3 Misconceptions About Private Credit: What Investors Need to Know

By Khang Nguyen, Chief Credit Officer, Heron Finance

Key Takeaways:

1. Private Credit Offers Stable Returns, Not Speculative Gains:  Private credit provides consistent net returns averaging 9-11% per annum, driven by reliable cash distributions and low credit loss rates.  Unlike equities, it focuses on income generation with robust downside protection, rather than potential for outsized returns.
2. Private Credit Is Built for Downside Protection:  Private credit assets predominantly consist of senior secured loans, which historically have demonstrated a robust recovery rate of approximately 70% in default scenarios. These loans are extended to borrowers which are typically well-capitalized, profitable, and backed by private equity.
3. Private Credit Is a Proven, Long-Term Strategy:  Although the sector has expanded post-2008, its foundations date back decades.  Experienced managers with 10-20 years of expertise consistently deliver strong performance, making private credit a reliable choice for income-focused investors seeking stability.

Private credit has seen significant growth in recent years, evolving into a $2 trillion industry. However, misconceptions about its role, risks, and returns persist, leading some investors to approach this asset class with misplaced expectations. Let’s unpack some common misperceptions about private credit and clarify what it should (and should not) be used for by investors.

Misconception 1: Private Credit Is a "Hot" Asset Class Promising Sky-High Returns

One of the biggest misunderstandings is the perception, especially by retail investors, of private credit as a high-risk, high-return asset akin to equity or speculative investments.  This couldn’t be further from the truth. While private credit offers attractive, stable yields, it is not designed to deliver outsized returns, at least not consistently.

Investors seeking outsized returns would probably be better served by equities or other high-risk speculative investments, provided, of course, that they would also accept the risks that come with such bets.  Experienced private credit managers operate within a relatively narrow band of total returns, typically averaging 9-11% (net) a year, thus offering consistent income rather than speculative gains.  Targeting, say, a consistent 16% annualized net returns from private credit would, therefore, imply taking on excessive, equity-like risk—a strategy that undermines the stability and reliability that this asset class is built on. 

Based on Heron’s fund performance data, private credit generates an average net return of 10% a year, which is approximately double that of public credit investment options such as leveraged loans and high yield corporate bonds.  Specifically with respect to private credit funds tracked and approved by Heron, net returns average 11% a year, nearly all of which is attributable to the funds’ regular cash distributions; additionally, these funds have reported a net realized credit loss rate of close to zero, as losses are offset by gains.  

Private credit stands out for its ability to deliver reliable cash yields across varying market conditions, setting it apart from any other asset class.  Additionally, it offers robust downside protection in challenging environments, showcasing its resilience.  These asymmetrical attributes make private credit a desirable option for income generation, and a distinctive choice for strategic asset allocation.

Misconception 2: Private Credit Is Inherently Risky

Another common myth is that private credit is risky simply because it involves lending to private companies.  This perception stems from private credit’s historical association with, and investors’ misunderstanding of, “shadow banking” or non-bank lending, which was once a relatively nascent space.  However, the landscape has dramatically changed, with the private credit market having increased nearly tenfold since the global financial crisis (GFC).

Today, the private credit sector is dominated by established managers with decades of investment experience and hundreds of billions of dollars in assets under management.  These firms operate with extensive in-house resources, employing hundreds—and, in many cases, thousands—of seasoned investment professionals across functional areas, including deal structuring, risk monitoring, and restructuring.

Many of these top-tier managers boast deep industry expertise and have successfully navigated multiple economic cycles.  With firsthand experience weathering one or more credit cycles, they bring a proven ability to manage risk and capitalize on tactical opportunities, even during economic downturns.  This breadth of knowledge, coupled with their comprehensive in-house capabilities, positions these managers to deliver a reliable, resilient source of high income for their investors even in the face of market challenges.

It is also important to note that the typical U.S. corporate borrowers in private credit are established, well-capitalized enterprises, often backed by private equity firms.  According to data tracked by Heron, a typical corporate borrower generates more than $100 million in annual EBITDA.  While many private credit firms still provide loans to smaller, private companies, the majority of private credit assets under management have shifted upmarket.  The focus now is on senior secured loans to profitable businesses—marking a significant departure from the riskier mezzanine loans commonly extended to sub-$20 million EBITDA companies by private credit firms in the years leading up to and following GFC.

Private credit’s structural protections, such as senior secured loans, have consistently resulted in high recovery rates during defaults.  Compared to bank-led financing transactions, private credit typically benefits from more rigorous due diligence and tighter underwriting standards, thanks to its privately negotiated nature and enhanced access to borrower information and management teams.  These conditions enable customized, lender-friendly terms, including tighter deal structures, broader information rights, and stricter financial covenants.

Additionally, private credit deals are underwritten and managed by a smaller, more agile group of lenders compared to broadly syndicated loans, allowing for swift remedial action in time-sensitive situations, such as covenant breaches.  This nimbleness contributes to higher recovery rates in default scenarios—typically around 70% of the principal, as compared to around 60% for leveraged loans and below 50% for high yield bonds.  Consequently, private credit has demonstrated a relatively low realized credit loss rate of approximately 1% annualized.  Notably, Heron-approved funds have achieved even better results, with average loss rates in the 10 to 20 basis point range, underscoring the strength and resilience of this asset class. 

Misconception 3: Private Credit Is a New and Unproven Strategy

Contrary to popular belief, private credit is not a new or unproven strategy.  While the majority of private credit managers today were established after GFC, the roots of private credit extend much further.  Prior to 2008, GE Capital was a dominant force in senior secured lending, while many private credit managers today used to provide mezzanine debt financing.

Experience and expertise should be significant factors when selecting a manager.  Longevity matters and  highlights the depth of knowledge and resilience necessary to set  a high standard for performance and reliability.  The private credit industry has grown exponentially in recent years, expanding its reach and evolving into a viable option for retail investors.  However, as this asset class gains traction, it’s crucial to recognize that not all managers have the experience required to navigate market complexities or deliver consistent returns.  Manager selection is more important than ever.

The Ideal Investor for Private Credit

Private credit is not for everyone. It is best suited for investors looking for high-quality, reliable income and a uniquely resilient investment option for smart portfolio allocation. 

Here are key considerations for determining if private credit is right for you:

1. Liquidity Needs:  Private credit investments typically lack the liquidity of public markets. If you anticipate potentially needing immediate access to your funds, this may not be the right fit.
2. Risk Tolerance:  Investors seeking stability and downside protection will appreciate private credit’s risk-return profile. Especially as compared to liquid credit investment options like loan and bond ETFs, private credit has proven superior in terms of both total returns and downside protection.
3. Investment Goals: If your priority is to generate consistent yield rather than achieve potentially outsized capital gains, private credit can be a desirable option.  It is particularly attractive for income-focused investors, such as retirees or those seeking passive income well above what the liquid credit options can offer.
4. Strategic Portfolio Allocation:  Especially when equities are overvalued or that there are no other compelling investment options in the market, private credit can be a dependable option where you can consistently harvest high yields.

Private Credit’s Role in a Balanced Portfolio

Private credit is not a “hot” asset class for speculative investors chasing equity-like upside.  Instead, it serves as a reliable source of income, backed by rigorous underwriting and high quality borrowers.  As more companies remain private for longer and traditional bank lending continues to face pressure, private credit provides an increasingly critical avenue for investors to participate in the real economy.

For investors who understand its nuances and set realistic expectations, private credit can be a cornerstone of a resilient and income-generating portfolio.  Even if you are already invested in loan ETFs and/or high yield bonds, it may make sense to trade some or all of those liquid credit investments for exposure to private credit, provided you don’t have imminent liquidity needs.  By better understanding the unique attributes and limitations of private credit, investors can better appreciate the unique value it brings to the table.

Disclosure:

This research report is for informational purposes only and reflects the opinions of Heron Finance as of the publication date. It does not constitute investment advice, an offer, or a recommendation to buy or sell any securities. Investors should conduct their own research and consult professional advisors before making investment decisions.

Heron Finance makes no guarantees regarding the accuracy or completeness of the information provided. Investments involve risks, including potential loss of principal.  By accessing this report, you acknowledge that Heron Finance is not liable for any decisions made based on its content.