Small and medium-sized companies have long relied on banks to finance their growth. But in recent years, regulatory pressures on capital have forced companies of this size to seek alternative sources of credit outside the conventional banking system. While private equity gets most of the headlines these days, private credit has become one 1.5 trillion dollars market and is expected to grow to $3.5 trillion by 2028according to BlackRock.

This is good news for private companies. However, investing in private credit is also a great way for your clients to diversify their fixed income portfolios and offset the impact of low returns on a traditional 60/40 allocation.

Related: Interest rate cuts do not spell punishment for private credit

As with bank loans, most personal loans are a form of variable rate debt that adjusts to changing interest rates. This gives investors real-time interest rate mitigation compared to fixed rate bonds and mark-to-market risks.

Let's clear up some misconceptions about personal loans and how you can best use them for your clients.

What is a Private Loan?

Related: Private credit is threatened by a cocktail of risks

Simply put, private credit refers to lending to privately held small and medium-sized businesses through non-bank financial institutions. These businesses are often highly leveraged and generally cannot borrow in the corporate bond markets. Private lending gained prominence in the wake of the global financial crisis of 2008-2009, when banks essentially froze credit to all but the most stable customers.

In the private credit market, lenders work directly with borrowers (usually companies) to negotiate and obtain private loans that are not traded in public markets. Borrowers have also flocked to private credit because loans have faster execution, greater flexibility and limited disclosure requirements compared to bank loans and public markets.

Although personal loans are a small part of overall business financing, their rapid adoption has taken market share away from banks that traditionally lend to small businesses. Regulators have expressed concern about the risks of private credit to the stability of the financial system. Memories of the 2008 subprime mortgage crisis caused by poor underwriting are still fresh in many people's minds.

Since private credit debt is riskier than traditional bank loans and publicly traded bonds, it must pay lenders/investors more than investment-grade debt of high-quality borrowers. The potentially higher return is the main appeal for investors, especially institutional investors.

Another attraction of private loans is that such loans are on top of a borrower's capital pile. This means that the company's assets are pledged as collateral. Private equity funds form the largest class of lenders in the space, followed by business development companies—see below. Investor redemption risks are low because most private debt funds have a closed-end structure and typically lock up their investors' capital for long periods.

Common examples of personal loans include:

• Direct lending: Offers loans mainly to private, non-investment companies. Typically, this refers to investing in the majority of a company's capital, which can provide stable current income with relatively lower risk.
• Mezzanine, Second Lien Debt and Preferred Equity: These types of private loans (aka “small equity”) provide borrowers with subordinated debt. These loans are riskier for investors because they are not secured by assets. Thus, they rank below older loans for repayment in the event of default or bankruptcy. In exchange for this credit risk, small equity often comes with equity “interpreters.” These incentives can support attractive total returns – often on par with equities – while still being a debt claim on the payment waterfall.
• Bad debt: When companies run into financial difficulties, they work with existing distressed debt investors to improve their prospects through operational turnarounds and balance sheet restructuring. Bad debt is very specialized. The prevalence of opportunities tends to coincide with economic downturns and periods of credit crunch. Here, investors take on a higher level of risk in exchange for lower prices and potentially higher returns.
• Special situations: Any type of non-traditional corporate event that requires a high degree of customization and complexity. This may include companies undergoing M&A transactions or other capital events, divestitures or spinoffs, or similar situations that are driving their borrowing needs.

How to help clients invest in private loans

Your clients who meet the test for “accredited investors” – $1 million + net worth excluding primary residence and annual income over $200,000 ($300,000 couples) – can invest directly in private loans. But there are other ways to invest in private loans, even if you are not an accredited investor:

1. Private credit funds: Some asset management firms offer private credit funds that are open to individual investors. These funds pool money from multiple investors to invest in various private credit instruments.
2. Business development companies: BDCs are publicly traded companies that invest in private companies, often through debt instruments. Individual investors can buy shares of BDCs on stock exchanges. Just be aware that BDCs may be required to distribute 90% of taxable income to shareholders and may be more volatile than the underlying investments.
3. Interval funds: These are a type of closed-end fund that invests in collateralized credit obligations and less liquid assets, including private credit. They provide limited liquidity to investors at specific intervals and may limit redemptions to 5% to 25% of the fund's assets.
4. Crowdfunding Platforms: Some platforms allow individuals to participate in private lending for businesses or real estate projects. Also, because holding times can be long and because investors can't exit their position as easily as they can with stocks and bonds, make sure clients are in good health and have plenty of liquidity. from other sources before investing.

Where does a private loan fit into my client's portfolio?

Investors have increasingly added private credit to their portfolios as a potentially higher-yielding alternative to bonds and other fixed-income strategies. Here are five attractive attributes of personal loans:

1. Current income: Like bonds, personal loans generally offer the potential for current income from interest payments and fees.
2. Illiquidity premium: Private credit can provide a yield spread over public corporate bonds to compensate investors for illiquidity.
3. Historically lowest loss rates: Private credit has shown lower loss rates compared to public credit over time.
4. Protection: Private credit is generally less correlated to public markets than stocks and bonds. This can help reduce portfolio volatility and improve risk-adjusted returns.
5. Building a custom portfolio: It may be possible to create highly customized portfolios of strategies to combine risk-adjusted returns across a variety of private credit strategies.

Private credit performance in high rate environments

Direct lending has outperformed bonds in high interest rate environments like today. When measured across seven different periods of high interest rates between the first quarter of 2008 and the third quarter of 2023, direct lending delivered average returns of 11.6%, compared to 5% for leveraged loans and 6.8% for yield bonds. high.

Make sure clients understand that private credit investments often come with higher risk and less liquidity than public market investments. Also be sure to review fees with your customers. A private fund can charge significant fees for its services, including acquisition fees, annual management fees based on the amount invested, and more. There may also be higher minimum investments. If you work through a private loan fund, your client will likely have to raise significant cash to get in the door. This is why I like interval funds, discussed above.

CONCLUSION

For clients in good health who have ample liquidity from other sources, a private loan can be an excellent hedge for their stock, bond and real estate holdings, especially in volatile interest rate environments. Private loans can also offer higher returns. Just make sure they know that their investments can be locked in for several years, that there is a higher risk of default compared to public bonds, and that there is less transparency than with public company investments. Also, ensure that you and your clients do due diligence on the manager's track record, fee structure, valuation policy and risk management safeguards. Finally, there are tax considerations. Private loan income is often taxed as ordinary income, although some structures such as BDCs may offer tax advantages. This is where it comes in.

Dr. Guy Baker is the founder of Wealth Teams Alliance (Irvine, CA).