Private credit, explained

Key points

• Illiquidity is a feature of private credit, with investors potentially earning a premium in exchange for giving up ready access to their money.

• Most private credit loans are unrated or below investment grade, giving them a different risk profile from public credit markets. 

• Private credit is not a substitute for traditional bonds and is not suitable for all investors, requiring sufficient risk tolerance and long investment horizons.

Private credit is having a moment in the headlines. Higher interest rates and a pullback in certain types of bank lending have pushed more financing activity into private markets. Investors may be left with a simple question: What exactly is private credit?

What is private credit?

Private credit refers to loans made to companies by nonbank lenders, typically through privately negotiated agreements rather than public bond markets. These loans are not traded on exchanges and are often extended to midsized or “middle‑market” businesses that may be too small, too complex or too specialised for traditional bank financing.

On the risk‑return spectrum, private credit sits between public fixed income and private equity. Investors are compensated primarily through income, not ownership stakes, and accept lower levels of liquidity than public credit offers in exchange for greater structural protections and (potentially) higher yields. Investors tend to incur higher costs to access private credit than for bond mutual funds or ETFs.

How does the private credit market work?

Private credit strategies are typically executed through pooled investment vehicles that raise capital from investors and deploy it to portfolios of loans. Portfolio managers source deals directly, negotiate terms with borrowers and typically hold loans through to maturity.

Key characteristics of private credit include:

• Direct origination. Lenders work one‑on‑one with borrowers rather than buying securities in public markets.

• Customised terms. Loan structures may include collateral, floating interest rates tailored to each deal and covenants or financial rules that the borrower needs to follow while the loan is outstanding.

• Active oversight. Managers monitor their loans on an ongoing basis, and the renegotiation of loan terms can be part of the return equation, often due to growth or stress in the borrower’s business.

Illiquidity is a feature - not a bug - of private credit investing

Private credit investments are not designed for frequent trading. Capital is typically locked up for years, valuations are reported periodically rather than daily and investors’ ability to sell their fund interests is limited.

This illiquidity is intentional. Investors who can commit capital for longer periods may earn an illiquidity premium -additional compensation for giving up ready access to their money. For suitable investors, that trade‑off can make private credit a differentiated source of income within a broader portfolio. For others, the lack of liquidity can make private credit unsuitable.

Private credit versus high‑yield bonds

A modest portion of private credit loans goes to investment-grade borrowers. Most private credit loans are unrated or below investment grade.

Here are key differences between private credit and high‑yield bonds, which also help finance below-investment-grade borrowers:

• Market structure. High‑yield bonds trade publicly; private credit loans do not.

• Liquidity. High‑yield bonds can generally be bought and sold daily; private credit cannot.

• Diversification. The exposures that private credit and high-yield bonds have to various industries - and thus their risks - differ significantly. For example, software companies historically have accounted for a larger share of the private credit market than for the high-yield bond market.

• Pricing and volatility. Private credit valuations tend to be smoother, reflecting infrequent pricing rather than daily market moves.

• Control. Private lenders often have more influence over borrowers through covenants and direct relationships.

The result is a different risk profile - one that is distinct from public credit markets.

Private credit and investor suitability

Private credit is not a substitute for traditional bonds, nor is it appropriate for every investor. To capture the potentially higher returns and diversification benefit of private credit (or other private assets), investors should have sufficient risk tolerance, long time horizons, adequate sources of liquidity and access to high-performing managers.