1.2 Fundamentals of private credit

Fundamentals of private credit

 

This video dives further into private credit, its opportunities and its risks. In particular, you'll learn about direct lending and asset-based finance, two major categories of private credit.

 

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Direct Lending and ABF

Direct lending and private asset-based finance (ABF)

The diagram explains direct lending and asset-based finance, or ABF. In both cases, a borrower takes on a loan and pays interest and principal back to investors. In direct lending, investors should consider the business's cash flows, value, and overall health. ABF is backed by a pool of many underlying loans, leases, hard assets, or financial assets. In a default, the lender is typically entitled to the collateral.

What is senior direct lending?

 

Senior direct lending is a specialized form of private credit in which lenders provide senior loans directly to upper-middle and middle-market companies under mutually agreed terms, and are based on the business's cash flows, value, and overall health. These loans can be made for various business needs, including buyouts, refinancing, recapitalization or to fund growth initiatives.

 

Senior direct loans sit on top of a borrower’s capital structure and are the first to be prioritized in the event of default, thus seeking to lower the potential for loss. Unsecured loan holders are repaid next. (You can learn more about a company’s capital structure in this lesson’s next reading.)

 

Direct lending’s potential benefits (to the different parties)

 

Direct lending is a private credit lending transaction that typically involves three parties: investors, a private credit investment fund and borrowers. Senior direct loans are mostly held-to-maturity, so value is created by a manager's ability to originate, underwrite and structure loan deals. The debt instruments purchased by the fund are subject to the risk that a borrower will default on the payment of principal, interest or other amounts owed. The benefits of direct lending to borrowers and investors include:

 

For borrowers:

  • Beyond the economics of the loan, borrowers may benefit from the support provided from the investment manager across the lifecycle of the loan. 
  • Direct loans typically benefit borrowers by providing liquidity, customization and additional loan opportunities — allowing borrowers the potential to access funds to support growth opportunities.

 

For investors:

  • Direct loans seek consistent returns relative to public debt.
  • Within a total portfolio, direct loans may provide diversification benefits like many categories of alternative investments.

The line chart shows yield-to-maturity for private credit, leveraged loans, and U.S. high yield from 2012 to 2024. The lines for leveraged loans and U.S. high yield closely track, with U.S. high yield generally a point or two higher than leveraged loans, until December 2022, when these lines intersect. Leveraged loans tracks higher than U.S. high yield from this point forward. Across the time period, private credit consistently tracks higher than the other categories, trending between 10% and 12%, except for a brief period in 2022 when private credit falls to 8% while U.S. high yield rises to 9%

What is asset-based finance?

 

Asset-based finance is a broad form of non-corporate lending backed by a variety of collateral, including tangible and financial assets. This collateral often generates cash flows and can act as a form of protection for the lender in the event a borrower does not meet its payment obligations. 

 

Four major categories of collateral within asset-based finance, include:

Six types of assets showing the diversity of assets that asset-backed finance can encompass: leased aircraft, rail cars, mortgages, auto loans, rental equipment, and royalties.

The potential benefits of ABF

 

Backed by large pools of collateral, ABF may benefit investors with predictable cash flows and low correlations to a range of public and private assets. There are risks associated with ABF — including fluctuating collateral values that can shift with market conditions. ABF investments differentiate from traditional public market investments in that they are privately originated and negotiated and may benefit from the potential to be structured in many ways. 

A closer look at direct lending

 

Private credit can offer potentially higher income than traditional fixed income investments, compensating for the increased credit and illiquidity risk. The largest part of the private credit universe is senior direct lending, and it is generally considered to be less risky than other types of private credit investments. 

 

Senior direct lending is a specialized form of private credit in which lenders provide loans directly to middle-market companies under mutually agreed terms and are typically backed by the financial health and cash flows of the borrowing company. These loans can serve business needs like buyouts, refinancing, recapitalization or growth initiatives.

 

Understanding the “capital structure”

 

What makes a loan “senior?” Senior loans sit atop a company’s capital structure — the hierarchy of claims on a company’s assets that is defined by the sources of a company’s financing, i.e., debt and equity. Not every borrower’s capital structure includes all the layers in the illustration, but senior debt sits at the top by definition.

The chart shows the tranches of investment that may constitute a business's capital structure. From least to most risk in liquidation, the tranches are senior debt, unitranche debt, subordinated or junior debt, mezzanine debt, and equity. The lower-risk a tranche is, the more likely it is to recoup money in a liquidation.

The higher a source of financing sits in the capital structure, the higher its priority on claims in the event of default or liquidation — and the less risky it is generally to invest in.

 

For example, in the illustration, equity sits at the bottom of the capital structure. It’s the most financially risky of these layers but also has the highest return potential because it represents an ownership stake in the company. If the company were to liquidate its assets in bankruptcy, the equity shareholders would be the most likely to suffer the greatest loss.

 

Above equity sit various levels of credit. Subordinated debt ranks above equity but below senior debt. If a company goes bankrupt, subordinated debt holders are paid by remaining funds after senior debt holders and before equity holders. 

 

With senior credit at the top of the capital structure, this means that in the event of liquidation, the senior creditors would be the highest repayment priority, making holding senior credit the least risky layer of the capital structure. Senior debt is also typically secured by collateral, which means if the borrower cannot meet its obligations, the lender has the legal right to recover the outstanding debt by liquidating the collateral. 

 

“Least risky,” of course, does not indicate that there is no risk at all. Even senior creditors may suffer losses in a serious bankruptcy. However, if you’re investing in the private credit market, senior direct lending is normally among the less risky segment.

End of lesson

You should now have a greater understanding of private credit. Don’t forget to review lesson takeaways here.


 

In the next lesson, you'll learn about interval funds, a vehicle that can open up access to private credit investment.

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The fund invests in private, illiquid credit securities, consisting primarily of loans and asset-backed finance securities. The fund may invest in or originate senior loans, which hold the most senior position in a business's capital structure. Some senior loans lack an active trading market and are subject to resale restrictions, leading to potential illiquidity. The fund may need to sell other investments or borrow to meet obligations. The fund may also invest in mezzanine debt, which is generally unsecured and subordinated, carrying higher credit and liquidity risk than investment-grade corporate obligations. Default rates for mezzanine debt have historically been higher than for investment-grade securities. Bank loans are often less liquid than other types of debt instruments and general market and financial conditions may affect the prepayment of bank loans, as such the prepayments cannot be predicted with accuracy.

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