The Private Credit Playbook
Today, private investors and wealthy families are facing uncertainties related to economic growth, inflation, interest rates, and private investment exit opportunities. Yet, these same market challenges are serving as tailwinds for certain asset classes, including private credit. In today’s environment, we believe private credit can deliver attractive returns, supported by a strong foundation in protected assets and faster capital deployment than other private growth assets. This paper presents an overview of the asset class and a discussion of how family investors can implement this strategy effectively in their investment portfolios.
What Is Private Credit?
Private credit investments are non-publicly traded investments provided by non-bank entities that fund private businesses. These investments encompass a wide range of strategies, including senior debt, subordinated capital, credit opportunities, distressed credit, and speciality finance, each with distinct features.1 At a high level, private credit consists of two distinct categories – lending and opportunistic (Figure 1).
Private credit strategies offer higher yields than traditional fixed income, with low correlations to both liquid corporate/municipal bonds and equity markets. In addition, private credit involves bespoke terms and structures that can offer ongoing cash yield and charges fees on invested rather than committed capital. Both elements help to mitigate a portfolio’s private investment J-curve impact.
Lending Strategies
Lending strategies offer money to borrowers for periods ranging from short to medium term, usually between three and five years. These loans often come with variable interest rates that can change over time. These strategies can be particularly appealing when the loans are for shorter periods and the lender has a priority claim on the borrower’s assets in case of default. Furthermore, many lending funds have provided attractive returns that are not closely linked to changes in interest rates – through self-liquidating investments that are designed to pay themselves off within a three-year period. In 2022, for example, these strategies generated strong positive returns, while liquid high-quality bonds (e.g., US government, corporate, municipal, mortgage) were all down more than 10%.
Private lending strategies feature privately negotiated, senior structured debt and traditionally generate 8%–10% net unlevered returns per annum. The deals usually include contractual payments, high-quality collateral, enforceable covenants, and bankruptcy remote structures to control and disburse cash from interest payments and fees. Based on our experience, lending strategy managers can currently achieve 10-12% net unlevered returns, benefiting from elevated base rates and reduced competition from traditional bank institutions.
Opportunistic Strategies
Opportunistic credit investments employ higher return and higher risk strategies by providing companies with a broader set of capital solutions relative to lending-only strategies. These funds fall between each end of the risk spectrum – from traditional direct lending to control-oriented distressed. Credit opportunity and speciality finance funds invest in instruments such as secondary market bonds and loans, directly originated loans with warrants, and structured equity solutions. These funds typically target net returns in the 12%–15% per annum range. We believe they have the potential to deliver even higher returns during periods of market stress when traditional capital sources are less widely available. For example, many opportunistic credit funds preserved capital with positive returns from interest and fees in 2022, offsetting modest marked-to-market losses amid broader interest rate uncertainty.
Combining Lending and Opportunistic
Investors can also create a blend of lending and opportunistic private credit approaches with the potential to target net returns of more than 12% per annum. In many cases, we believe a blended private credit program can provide investors with a balanced source of returns, with current income received sooner and the opportunity for higher returning assets over medium- to long-duration periods. In these balanced programs, the distributions and return of capital from the lending strategies can also be used to fund capital calls for longer lock-up, opportunistic credit funds with longer investment periods and fund life.
Current Opportunities for Private Investors
The current investment environment presents a unique set of private credit opportunities for families and private wealth investors. Traditional banks have become more cautious about lending due to mixed economic forecasts and interest rate uncertainty. This caution is partly because some borrowers, especially in commercial real estate and corporate debt, are facing difficulties due to higher interest costs, particularly with floating rate loans. Some of these borrowers are finding it harder to refinance their debts at reasonable costs and struggling to sell off loans without incurring significant losses. Consequently, banks are reserving more funds to cover potential losses and are being very careful about issuing new loans, leading to reduced loan activity and less money available for borrowers. As a result, private credit funds have emerged as a critical source of financing, especially for mid-sized companies that are often overlooked by larger financial institutions. These funds are stepping in to fill the gap, providing much-needed capital in a tighter lending environment.
Second, in a market characterized by volatility and ambiguity, private credit offers a relatively stable investment option due to its secured nature and structured returns. Engaging in direct lending opportunities can allow for more customized deal structuring, providing both protection and flexibility. This can include negotiating stronger covenant protections or opting for asset-based lending to further secure investments.
Investors may also want to explore opportunities in distressed debt markets. Economic downturns and market dislocations can create attractive entry points for investors with the expertise to navigate these complex situations, potentially leading to outsized returns as markets recover.
Last, it’s crucial for private investors and wealthy families to partner with experienced fund managers who not only have a proven track record in private credit but also possess deep sectoral expertise and the ability to conduct thorough due diligence. We believe partnering with an investment advisor with deep private credit research capability is instrumental in uncovering hidden gems and avoiding pitfalls in this nuanced space.
Understanding Key Risks
While private credit offers attractive benefits, it is important to be aware of its inherent risks. These risks include illiquidity, constrained upside potential compared to private equity, manager selection, and tax inefficiency.
Depending on the strategy, private credit investments can involve capital lock-ups of three to ten years. Although slightly more liquid than other private investments, private credit investors need to be prepared to commit for the long term. What’s more, unlike the high-growth potential of private equity, private credit strategies often come with fixed returns – or return levels in which the upside is capped. While this can result in more stable returns with lower risk relative to other private investments, it represents a ceiling on how much a strategy can earn.
As with all private market investments, performance dispersion in private credit is wide (Figure 2). In some cases, steady returns might mask underlying challenges, including borrowers that have limited credit histories. We believe success in private credit investing comes from partnering with managers who have a proven track record, expertise in assessing credit risk, and a history of recovering investments. Selecting top-tier managers is essential for tapping into the full potential of private credit and earning an illiquidity premium.
Lastly, tax inefficiency poses a notable challenge for private and family investors in private credit. This issue arises because the interest income generated from private credit investments is often taxed at higher ordinary income rates, rather than the lower capital gains rates applicable to some other types of investments. This can significantly reduce the net returns that investors receive, especially for those in higher tax brackets. The complexity of the investment structures within private credit can also further complicate tax matters, requiring careful planning and management to meet the tax obligation. Understanding and navigating these tax implications can help maximize the efficiency and overall returns of private credit investments (see “Managing Tax Implications”).
Implementation: Things to Consider
To take advantage of attractive yield opportunities available in private credit, family and private investors should carefully consider several key implementation factors:
Know your liquidity needs.
Private credit investments often require capital lock-ups and a commitment of several years.
Define your target and risk tolerance.
Investors should clearly identify their desired yield and understand the level of risk they are comfortable taking.
Stay diversified.
Look to diversify private credit investments across different sectors, geographies, and credit qualities to help mitigate risk and capitalize on emerging trends.
Engage in comprehensive due diligence.
Focus on managers with a strong track record, deep sectoral expertise, and robust credit analysis capabilities
Understand regulatory and tax implications
Consider consulting with a tax advisor to optimize investment structures for tax efficiency.
First, liquidity needs are an important consideration, given the illiquid nature of many private credit investments, which may not be easily sold or converted to cash. The longer commitments required of some private credit investments make them more suitable to investors with a longer-term outlook that have a clearly defined target yield. Determining this target requires a close assessment of risk tolerance, as higher yields often come with higher risks.
Diversification is another key aspect of private credit implementation. Investors should consider diversifying their private credit portfolios across sectors that demonstrate resilience and growth potential, such as technology, healthcare, and renewable energy. A diversified approach can help spread risk across various sectors and credit qualities while capitalizing on emerging trends.
Robust due diligence is also imperative. Understanding the borrower’s ability to meet its debt obligations is paramount to mitigating default risks. Market conditions continually influence the availability of opportunities and the risk/return profile of private credit investments. Staying mindful of regulatory and tax policy changes is also important, as these can impact investment structures, compliance requirements, and overall returns.
When implementing private credit strategies, private investors and wealthy families often have a flexibility advantage. They can allocate more nimbly than other large investors, such as pensions or endowments, and are thus well positioned to take advantage of the current robust opportunity set. Flexible asset class definitions and target ranges can likewise allow them to allocate more opportunistically. For instance, credit opportunity funds that target higher-returning assets can be sourced from traditional private investment allocations. But private investors and wealthy families can also consider a wider range of capital sources. They can, for example, position lending strategies within a portfolio as part of a fixed income or diversifier allocation, helping to smooth returns and provide protection in adverse market environments. For investors building new private growth sleeves, private credit can provide another option for generating risk-managed alpha.
Giving Private Credit its Due
Private credit investments have experienced a rapid evolution over the past decade. In fact, the private credit landscape has changed so much that investors who last explored it ten or more years ago may not recognize it today. Market conditions have helped to shape what may be a particularly auspicious cycle for the asset class. Higher interest rates and changing credit market dynamics have created attractive opportunities for private investors and wealthy families – but proper due diligence and implementation are essential. Allocations to private credit can be additive to overall portfolio positioning, serving as a complementary source of growth and income generation along with strong downside protection. Ultimately, a customized approach to private credit that accounts for liquidity and tax challenges may be the best path for investors seeking a consistent income source that is less correlated to traditional fixed income and equity markets.
Buck Reynolds is Senior Investment Director in the Private Client Practice and Wilbur Kim is Partner in the Private Client Practice both at Cambridge Associates.
Copyright © 2024 by Cambridge Associates LLC. All rights reserved. This report may not be displayed, reproduced, distributed, transmitted, or used to create derivative works in any form, in whole or in portion, by any means, without written permission from Cambridge Associates LLC (“CA”). Copying of this publication is a violation of US and global copyright laws (e.g., 17 U.S.C. 101 et seq.). Violators of this copyright may be subject to liability for substantial monetary damages.
This report is provided for informational purposes only. The information does not represent investment advice or recommendations, nor does it constitute an offer to sell or a solicitation of an offer to buy any securities. Any references to specific investments are for illustrative purposes only. The information herein does not constitute a personal recommendation or take into account the particular investment objectives, financial situations, or needs of individual clients. Information in this report or on which the information is based may be based on publicly available data. CA considers such data reliable but does not represent it as accurate, complete, or independently verified, and it should not be relied on as such. Nothing contained in this report should be construed as the provision of tax, accounting, or legal advice. PAST PERFORMANCE IS NOT INDICATIVE OF FUTURE PERFORMANCE. Broad-based securities indexes are unmanaged and are not subject to fees and expenses typically associated with managed accounts or investment funds. Investments cannot be made directly in an index. Any information or opinions provided in this report are as of the date of the report, and CA is under no obligation to update the information or communicate that any updates have been made. Information contained herein may have been provided by third parties, including investment firms providing information on returns and assets under management, and may not have been independently verified.
The terms "CA" or "Cambridge Associates" may refer to any one or more CA entity including: Cambridge Associates, LLC (a registered investment adviser with the US Securities and Exchange Commission, a Commodity Trading Adviser registered with the US Commodity Futures Trading Commission and National Futures Association, and a Massachusetts limited liability company with offices in Arlington, VA; Boston, MA; Dallas, TX; Menlo Park, CA, New York, NY; and San Francisco, CA), Cambridge Associates Limited (a registered limited company in England and Wales, No. 06135829, that is authorised and regulated by the UK Financial Conduct Authority in the conduct of Investment Business, reference number: 474331); Cambridge Associates GmbH (authorised and regulated by the Bundesanstalt für Finanzdienstleistungsaufsicht (‘BaFin’), Identification Number: 155510), Cambridge Associates Asia Pte Ltd (a Singapore corporation, registration No. 200101063G, which holds a Capital Market Services License to conduct Fund Management for Accredited and/or Institutional Investors only by the Monetary Authority of Singapore), Cambridge Associates Limited, LLC (a registered investment adviser with the US Securities and Exchange Commission, an Exempt Market Dealer and Portfolio Manager in the Canadian provinces of Alberta, British Columbia, Manitoba, Newfoundland and Labrador, Nova Scotia, Ontario, Québec, and Saskatchewan, and a Massachusetts limited liability company with a branch office in Sydney, Australia, ARBN 109 366 654), Cambridge Associates Investment Consultancy (Beijing) Ltd (a wholly owned subsidiary of Cambridge Associates, LLC which is registered with the Beijing Administration for Industry and Commerce, registration No. 110000450174972), and Cambridge Associates (Hong Kong) Private Limited (a Hong Kong Private Limited Company licensed by the Securities and Futures Commission of Hong Kong to conduct the regulated activity of advising on securities to professional investors).
