By Yieldstreet
Key takeaways
- “Private credit” identifies a large part of the credit market – beyond publicly traded fixed income instruments or bank lending – that has been traditionally inaccessible to everyday investors.
- While private credit has emerged as an attractive means of financing, it can also come with a unique set of risks that investors should be aware of before committing to the asset class.
- There are two ways to access the asset class – through single offerings, a curated list of individual private debt investment offerings, or through selected private credit funds sponsored by leading private credit fund managers.
While we’ve previously discussed the private credit space and explained the asset class, and how it can generate returns for investors, it’s important for those considering the space to understand the risks associated with private credit. Unlike stocks or other household investment vehicles, there are risks unique to the asset class that investors should carefully consider before making an investment.
Risks Associated w/ Borrower and Collateral
The first type of risk that investors should carefully take into account is the one related to the quality of the borrower, issuing company, or collateral asset that they’re working with. High quality? borrowers, companies, and collateral may provide greater confidence to lenders that there is a path to achieve the underwritten results, or that in challenged situations, there will be sufficient interest in the underlying value of the collateral to achieve a return of capital.
Covenants and Reporting Package
Beyond the strength of the borrower and collateral, investors should also consider the risks inherent to the structuring of the loan. Most companies employ adequate guardrails around the use of loan proceeds, the use of profits of the business, and the ability of the business to incur new debt or issue new equity. These guardrails can provide lenders of capital with greater confidence that the loan amount will be handled appropriately, and that repayment of the loan will be prioritized. Loan structures that provide lenders with vehicles for retribution and capital protection are likely to inherently provide greater confidence.
LTV / Advance rate
Investors should also be careful to eye the amount of debt issued to a company or an asset in their risk considerations. The higher the leverage, the greater the reliance on achieving a high exit price to repay the original loan or the greater the reliance on achieving another higher leverage loan to refinance the original loan. Often, when macroeconomic or capital markets conditions change for the worst, new buyers and lenders become increasingly conservative. Therefore, higher LTV loans can be associated with a higher likelihood of losses if macroeconomic conditions worsen.
Coverage Risks
Because a key driver of private credit returns is periodic interest payments, the ability of the borrower, issuing company, or collateral asset to make such periodic interest payments is a key lender consideration. Often loans will be sized with adequate coverage over interest payments and other fixed operating costs so that if the company or asset is underperforming, there is a margin of safety before interest payments will be impacted or, with fixed operating costs, the operations of the business are disrupted.
A key area of focus is the sensitivity of the business/collateral to challenges in the macroeconomic backdrop and, in the case of floating rate loans, the level of coverage that exists should reference rate rise.
Role in Transaction
Private credit investments can take multiple forms, including a single lender advancing a loan to a single borrower or, with larger loans, a consortium of lenders providing that loan. The control rights of the lender vis-à-vis the consortium of co-lenders is a consideration as consensus may be needed to effectuate corrective actions if the loan is not performing.
Complicating any risk calculations, lead lenders with the appropriate voting and control rights have greater latitude to take corrective actions if the loan is not performing, while participating lenders may be beholden to the actions of other members of the consortium. Thus, investors should be aware that having a leading, or participating position as a lender can carry a different level of risk.
Macroeconomic and Capital Markets Conditions
While tangential to a few of the above risks, macroeconomic conditions and the overall performance of capital markets are a key consideration for private credit investing. As market conditions were likely at the top of investors’ minds in the especially turbulent start of this year, it’s important to understand how they affect private credit . In expansionary market environments, lending criteria tend to be looser and subject to fewer conditions. Alternatively, in contractionary market environments, lending also contracts and the underwriting criteria tend to become more stringent, as lenders become more risk-averse
Importantly, investors should be mindful that the repayment of loans originated before macroeconomic conditions deteriorated may be beholden to the new and tightened underwriting conditions, which may constrain the extent to which a full repayment may be achieved for the original loan.
Portfolio Construction
For investments in private credit funds or portfolios of loans, a key consideration is the level of diversification by number and types of loans, as well as the underlying concentrations by borrower, issuing company, or collateral asset within the portfolio. This can include concentrations of the single or the largest few loan positions, the overall seniority and security of the loans, concentration in specific industries or asset classes, etc. A key focus is that no single loan within the portfolio will meaningfully impact the performance of the fund at large and, in the event of a broader macroeconomic contraction, there is adequate balance across the portfolio to accommodate repayment of principal and a reasonable return on the investment.
Another consideration for investors should be the level of portfolio management discipline associated with a fund – we try to understand how a fund manager will manage the portfolio to ensure adequate resources and reserves are available to take corrective action should overall investment conditions change.
Portfolio Borrowings
Another focus is whether a lender borrows money to finance a single loan or a portfolio of loans. A lender of a loan may borrow debt financing to make that loan in order to enhance the return and limit the amount of capital invested in the loan. The nature of the borrowings at a single loan level or at the portfolio level is a key risk consideration.
Among other potential risks, this risk may be expressed if there is:
– A mismatch between the interest of the loan and the underlying borrowings, say if the loan was fixed rate and the borrowings were floating rate;
– A mismatch between the horizon of the loan and the underlying borrowings, say if the loan had a term of 3 years and the borrowings had a term of 1 year;
– A high amount of borrowings are used to make the loan and the loan experiences challenges; or
– The borrowings have more stringent terms than the loan(s) being financed, creating exposure if changes in conditions of the borrowings cannot be carried through to the loan(s).
Conclusion
While private credit opportunities often benefit from low market correlation, and thus won’t experience the same adverse effects during periods of volatility, they can come with their own risks that investors should make themselves aware of. While the above list is by no means exhaustive, it should help any investor understand some of the major risks that can be associated with private credit, especially during periods of market volatility.
Original Article
All posts are the opinion of the contributing author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CAIA Association or the author’s employer.