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What is private credit and how does private credit work?

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Updated: May 24, 2024

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Private credit is a system in which people can borrow from non-traditional lenders. Individuals and businesses can borrow from others instead of borrowing from a bank or in the public debt market. The lenders are typically willing to lend to a higher-risk borrower in exchange for an above-average return.

If you want to level up your financial IQ, here’s an in-depth look at how private credit works for investors and borrowers.

What is private credit?

Private credit enables direct lending between a borrower and lender without a traditional financial institution in the middle. Private credit arrangements may offer the participants terms that wouldn’t be available from conventional loans, potentially offering savings to borrowers and higher yields to lenders.

Unlike many large lenders that adhere to strict credit criteria and offer a fixed set of borrowing terms, private credit lenders are often more flexible. They may be willing to assume more risk and provide borrowers with a wider range of repayment options, offering a more personalized and potentially advantageous borrowing experience.

Large investment companies and wealthy lenders sometimes work directly with the borrower. If you’re interested in investing with private credit, peer-to-peer lending platforms offer smaller investment opportunities.

Private credit vs private debt

The terms private credit and private debt are often used interchangeably and mean effectively the same thing. Both terms generally represent non-bank lending or bonds outside traditional bond markets. Both terms typically refer to higher-risk loans with higher interest rates than conventional debt.

Private credit vs private equity

Private credit refers to non-traditional loan arrangements. Private equity, on the other hand, is a term for investments made in a private company outside of the public stock market. With private equity, an investor can buy a portion of a company directly from existing owners.

Private credit vs bank lending

Most people are familiar with the concept of bank lending. With bank lending, borrowers access funds from large financial institutions through public and standardized loan offerings. These may include business, personal, credit cards, home, auto and other loans. Private credit, on the other hand, is arranged directly between the borrower and lender without a bank’s involvement.

Types of private credit

Private credit comes in several forms, with flexible options for borrowers and lenders. Here's a look at some of the more common types of private loans:

  • Direct lending: Direct lending involves private institutions and individuals providing loans directly to companies without intermediaries like banks. These loans often target middle-market businesses, offering customized financing solutions.
  • Infrastructure debt: Infrastructure debt refers to loans provided to fund large-scale infrastructure projects such as highways, airports and utilities. For private companies, this could expand to business infrastructure, such as factories. These investments are typically long-term and secured by the project's assets and cash flows.
  • Real estate debt: As the name suggests, real estate debt allows the borrower to purchase real property. That could include business locations or investment properties. Like a traditional mortgage or real estate loan, the underlying asset usually secures private real estate debt.
  • Mezzanine debt: Mezzanine debt is a type of loan that combines features of both loans and investments. It usually has higher interest rates because it's riskier and is paid back after other loans. It often comes with the option to convert into company shares if the loan isn't repaid.
  • Venture debt: Venture debt is financing for early-stage, high-growth companies, often used alongside venture capital. It provides additional capital without diluting ownership and is typically secured by the company's assets.
  • Distressed debt: Distressed debt involves investing in the bonds or loans of companies experiencing financial or operational difficulties. Investors often seek to restructure the debt to improve the company's financial health.
  • Junior debt: Junior debt is subordinated to senior debt regarding repayment priority. It carries higher risk and offers higher returns. Junior debt may be used in leveraged buyouts or capital restructurings.
  • Specialty finance: Specialty finance refers to lending to companies in niche markets or underserved sectors, such as consumer credit, equipment leasing or healthcare finance.
  • Special situations debt: Special situations debt involves financing companies facing unique challenges or opportunities, such as mergers, acquisitions or restructurings. It often requires custom-tailored solutions and a higher risk tolerance.
  • Small business credit: Small business credit encompasses loans and credit for small and medium-sized companies. These loans help businesses with working capital, expansion and other operational needs.
  • Capital appreciation: Capital appreciation in debt investing refers to the increase in the value of a debt instrument.
  • Senior lending: Senior lending involves providing loans that have priority over other debts in case of borrower default. These loans are secured by collateral and offer lower risk and interest rates than junior debt.

Investing in private credit: Is it worth it?

Private credit investment isn’t for new investors or individuals with a lower risk tolerance. It’s best for someone with a healthy investment portfolio who wants to expand into alternative investments. If you have the financial stability to take on extra risk, you may enjoy healthy profits from a well-positioned private credit investment.

Investing in private credit: Pros and cons

Pros

Pros

  • Higher returns: Private credit often offers higher yields compared to traditional fixed-income investments, attracting investors seeking better returns.

  • Diversification: Investing in private credit can diversify a portfolio, reducing overall risk by spreading investments across different asset classes.

  • Customized solutions: Private credit allows for tailored financing solutions that can meet the specific needs of borrowers, providing flexibility.

Cons

Cons

  • Illiquidity: Private credit investments are generally not easily sold or traded, making it harder to access invested capital quickly.

  • Higher risk: Higher returns come with higher risks, including the potential for borrower defaults and inability to repay the loan as agreed.

  • Complexity: Private credit deals can be complex, requiring thorough due diligence and expertise to manage effectively.

How to invest in private credit

If you want to invest in private credit, you can look for unique marketplaces offering direct and marketplace lending to private individuals and businesses. Pay close attention to the risk profile and fees to ensure you understand exactly what you’re investing in and what to expect over time.

For example, the Arrived Private Credit Fund is an investment vehicle that allows you to invest in short-term financing for real estate projects, with some diversification provided by the fund.

Other platforms for individuals to invest in private credit include:

With a good understanding of how private credit works, you may decide it’s a good fit for your investment goals.

Eric Rosenberg Freelance Contributor

Eric Rosenberg is a finance, travel and technology writer in Ventura, California. He is a former bank manager and corporate finance and accounting professional who left his day job in 2016 to take his online side hustle full time.

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