What is private credit and how does it work?

Private credit refers to loans made by private lenders rather than banks or public markets. The lenders are typically willing to lend to a higher-risk borrower in exchange for an above-average return. Here’s an in-depth look at how private credit works for investors and borrowers.

Wise takeaways

• Private credit refers to lending that takes place outside of traditional financial institutions, allowing individuals and businesses to borrow directly from private lenders.
• Private credit presents an opportunity to earn higher returns than traditional fixed-income products, though it comes with increased risk.
• Different types of private credit include direct lending, mezzanine debt, venture debt and infrastructure financing.
• Because of its complexity and risk, private credit is best suited for experienced investors with diversified portfolios who are looking to expand into alternative investments.

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

Unlike traditional bank lending, where borrowers receive funds through standardized loan products like mortgages, auto loans and credit cards, private credit involves direct arrangements between borrowers and private lenders. These loans often come with customized terms and are tailored to specific business or financial needs.

Core types of private credit

• Direct lending: Loans provided directly to companies by private institutions or individuals without bank involvement. These often target middle-market businesses and offer customized financing solutions.
• Senior lending: Debt instruments that may increase in value over time, offering returns beyond regular interest income.
• Junior debt: Subordinated to senior debt in terms of repayment priority. Because of the higher risk, it typically offers higher returns and is often used in leveraged buyouts.

Specialized private credit strategies

• Mezzanine debt: A hybrid of debt and equity, mezzanine loans carry higher risk and interest rates. If unpaid, the debt may convert into equity in the borrowing company.
• Venture debt: Offered to early-stage or high-growth startups, often in conjunction with venture capital. This type of loan is usually secured by company assets and allows founders to avoid equity dilution.
• Distressed debt: Involves purchasing or investing in the debt of financially troubled companies, often with the goal of restructuring or gaining control during turnaround efforts.
• Special situations debt: Customized lending for unique corporate events, such as mergers, acquisitions, or restructurings. These loans require a flexible approach and higher risk tolerance.

Asset-backed lending

• Real estate debt: Loans to finance the purchase or development of commercial or investment properties. Like traditional mortgages, these are often backed by the property itself.
• Infrastructure debt: Used to fund large-scale infrastructure projects such as highways, utilities, or airports. These long-term loans are typically secured by the project’s assets and expected cash flow.
• Capital appreciation: Debt instruments that may increase in value over time, offering returns beyond regular interest income.

Niche and sector-specific credit

• Specialty finance: Lending to niche or underserved markets such as consumer credit, equipment leasing, or medical finance. It often requires sector-specific knowledge.
• Small business credit: Loans tailored for small to mid-sized businesses, typically used for operations, growth, or short-term capital needs.

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

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.

1. 1 Assess your risk tolerance: Private credit can be high-risk and illiquid. Make sure you’re financially stable and understand that your money may be tied up for years.
2. 2 Pick your entry point: You can invest through online platforms (like Fundrise or Yieldstreet), private credit funds, peer-to-peer lending, or institutional offerings.
3. 3 Review investment details: Look closely at the loan’s interest rate, term, borrower profile, collateral, and default protections before committing any funds.
4. 4 Start small and diversify: Don’t go all-in on a single deal. Spread your investments across different borrowers, loan types, or platforms to manage risk.
5. 5 Monitor performance: Stay updated on repayment progress, platform communication, and any changes in the investment’s status or terms.

Our pick for investing in private credit

Other platforms for individuals to invest in private credit include:

• Fundrise
• Yieldstreet
• LendingClub
• Kiva
• Prosper

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