some synergies which can be achieved. But in order to do that one need to first understand how these markets work and who are different players. This is just my attempt to give you a high-level overview based on my understandings of the Private Credit Market.

What is really a Private Credit?

Credit is usually a contract/loan which borrower has an obligation to repay to the lender along with interest. Private Credit is privately negotiated loan between borrower and non-bank lender.

Background:

Today it is one of the fastest growing Investment Asset Class, but there are potentially many reasons behind it's rise.

1. Retrenchment of banks in US and Europe creates window for private lenders and borrower seek them as they provide flexibility, speed of execution and suety of capital.
2. Overall decline in the number of commercial banking lenders.

Private Credit Vs Traditional Fixed Income

Private Credit offers the potential for Higher yield and increased investor protections through negotiated terms, covenants and pricing.

Market Description -->

Traditional Fixed Income: Publicly syndicated and sold.

Private Credit: Privately originated and held.

Trading-->

Traditional Fixed Income: Yes

Private Credit: No

Coupon Payments:

Traditional Fixed Income: Yes

Private Credit: Yes

Credit Rating:

Traditional Fixed Income: Rated

Private Credit: Not Rated

Call Protection:

Traditional Fixed Income: Varies

Private Credit: Yes

Liquidity:

Traditional Fixed Income: Yes

Private Credit: No

Valuation:

Traditional Fixed Income: Frequent

Private Credit: infrequent

Private Credit Market for Investors Gives:

• Income: Offers Higher yields than traditional Fixed Income Assets
• Total Return: Has in the past given healthy absolute return across various market environments.
• Lower volatility: The return pattern of private credit is historically smoother than Equity.

Common Investment Strategies:

• Senior Direct Lending: Secured Seniors loans given directly to middle-market companies.
• Junior Debt: Subordinated loans for businesses which sit between Senior Debt and Equity.
• Mezzanine Debt: A type of Junior Debt that combines elements of both debt and equity with the expectation of Higher Returns than Traditional Senior Debt holders.
• Distressed Debt: Lending to borrowers that are insolvent or in distress.
• Specialty Finance: Typically, non-corporate lending occurring outside of traditional banking system; can include areas like equipment leasing, consumer finance, commercial real estate finance or asset-based finance.

Risk/Return Profiles by Strategies:

1. Senior Direct Lending --> Low Risk, Low Return
2. Distressed Debt --> High Risk, Low Return
3. Specialty Finance --> High Risk, Medium Return
4. Junior Debt --> Low Risk, High Return
5. Mezzanine Debt --> Low Risk, High Return

Factors for Risk/Return Profiles:

• Creditworthiness of the borrower: Includes current financial health and prospect of repayment in the future.
• Seniority: Order in which investors are repaid if there is default. Senior Debt takes precedence and has lowest Risk and Return potential. Equity holders sit below Debt owner and receive Highter returns for taking higher amount of risk.

It goes like this:

1. Repaid First Lower Risk, Lower Return: Seniority Debt
2. Typically, uncollateralized Higher Risk/Return than Seniority Debt: Subordinated Debt (Junior, Mezzanine, 2nd Lien...)
3. Repaid Last Higher Risk, Higher Return: Preferred Equity
4. Repaid Last Higher Risk, Higher Return: Common Equity

Interest Earned: These loans are usually Floating or variable rates Vs Fixed Rate. When in floating rate, interest owed will float higher or lower as short-term rates rise or fall.

Fixed Rate Debt:

1. Has a fixed Interest rate.
2. Price of debt rises as interest rate fall.
3. Price of debt falls as interest rate rise.

Floating Rate Debt:

1. Interest Rate changes periodically based on changes in Secured Overnight Financial Rate (SOFR)
2. As interest rate rises , income increases and vice versa.
3. In a rising rate period , is good for lenders but may stress borrowers.
4. Price of debt falls as interest rate rise.

#alternativeinvestment #privatecredit #debt

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