Private Credit: How It Works, Risks and Benefits

What is private credit?

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

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

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 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]

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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. Private credit 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.)

Diversification. Private credit is one of many options that investors may consider if they're seeking to spread their investments across different asset classes.

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Disadvantages of private credit

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 many conventional investments. Private credit exchange-traded funds (ETFs) may offer daily liquidity, like most other ETFs. However, the underlying private credit investments can’t be bought and sold on demand. In turn, if the ETF is unable to sell 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.

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The bottom line on private credit

Private credit is growing and may offer relatively high returns because it fills a demand for quick-and-easy financing from companies that aren’t established enough to borrow money conventionally.

However, private credit is very new to retail investors, and it doesn’t always offer on-demand withdrawals or other features investors are accustomed to have. Plus, lower regulation could create additional risk.

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