What Is Private Credit? Risks and Benefits

What is private credit?

Private credit is nonpublicly traded, privately negotiated loans between a borrower and a nonbank lender. Non-bank lenders, also known as “shadow banks,” include hedge funds, mortgage lenders, and other financial institutions that are not bound by certain banking regulations.

» MORE: See our picks for the year's best financial advisors

The difference between private credit and public credit

The main difference between private and public credit is that private credit is from nonbank lenders and public credit, such as bonds, are publicly-traded loans from a bank.

Khang Nguyen, the chief credit officer of registered investment advisor Heron Finance, broke down private credit in simple terms in an email interview. According to Nguyen, post-Great Recession financial regulations have limited banks’ ability to lend, especially to private equity-backed companies that may not have all the paperwork needed to borrow money from banks at competitive interest rates.

That “regulatory workaround” appeal — along with the strong performance of private credit investments — has helped private credit grow rapidly into a $30 trillion market, according to McKinsey^[0]

Pros and cons of private credit

Before you invest in this novel asset class, it’s worth understanding its unique pros and cons.

Private credit advantages

Potential for high returns. The asset class averages returns of 9% to 11% per year, Nguyen says, which may be higher than some bond funds. (Past performance does not guarantee future results, however.)

» MORE: Learn how alternative assets work

Private credit risks

Illiquidity. Nguyen said some private credit investments are illiquid — you aren’t necessarily allowed to pull your money out whenever you want, like you can with most conventional investments. Private credit exchange-traded funds (ETFs) may offer daily liquidity, like most other ETFs, but regulators say that might not be a good thing, given that the underlying private credit investments can’t be bought and sold on demand.

In turn, if a large number of investors sold shares of the ETF, for example, and the ETF was unable to sell a corresponding amount of its private credit investments, the price of the ETF could diverge sharply from the actual value of its holdings.

Short history. Nguyen added that the private credit industry is “relatively young and filled with many inexperienced managers, and has not experienced a systemic correction or significant downturn since its inception.”

Unpredictability. Given that private credit is less regulated than conventional fixed-income investments, such as bonds, it’s hard to predict how bad a downturn might be.

» MORE: What are angel investors?

The bottom line on private credit

Private credit is growing fast — and offering investors much higher returns than many bonds pay — because it fills a demand for quick-and-easy financing from companies that aren’t established enough to borrow money conventionally.

But it’s very new to retail investors, and doesn’t always offer features that most conventional investments do, like on-demand withdrawals. Plus, that lack of regulation could also leave it vulnerable to a big crash in the future.

If this sounds too risky to you, traditional bonds may be a better way to diversify your portfolio.