With tighter lending regulations imposed after the 2008 Global Financial Crisis, private credit fills a financing gap left by traditional banks. Influenced by economic factors, interest rates and regulatory constraints on banks, private credit funds address various financing needs like growth capital, real estate and distressed debt restructuring. These funds have become a vital capital source for many companies, especially those unable to tap into traditional bank financing or public debt markets.
How a Private Credit Fund Works
Private credit funds pool investor capital to provide financing to private entities through loans or debt investments. With its potential for attractive risk-adjusted yields, private credit has become an appealing choice for institutional investors and individuals searching for income-generating assets. These funds are alternatives to traditional bank loans, serving borrowers who don’t meet bank qualifications or seek flexible financial solutions. By committing capital, investors typically assume the role of a lender or limited partner, entrusting a general partner and the fund’s management team with conducting due diligence, underwriting loans and managing the portfolio.
A private credit fund’s investment strategy can range from direct company lending, mezzanine debt, distressed debt and real estate financing to other specialized credit instruments. After raising capital from institutional investors, the fund provides credit to private companies or borrowers. The primary returns of a private credit fund come from interest income earned on the loans in its portfolio. And after a fixed investment period, investors receive distributions from the fund. Once this period is over, the fund exits investments as loans are repaid or mature. The proceeds from these exits are returned to the investors, leading to the eventual winding down of the fund.
Private Equity Funds Versus Private Credit Funds
While private credit funds invest debt securities for regular interest income and principal returns, private equity funds target equity ownership in private companies for potential capital appreciation. Each one has distinct strategies, risk-return profiles and target assets. Investors choosing between the two types of funds should understand their risk tolerance and investment objectives.
Here is a brief comparison of both types of funds:
The Benefits of Private Credit Funds for Investors
Investing in a private credit fund offers several benefits for investors, including:
Diversification: Private credit funds diversify an investor’s portfolio beyond traditional stocks and bonds by investing in a wide range of private debt instruments, potentially reducing risk and boosting returns.
Income generation: Private credit funds are designed to provide a steady stream of income to investors through interest and principal payments from private debt investments—an appealing alternative for investors seeking regular returns.
Attractive risk-adjusted returns: Private credit funds offer the potential for compelling risk-adjusted returns by targeting higher returns than traditional fixed-income investments through investment in riskier, less liquid debt instruments.
Capital preservation: Some private credit funds provide senior secured loans or other credit instruments with strong collateral, attracting investors seeking to protect their capital while generating income.
Lower interest rate sensitivity: Private credit investments are typically less sensitive to interest rate fluctuations than publicly traded bonds due to their exemption from daily mark-to-market pricing. This reduces the impact of short-term market shifts and interest rate movements.
Limited volatility: Private credit funds typically exhibit lower volatility than publicly traded assets (e.g., stocks), due to their illiquid nature, which buffers against short-term market fluctuations.
Mitigation of systemic risk: As private credit funds invest in private companies, they can offer protection from systemic risks that affect publicly traded assets, such as major financial crises or widespread banking sector collapses. Their performance is often more tied to the creditworthiness of the borrower than overall market trends.
Risks and Considerations
As with all investments, investments in private credit funds come with some inherent risks, including:
Lack of liquidity: Private credit funds often have extended lock-up periods, limiting investors’ access to their capital, which can be concerning for investors needing short-term liquidity.
Credit and default risk: Private credit funds invest in debt instruments such as private company loans, which carry credit risk. Compared with traditional fixed-income investments, private credit often carries a higher default risk, as private borrowers in the private lending market are likely to have weaker credit profiles and face less scrutiny than publicly traded companies.
Interest rate risk: Rising interest rates can impact private credit funds, potentially reducing fixed-rate debt values.
Manager risk: A private credit fund’s success relies heavily on the fund manager’s skills, experience and judgement. Poor decisions can lead to underperformance.
Valuation risk: Private credit assets, especially illiquid ones or ones with limited market data, may have valuation changes. This could lead to discrepancies between performance reporting and actual market value.
Regulatory risk: Changes in regulations can impact the operations and strategies of private credit funds, potentially affecting their return potential.
Leverage: Some private credit funds may use leverage to enhance returns. However, leverage can also amplify losses, increasing overall risk.
Limited transparency: Private credit investments are not as transparent as publicly traded securities due to different regulatory standards. For instance, they typically lack the rigorous financial reporting, management disclosures and regulatory filings that publicly traded securities are mandated to provide. This reduced transparency can limit investors’ visibility into their underlying assets, which can make risk assessment challenging.
To mitigate these risks, investors should conduct thorough due diligence, understand the fund’s investment strategy and risk management practices, and ensure alignment with their own risk tolerance and goals before investing in such funds. Diversifying across different investment opportunities can also help distribute risk and reduce the repercussions of any default or market downturn.
Example of a Private Credit Fund
The open-end Strategic Credit Fund, from Origin Credit Advisers—an investment advisor registered with the SEC and an affiliate of Origin Investments—is a portfolio of yield-focused multifamily debt investments for qualified purchasers that seeks to provide a consistent stream of risk-adjusted income and capital protection.
The benefits of the Fund include:
Priority Position: Investments are senior to underlying common equity in payback priority, seeking impairment protection by a 30% to 40% cushion to loss in underlying collateral value.
Income generation: The Fund intends to make regular monthly distributions and provide a distribution reinvestment program for investors to auto-reinvest distributions back in the Fund.
Inflation hedge: The Fund seeks to allocate 30% to 60% of its equity to floating rate debt investments, which means when interest rates rise, so do the borrowers’ interest payments.
Tactical portfolio management: The Fund is designed with the goal of delivering risk-adjusted returns and income in any market environment by moving to where the market is providing mispriced buying and selling opportunities.
If you’d like to learn more about this Fund, download the due diligence materials.