Is Private Credit Safe? What Smart Investors Get Right - and Dumb Money Gets Wrong

Private credit offers higher yields and portfolio diversification but comes with significant risks like low transparency, economic sensitivity, and weak loan terms. Smart investors minimize these risks by choosing experienced fund managers, diversifying investments, and actively monitoring portfolios. Key takeaways include:

• Higher Yields, Higher Risks: Private credit can deliver returns exceeding 11%, but it involves lending to smaller, less-established companies with limited financial reserves.
• Transparency Issues: Unlike public bonds, private credit lacks regular ratings and disclosures, making due diligence crucial.
• Economic Vulnerability: Smaller businesses are more likely to default during recessions or periods of rising interest rates.
• Weaker Loan Terms: The rise of "covenant-lite" loans reduces lender protections, increasing risks in borrower defaults.
• Smart Strategies: Diversify across sectors and geographies, insist on strong loan covenants, and monitor portfolios actively.

Private credit can be a strong addition to a portfolio if approached with discipline, thorough research, and a focus on risk management.

High yields or high risk? What investors need to consider before investing in private credit

The Main Risks of Private Credit Investments

Private credit can deliver appealing returns, but it comes with its fair share of risks. To navigate this investment space effectively, it’s essential to understand these risks thoroughly. Unlike public markets, private credit investments operate in a more opaque environment, bringing unique challenges that can catch investors off guard. Let’s break down some of the primary risks, starting with transparency issues.

Limited Information and Poor Transparency

One of the biggest hurdles in private credit is the lack of transparency. Unlike public bonds, which are accompanied by regular financial reports and credit ratings, private credit operates with far less disclosure. Fund managers often share limited details about borrowers, loan terms, or any amendments. This lack of transparency can leave investors in the dark about critical borrower information until it’s too late.

Another issue is the absence of public market prices. Fund managers rely on internal valuation models, which can sometimes lead to discrepancies. For example, a February 2024 Bloomberg investigation revealed a stark contrast in loan valuations for Magenta Buyer, a cybersecurity firm. One lender valued the loan at 79 cents on the dollar, while another marked it down to just 46 cents.

Additionally, the weak secondary market for private credit exacerbates the problem. Funds often have to sell troubled loans at steep discounts, leaving investors stuck with underperforming assets.

Economic Downturns and Market Changes

Economic shifts pose another significant risk to private credit portfolios. These investments often involve smaller, less-established companies, which tend to have limited financial reserves. During economic downturns, these businesses are particularly vulnerable, and the risk of downgrades far outweighs the chance of upgrades - especially in volatile industries like retail, hospitality, and manufacturing.

Andrew Dennis, Head of Private Placement Research, noted, "As we look ahead to the likelihood of impending recession in the major developed economies and many emerging ones, it's critical to construct private credit portfolios for which the risks of credit default and downgrade are as low as possible".

Rising interest rates compound these challenges. Companies holding floating-rate debt face increasing borrowing costs, putting additional strain on their finances. While secured loans have historically helped minimize losses in the U.S. capital markets, even these can result in significant losses if the underlying businesses collapse.

Weak Loan Terms and Agreements

The structure of loan agreements plays a critical role in mitigating risk, but recent trends in private credit have raised concerns. In the past, private credit loans often featured lender-friendly terms, including multiple financial covenants tested quarterly. However, competitive pressures have led to the rise of weaker agreements.

Today, "cov-lite" loans, which lack strict maintenance covenants, and "cov-loose" agreements, which only trigger breaches after severe underperformance, dominate the market. In fact, cov-lite loans now account for 90% of the broadly syndicated loan market. Just five years ago, private credit loans were distinguished by their stricter covenant requirements.

Other risk factors include payment-in-kind (PIK) loans, where borrowers pay interest with additional debt instead of cash, and non-accrual loans, where borrowers stop making payments altogether. These can quickly inflate loan balances and lead to capital losses. According to S&P Global, borrowers funded by private credit are slightly more likely to default multiple times, with shorter intervals between defaults. Recovery rates for private credit loans are also generally lower than those for syndicated loans or high-yield bonds.

Finally, the increasing use of unitranche loans adds another layer of complexity. These single-tranche loans simplify the lending process but often involve side arrangements that split and sell portions of the loans in secondary markets. While unitranche loans offer speed and convenience, they can introduce additional risks for investors.

How Smart Investors Reduce Private Credit Risks

Savvy investors take deliberate steps to minimize risks and achieve steady returns in private credit. With the market expected to grow from US$1.5 trillion in early 2024 to a projected US$2.8 trillion by 2028, the stakes are higher than ever. Navigating this opaque and complex space requires disciplined risk management.

Thorough Research and Manager Selection

A solid private credit strategy starts with choosing the right manager. Unlike public markets, where information is abundant, only about 20% of private credit issuers are rated. This makes manager selection a critical step.

Investors analyze managers' portfolios by looking at factors like debt service capability, loan-to-value ratios, and lender protections. They also assess past performance, underwriting expertise, and experience with economic cycles.

"As private credit popularity rises, investors must be even more discerning. Alpha in private credit derives from loss avoidance, not upside potential." – Adams Street Partners

A manager's investment pace is another key indicator. Deploying capital too quickly may signal a compromise on quality, whereas a disciplined manager will pass on deals that don't meet their standards. Investors also review loan documents for terms like collateral strength and protections against being "primed" by other lenders.

Operational capabilities matter too. Investors evaluate how managers handle cash flows, allocations, and partnerships with service providers. They also benchmark managers against competitors, examining metrics like gross yields, cash income, net income, volatility, default rates, and loss rates.

This rigorous evaluation process sets the stage for additional strategies like diversification and ongoing monitoring.

Diversification and Conservative Investment Methods

True diversification in private credit goes beyond surface-level metrics. Smart investors dig deeper, analyzing correlations to ensure their portfolios are genuinely balanced.

Effective strategies include balancing sponsor-backed and non-sponsor-backed deals. For instance, while upper middle market direct lending often involves private equity-led transactions, non-sponsored deals - making up about one-third of the private credit market - are less correlated to interest rates, capital markets, and recessions. These deals typically feature lower leverage and broader sector exposure.

Investors also diversify across corporate lending and asset-based financing, maintain broad sector exposure, and spread investments across multiple geographies. Conservative position sizing further reduces risk. However, they stay cautious with co-investments among major firms, as these can obscure concentration risks.

Geographic diversification minimizes exposure to country-specific risks, while sector diversification protects against industry downturns. Although private credit spreads are often 200 to 600 basis points higher than those in public markets, smart investors prioritize understanding the risks behind the yields rather than simply chasing the highest returns.

Active Portfolio Monitoring and Stress Testing

Private credit requires active oversight throughout the investment lifecycle. Unlike public market positions that can be quickly traded, private credit demands consistent attention to ensure risks are managed effectively.

Investors conduct regular stress tests and scenario analyses to evaluate portfolio health. They also maintain communication with borrowers and fund managers to detect early signs of financial trouble. Key performance indicators like payment patterns, covenant compliance, and borrower financial health are closely tracked to address emerging risks before they escalate.

The Importance of Strong Loan Covenants

To mitigate risks tied to weak loan agreements, savvy investors insist on robust loan covenants. In a market where over 90% of high-yield and broadly syndicated deals are covenant-lite, securing strong protections is a critical strategy.

"The primary function of covenants is to protect lenders by ensuring borrowers adhere to agreed parameters. When a borrower diverges from these terms, lenders can intervene to renegotiate and restore compliance. This process is crucial for maintaining the stability and performance of the underlying asset or business."

Strong covenants serve as an early warning system, enabling lenders to take action before problems worsen. By tailoring covenant terms to a borrower's specific circumstances, investors gain tools to monitor risks more effectively. These structures also lead to higher recovery rates compared to covenant-lite agreements, which have shown weaker outcomes as default levels increase. Investors demand agreements that offer meaningful control and the flexibility to adapt to each borrower's unique situation.

Common Mistakes Made by Inexperienced Investors

Navigating the world of private credit can be rewarding for those who approach it with discipline and a clear strategy. However, for inexperienced investors, certain common mistakes can lead to costly outcomes. Recognizing these pitfalls is crucial to avoiding unnecessary losses and building a more resilient investment approach.

Chasing High Returns Without Understanding Risks

The promise of high yields in private credit often tempts investors to dive in without fully grasping the risks involved. While private credit has historically offered an average yield premium of 4.2% over public credit during the past decade, that extra yield comes with strings attached. It compensates for higher-risk factors like weaker borrower credit, less favorable loan terms, and exposure to volatile industries.

"With opportunity comes complexity, and navigating these markets requires manager experience, investor discipline, and a nuanced understanding of risk." - John Griffith III, Managing Director, Senior Strategist, Global Private Debt

During times of market stress, the dangers of chasing returns become glaringly obvious. Private credit loans, for instance, have lower recovery rates upon default - direct loans recover about 33%, compared to 52% for syndicated loans. Investors who focus solely on yield often realize too late that they’ve underestimated the downside risks.

Poor Research and Analysis

Inadequate research is another frequent pitfall. Private credit investing isn’t straightforward; it demands deep knowledge of asset classes, regulations, and market trends. Yet many new investors cut corners when conducting due diligence.

Some fail to thoroughly evaluate fund managers, skipping over critical details like performance across credit cycles. Others neglect to assess borrower financial health or fully understand the implications of deal structures. This lack of scrutiny can lead to investments that misalign with their risk tolerance or return goals. Adding to the complexity, only about 20% of private credit issuers are rated, leaving investors with limited public information to rely on.

Market dynamics further complicate matters. A surge in available capital and heightened competition can lead to looser underwriting standards, increasing the risk of defaults. Without a comprehensive approach to research, investors may find themselves blindsided by these broader trends.

Too Much Concentration in Risky Assets

Concentration risk is particularly perilous in private credit, given its illiquid nature. Inexperienced investors often allocate too much capital to similar deals, sectors, or regions without fully considering how these investments are interconnected.

For example, focusing heavily on private equity-linked deals can expose investors to high-debt loans, weak credit documents, and industries heavily influenced by interest rates or economic downturns. Even when investments appear diversified across multiple funds, they may still be tied to similar underlying assets, amplifying correlation risks.

Another common mistake is overloading portfolios with high-risk, high-return strategies like distressed or opportunistic investments. While these approaches can be lucrative, failing to balance them with more stable assets leaves portfolios vulnerable during downturns.

Ignoring Weak Loan Terms and Problem Loans

One of the most dangerous errors inexperienced investors make is overlooking weak loan terms or ignoring warning signs in their portfolios. Loan covenants, collateral arrangements, and other protective measures are critical to preserving capital, especially during periods of borrower distress.

The prevalence of covenant-lite deals - over 90% of high-yield and broadly syndicated loans lack strict financial maintenance covenants - has made this issue even more pressing. Investors who accept weak terms without demanding adequate compensation put themselves at greater risk when borrowers face financial trouble.

Additionally, failing to monitor key indicators like payment patterns, covenant compliance, or borrower health can allow issues to escalate unnoticed. For instance, a high percentage of non-accrual loans in a portfolio is often a red flag. By the time these problems surface, it’s often too late to take corrective action.

Compounding these challenges is the illiquid nature of private credit. Unlike public market investments, which can be sold relatively easily, private credit requires a long-term commitment. This makes thorough upfront analysis and ongoing monitoring absolutely essential. Without it, investors may find themselves stuck in unfavorable positions with limited options to exit.

Case Study: Steadfast Equity's Approach to Safety and Returns

Steadfast Equity demonstrates how disciplined strategies and ethical management can deliver strong returns while keeping risks in check. These principles form the backbone of their bond solutions, ethical investment practices, and thorough risk management strategies.

High-Yield Bond Options with Transparent Terms

Steadfast Equity provides structured bonds that offer fixed, contractual returns, unaffected by market volatility.

Their DualYield™ Bonds deliver an impressive annual yield of 19.7%. Investors can allocate up to 12% APY as monthly income while compounding the remaining 7.7%. With a minimum investment of $200,000 over a five-year term, these bonds also offer flexibility - investors can adjust their allocation with 45 days' notice, giving them more control over their cash flow without sacrificing returns.

"As a bondholder, your returns are not dependent on company performance - they are contractually defined. You receive fixed interest payments and principal repayment, regardless of market conditions. Your primary concern should be credit risk, which is why our strong financial position is the key factor to consider."

This straightforward structure is essential for effectively managing credit risks, ensuring clarity and reliability for investors.

Ethical Investment in Growth-Oriented Sectors

Steadfast Equity pairs its clear bond offerings with a focused and ethical approach to capital deployment. The firm prioritizes investments in stable, high-growth sectors such as technology, artificial intelligence, biotechnology, and real estate - industries with strong, proven fundamentals. For instance, the AI sector is expected to grow at an annual rate of 35.9% between 2025 and 2030, making it a key area of focus for future opportunities.

"At Steadfast Equity, our investment philosophy is rooted in the principles of long-term value creation, safety, and ethical stewardship."

By avoiding ventures that could lead to exploitation or conflicts of interest, Steadfast Equity not only protects its reputation but also ensures its investments deliver meaningful value. This commitment to ethics reduces both financial and reputational risks while aligning with long-term growth objectives.

Prioritizing Risk Management and Financial Stability

Steadfast Equity emphasizes the importance of financial strength in private credit investing. With over $800 million in assets and liabilities kept below $200 million, the firm maintains a strong asset-to-debt ratio. This financial cushion allows them to repay bonds early if needed, safeguarding investor interests during market fluctuations.

The company’s disciplined capital management ensures that bond offerings are tied to sound investment opportunities, preventing over-leveraging. Additionally, they retain the option to repay bonds early, a measure designed to protect the overall health of their portfolio.

"This clause exists to protect the long-term health of our portfolio and to safeguard all investors - not as a loophole or exit strategy."

These practices highlight that successful private credit investing requires more than just attractive yields. It demands a foundation of financial stability, ethical diligence, transparency, and disciplined investment strategies. Steadfast Equity’s approach exemplifies how these elements come together to create a secure and rewarding investment environment.

Conclusion: Making Smart Decisions in Private Credit

Building on the strategies outlined earlier, savvy investors know that navigating private credit requires a mix of discipline, thorough research, and a clear understanding of risks.

When approached thoughtfully, private credit can be both a secure and profitable investment. The key lies in meticulous due diligence - digging into financial statements, evaluating business models, and understanding industry trends. Craig Machel, senior portfolio manager and senior investment advisor with Richardson Wealth in Toronto, emphasizes this point:

"Building portfolios that are not just stocks and bonds requires an enormous amount of work. You don't just buy it and you're done; it requires due diligence along the way."

Diversification is another critical pillar. By spreading investments across different sectors, borrower profiles, and credit types, investors can mitigate concentrated risks. With the private credit market projected to hit $2.8 trillion by 2028, the opportunities to construct diversified portfolios are substantial.

Staying vigilant is equally important. Active monitoring and stress testing help investors identify potential problems early, especially in a market that evolves quickly. Strong loan covenants, combined with a commitment to ethical capital allocation, provide an extra layer of protection, guarding against both financial losses and reputational damage.

Sean O'Hara, chief investment officer and lead portfolio manager with Obsiido Alternative Investments Inc, offers a cautionary note:

"Private credit is a legitimate and attractive asset class - if you play it well and play it smartly. But it's not attractive if you lose half your capital."

Ultimately, success in private credit hinges on working with experienced professionals, maintaining a long-term outlook, and avoiding the temptation of chasing high yields without fully grasping the associated risks. With proper research, diversification, and risk management, private credit can deliver meaningful opportunities for those willing to put in the effort. Ethical investing not only protects assets but also creates lasting value.

FAQs

What steps can investors take to assess risks and ensure transparency in private credit investments?

Investors can navigate the complexities of private credit by prioritizing independent evaluations and conducting thorough due diligence. Independent risk assessments and transparent credit scoring systems offer critical insights into potential weak spots, helping to uncover risks that might otherwise go unnoticed.

It’s also crucial to grasp the unique characteristics of private credit, such as extended lock-up periods and floating interest rates, as these can directly impact liquidity and exposure to interest rate fluctuations.

To make well-informed decisions, investors should take the time to review asset valuations in detail, assess the robustness of risk management strategies, and fully understand the terms of their investments. When combined, these steps can help reduce uncertainties and build a stronger sense of confidence in navigating the private credit landscape.

How do experienced investors manage the risks of covenant-lite loans in private credit?

Experienced investors tackle the risks associated with covenant-lite loans by staying vigilant and maintaining a disciplined approach. Even without strict covenants in place, they keep a close eye on the financial health of borrowers, aiming to spot potential problems before they escalate. To further safeguard their investments, they negotiate clear terms and conditions at the outset, ensuring accountability and protection.

Another important tactic is routinely evaluating the credit risk of their portfolios. By staying attuned to shifting market conditions, they can make timely adjustments to reduce exposure to potential defaults. This blend of careful monitoring, structured planning, and adaptability allows them to navigate risks effectively while striving for steady returns in the private credit market.

How do economic downturns affect private credit investments, and what can investors do to protect their portfolios?

Economic downturns often bring heightened risks for private credit investments, including increased default rates and credit downgrades, especially in industries that are closely tied to economic cycles. These challenges can directly affect both returns and the overall stability of a portfolio.

To safeguard their investments, it’s essential for investors to emphasize diversification across different sectors, which helps spread out risk and avoid overexposure to any single area. Strategies focused on capital preservation should also take center stage. Additionally, conducting in-depth due diligence to evaluate the financial health of borrowers is crucial. Having clear exit strategies, such as refinancing options or loan sales, can further reduce the chances of significant losses during periods of economic stress. Staying informed and taking a proactive approach are critical for navigating these uncertain times effectively.

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