A Comprehensive Guide to Private Credit Funds

Imagine you’re taking a walk through a bustling marketplace. You look to your left and see merchants selling generic products designed for the broad public (think toothbrushes and shampoo). You look to your right and see another set of merchants selling specialized goods to clientele with bespoke requests (think custom suits and handmade furniture).

If this were a commercial lending marketplace, to your left would be the banks (generic products), and to your right would be the private credit funds (specialized products). Private credit funds differ from banks in that they provide tailored financial solutions to businesses whose lending needs may not fit the conventional mold. Understanding these funds is crucial for investors, as they help support growth, innovation, and financial stability within the broader economy.

In this article, we'll dive into the intricacies of private credit funds, exploring their various features. We'll also discuss the pros and cons of investing in private credit funds, and consider how digital platforms are changing the way investors access these unique investment opportunities.

Key Highlights

• There are a wide variety of private credit funds, each with unique features and investment focuses
• Private credit offers benefits and drawbacks to investors considering fixed income strategies
• Private credit funds have historically been reserved for institutional investors and the ultra wealthy. Digital platforms like Heron Finance are disrupting the status quo by enabling accredited investors to access this asset class

What is a Private Credit Fund?

Private credit funds are specialized investment vehicles that extend loans to companies outside of the conventional banking sector. They are distinguished by their ability to offer a range of credit solutions, from secured senior loans to riskier subordinated debt, and can cater to both corporate and asset-backed financing needs.^[1]

Private credit funds come in various forms, each with a unique investment focus:

• Direct Lending Funds: These funds circumvent traditional banking channels to provide direct financing to businesses, filling the gap left by the pullback in bank lending in the wake of recent regulatory changes. Most private credit comes in the form of direct lending.
• Mezzanine Funds: Offering subordinated debt, mezzanine funds accept a higher degree of risk in exchange for the potential for enhanced returns and a possible equity stake in the business.
• Distressed Debt Funds: Targeting the debt of financially troubled companies, these funds often lend to borrowers undergoing bankruptcy and restructuring.
• Special Situations Funds: These funds are opportunistic, capitalizing on unique circumstances such as market disruptions or specific company challenges.

The Pros and Cons of Investing in Private Credit

Private credit funds present a mix of benefits and drawbacks for investors.

Benefits:

• Tailored Leverage Options: Private credit funds maintain greater flexibility than banks when issuing loans, and can therefore create bespoke lending agreements. Bank loans tend to be more standardized in terms of the debt structure and covenant terms.
• Versatility in Capital Deployment: Banks typically maintain strict concentration limits (e.g., they place quotas on annual lending to certain industries or regions of the country). That means banks may pass on creditworthy deals if the deal would cause the bank to surpass its concentration limit. Private credit funds can be more agile and less beholden to investment committee-imposed limitations.
• Specialization: Private credit funds often specialize in certain sectors, meaning they are more likely to understand a business’ growth model and cash flow needs. This is critical, as lenders need to understand how the borrower will drive revenue, generate new customers and remain resilient in the face of broader economic turmoil.

Drawbacks:

• Not as Much Liquidity: Private credit lacks a robust secondary market (unlike publicly-traded debt which can be bought and sold on public exchanges). Given this, most private credit investors lock up their capital for many years when investing (Heron Finance is seeking to change this–more on that below). This implies that such funds don’t have the resources to withstand a market correction in the way that most banks do.
• Higher Cost of Borrowing: As a result of this lack of liquidity, borrowers usually pay a hefty illiquidity premium. In other words, borrowers typically pay a higher interest rate on private credit loans than they otherwise would on a bank loan. Hence, most borrowers would opt for a bank loan if they could access one (many borrowers cannot, for a variety of reasons).
• Not as Regulated: This has positive and negative connotations. On the one hand, you can make the argument that since banks are more tightly regulated, they provide an extra layer of protection to their investors. The flip side of this is that regulation can sometimes hamstring a business (see the aforementioned point of banks passing on creditworthy loans because of concentration limits).

In short, private credit funds can offer more adaptable financing solutions than banks, plus the potential for improved risk-adjusted returns, albeit with an additional set of risks.^[2]

How Do Private Credit Funds Work?

Private credit funds engage in a variety of debt investments targeting higher-than-average yields. These specialized funds often focus on niche markets or specific industries to which they can provide bespoke financing solutions.^[3] The investment process is meticulous, involving comprehensive due diligence, loan term structuring, and continuous performance monitoring.

Historically, private credit has outperformed traditional fixed-income investments when it comes to yield generation. With U.S. 10-year Treasury yields currently ranging around 4%,^[4] private credit's higher yields (Heron Finance is offering a target 11-16% APY net of fees) can provide a cushion against interest rate movements, making them a favorable option for income-focused investors.

It’s important to note that while private credit funds offer the potential for higher returns and portfolio diversification, they also come with risks, such as illiquidity and credit risk. For more, read our post on the risks of investing in private credit.

Capital for these funds is sourced mainly from institutional investors, including pension funds, insurance companies, and endowments, as well as from high net worth individuals. Yet digital platforms like Heron Finance are changing the game–enabling accredited investors to invest in diversified portfolios of private credit deals.

This market disruption has the potential to accelerate the growth trajectory of private credit as a whole, which is likely to benefit private credit funds (a rising tide lifts all boats). As more individual investors pile into the space, we may see capital inflows and fundraising numbers continue to break records (private credit fundraising and AUM are both at all time highs).

If you’re an accredited investor and would like to get in on the ground floor of private credit’s upward trajectory, create an account with Heron Finance by clicking the button below.