Discover new opportunities with Private Credit

Private Credit explained simply

Alongside private equity and private infrastructure, private credit is one of the largest and most popular asset classes among investors in the private markets and is considered an alternative form of corporate financing. The granting of private credit—that is, loans issued outside the banking system—increased sharply in the years following the global financial crisis, not least because banks in many countries were subject to strict regulatory regimes, capital requirements, and liquidity regulations. In areas where banks withdrew from lending, private credit funds stepped in. These are investment products financed by private and institutional investors.

Global assets under management in the private credit sector have nearly tripled in the last 10 years alone.

Why do companies use private credit?

Companies seeking loans can access capital more directly, efficiently, and flexibly through private credit and increasingly view private credit providers as long-term and trustworthy financing partners. Private lenders can make faster investment decisions, operate without red tape, and offer customized repayment models. Companies particularly benefit from the flexibility in loan structuring and repayment terms.

However, financing is contingent upon a thorough review of the company—the so-called due diligence process. In many cases, contractual covenants are also agreed upon for the entire term of the loan, designed to ensure the company’s long-term success and a sound capital base. To this end, regular reports must be submitted to provide insights into the company’s performance.

Private loans are used to implement operational growth projects, for expansion, to enter new markets, for product development, for investments, or even for day-to-day operations.

An alternative to public bonds or syndicated bank loans

Private credit investments are, on the one hand, less liquid than investments in syndicated bank loans or high-yield corporate bonds. On the other hand, they feature variable interest rates and higher returns.

Stable returns

Private credit has the potential to deliver stable and ongoing cash flows (interest payments) during the investment period, whereas with private equity, for example, returns are often realized at the end of the term (sale of the company or “exit”). The establishment of covenants helps protect capital.

The excess returns of private credit compared to traditional debt investments are particularly evident in a rising interest rate environment. The chart below compares average returns in high-yield environments (quarters in which benchmark interest rates rose by more than 75 basis points) between the first quarter of 2009 and the second quarter of 2022.

Inflation protection

Private credit financing typically features variable interest rates, and the amount of interest payments is regularly adjusted to a benchmark interest rate. Unlike fixed-income bonds, rising benchmark interest rates therefore do not lead to price losses but instead increase current income, which consequently carries lower to no interest rate risk. This allows investors to participate in rising interest rates and reduce the portfolio’s sensitivity to inflationary dynamics, which often lead to higher interest rates.

Low correlation with other asset classes

Returns from private credit often exhibit low correlation with those from traditional asset classes. Adding private credit to a portfolio can help diversify risk and stabilize the overall portfolio’s returns. This has been particularly evident in the past during turbulent market phases.

Private Credit – A Look Under the Hood

Private credit today takes many forms, differing in terms of seniority, collateralization, maturity, and risk profile.

Senior Debt

A direct corporate loan, like bank loans, is considered a senior debt obligation and is negotiated with flexible terms. This form of credit is typically secured by the borrower’s cash flows and assets.

Subordinated Financing (Junior Debt)

Junior debt refers to subordinated debt. In many cases, it is not secured or only partially secured. Junior debt is repaid to creditors only after senior debt. For this reason, lenders demand higher interest rates to be appropriately compensated for the higher credit risk.

Unitranche

In unitranche financing, various private loans from multiple lenders are bundled into a single product. Instead of negotiating with several banks or financiers, there is only one lender or a small consortium. Since the lender pools more risk into a single product and assumes multiple seniority levels simultaneously, they receive a higher interest rate than in traditional senior debt financing. This is often referred to as “stretched senior” financing, as these liabilities typically result in a higher debt-to-equity ratio (leverage). Typical scenarios include corporate acquisitions or larger, more complex financing transactions.

Mezzanine Financing

Mezzanine financing is a form of financing that combines equity and debt capital. For example, companies receive subordinated loans, which in many cases have equity-like characteristics due to their subordinated status. This capital improves the company’s creditworthiness and, at the same time, its balance sheet ratios (such as the proportion of debt to total capital).

Convertible Notes

Convertible notes are loans that are converted into company shares—i.e., equity—at a pre-agreed (often more favorable) value during a subsequent equity financing round. As a result, the lender acquires shares in the company at a discount because they assumed the financing risk earlier than the new shareholders.

A convertible loan can be arranged much more quickly than a traditional equity round. Particularly in the case of startups or other rapidly growing companies, a final valuation has not yet been determined at the time the convertible loan is issued. This is deferred until the time of the equity round. The time until then is effectively used to increase the company’s valuation through further growth, increased revenue, or the expansion of the business model. Convertible loans and Simple Agreements for Future Equity (SAFEs) are widely used in the venture capital sector.

 

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