By Gordon Henderson
Editor’s note: This post originally appeared in the Globe & Mail.
Private credit refers to loans by non-bank lenders, such as investment funds and speciality finance companies, that aren’t issued or traded on public exchanges. Although it has a long history, over the past two decades, economic and regulatory changes have driven robust growth in the category to the benefit of borrowers and lenders alike.
Fundamentally, the role of private lenders is to provide options for borrowers when banks are unwilling or unable to lend them money. As such, there are many use cases. Corporate borrowers, for example, can use private credit to finance growth initiatives, mergers, and new ventures, or to fund working capital requirements, even if they lack assets or positive cash flows. Private lenders can also provide bridge financing, leveraged loans, and debt to distressed borrowers, among others.
In addition, individuals can use private credit to fund a range of activities, including auto purchases, home improvements, and mortgages. They can also use it for more esoteric purposes, such as purchasing art or paying for litigation.
Specialized lending capabilities
The common underlying dynamic in all of these use cases is that specialist lenders are able to utilise deep domain knowledge to adjudicate credit in ways that are unavailable to banks. After all, if underwriting the loans were straightforward, banks would probably be more inclined to fund them in the first place.
Venture debt lenders, for example, need to be able to accurately value money-burning companies with negligible assets and short operating histories. Similarly, distressed debt providers have to understand the legal framework and processes that drive bankruptcy proceedings, while auto finance companies can’t operate effectively without up-to-the-minute awareness of residual asset values.
In addition to their analytical skill sets, private lenders also need robust monitoring capabilities to ensure that the loans they’ve extended are actually repaid. Alternative lenders to corporate clients will often require much more frequent reporting than a bank might, to enable them to quickly get ahead of any problems that manifest in the loan. Similarly, auto lenders don’t just need to know what their collateral is worth, they also need processes for recovering that collateral and monetising it if they have to. How powerful those systems are will have a considerable impact on their returns.
Benefits to investors
For investors, private credit offers significant benefits. Most obviously, interest rates on private loans are often much higher than those obtainable in more traditional yield categories — something that’s especially relevant in today’s low interest rate environment. Those interest rates are a function of the idiosyncratic nature of the underlying loans, and the fact that for the most part, private lenders don’t have to compete against a host of banks to make each loan.
Higher interest rates often speak to higher risks, because risky borrowers pay higher interest rates than safer ones. However, there are a variety of reasons why risk and return aren’t quite so precisely correlated in many sectors of private lending. For instance, there are a limited number of specialists with the capacity to extend credit in any given sector, so competition is structurally limited, and correspondingly less intense. Moreover, many categories of private lending require highly customized solutions, such that price is only one of the decision drivers for borrowers.
Even in relatively straightforward contexts, like HVAC loans for example, a borrower might be more concerned with the timeliness of the approval than the ultimate cost of the loan. If a furnace retailer can approve them for financing on the same February weekend night that their furnace has broken, that’s probably a better option than waiting for a bank to start its credit approval on the following Monday.
But higher interest rates are only part of the potential attraction for investors. Private credit also offers a return profile that’s largely uncorrelated to the returns from other asset classes, which is an important consideration in terms of portfolio construction. Recent years have seen many investment categories move together, raising the value of diversification still higher.
To be clear, private credit isn’t a magic bullet. While the number of lenders and strategies available today increases the chances that an investor or borrower will find something that solves for his or her particular problem, it also suggests that there is a larger number of options that aren’t suitable.
Nevertheless, private credit is often capable of generating solutions to problems when traditional approaches simply won’t work. For borrowers, it can provide non-dilutive capital in situations where traditional credit is unavailable. Meanwhile for investors, private credit can offer higher yields than they can earn elsewhere, while also affording them an element of portfolio diversification that’s desirable in its own right.