As investors look to diversify their portfolios away from traditional stock and bond investments, they are increasingly turning to alternative investments–specifically private credit, as a means of generating strong, consistent returns.
But that begs the question–why are private credit’s returns so strong in the first place?
Heron Finance, for example, is targeting an 11-16% annual percentage yield (net of all fees). For investors used to experiencing an annualized 10% return from stocks, and even less for bonds–that is a fairly compelling proposition!
So what’s the catch?
In this article, we’re going to dive into the risk/return tradeoff of investing in private credit. We’ll explore how private credit investments compare to publicly-traded debt, the increased risks of investing in private credit, and how digital platforms like Heron Finance are working to mitigate those risks.
Key Highlights:
- Private credit offers the potential for higher returns due to additional credit risk, an illiquidity premium, and the opportunity for customized credit agreements
- The higher interest rates of private credit loans carry inherent risks, including liquidity challenges and regulatory uncertainties
- Diversification, thorough due diligence, and a unique approach to liquidity are all risk mitigation factors employed by Heron Finance, as the platform builds portfolios of private credit deals for accredited investors
What is Private Credit?
Private credit offers an alternative to traditional debt markets (bonds, Treasury bills and CDs), providing investors with a diverse array of non-public investment opportunities. Private credit investments are not listed on public exchanges, making them an intriguing option for investors seeking the potential for higher returns than those of traditional public debt investments, albeit with added risk.
Private credit's appeal lies in its potential for higher returns, which can be attributed to:
- Banks Not Lending: Borrowers might not be able to secure a traditional bank loan (banking regulations are forcing banks to narrow their lending criteria), and must therefore accept pricier debt instruments offered by private credit funds[1]
- Unique Credit Agreements: Private credit funds are typically extremely flexible on debt structures and covenant protections, often working with borrowers to craft bespoke lending agreements.[2] Lenders are compensated for this added customization in the form of higher interest rates on their debt
- Illiquidity Premiums: The lack of a secondary market in private credit leads to a reduction in liquidity, meaning private credit investors typically have their capital locked up for many years[3] (Heron Finance is working to change this–more on that below)
Examples of private credit loans include:
- Senior Secured Loans: Loans secured by collateral, which get paid out first in the event of a default
- Unsecured Subordinated Loans: Collateral-free loans which are paid after senior lenders
- Mezzanine Financing: Combines debt and equity, with conversion rights in default scenarios
- Specialty and Alternative Credit Opportunities: Tailored financing for unique industries or projects
- Distressed and Opportunistic Strategies: Focuses on financially troubled companies, or those in restructuring
- Merchant Cash Advances: Unsecured loans based on a company’s cash flow or profitability
What is Publicly-Traded Debt?
Publicly-traded debt (or traditional credit) encompasses debt financing instruments accessible through publicly-traded markets, such as corporate bonds, government bonds, municipal bonds, certificates of deposit, and asset-backed securities.
Publicly-traded debt instruments typically have lower interest rates than private credit, as the loan contracts are more standardized and the robust secondary markets associated with these investments lower the required rates of return for investors.
One caveat here is that publicly-traded investments must adhere to stricter transparency and regulatory standards than private credit investments, which are not as heavily scrutinized, given that they are less accessible to retail investors.[4]
Yield Generation in Public vs. Private Credit
The disparity in interest rates between private and public credit stems from several factors:
- Credit Risk Assessment: The lack of transparency within the private credit sector, coupled with fewer rated issuers, necessitate a more thorough evaluation process by lenders. This in turn leads to higher interest rates from lenders due to the perceived increased risk[5]
- Illiquidity Premium: Borrowers must pay higher interest rates due to a lack of liquidity in the private credit market (meaning lenders must hold onto their investments for longer periods of time)
- Regulatory Scrutiny: Banks and publicly-traded companies face increased regulatory scrutiny, which helps ensure a degree of perceived security (emphasis on the word ‘perceived’, as recent bank failures remind us that no investment is 100% secure!)
According to Goldman Sachs, “Private credit has outperformed public loans over the past decade, having delivered 10% annualized returns compared to an annualized 5% for public loans.”[6] This highlights the substantial interest rate difference between the two asset classes, which illustrates why investors might favor private credit for its higher potential returns, despite the increased risk associated.
Mitigating Liquidity Risk
For those looking into private credit investments, it's crucial to weigh the potential rewards against the inherent risks.
One of those risks, as mentioned above, is liquidity risk–the lack of liquidity that is inherent in the private credit asset class. This lack of liquidity stems from the absence of a robust secondary market–it is much more difficult to sell off some or all of your private credit loan, without the benefit of a public market to enable secondary investments.
Heron Finance is providing a potential solution.
As a registered investment advisor (RIA), we are not structured like typical private credit funds, most of which operate as closed-end funds (CEFs). CEFs raise a certain amount of money and invest that pool of money into a deal or portfolio of deals.[7] Once the fundraising cap is met, the fund closes to new investors.
Heron Finance is not a CEF. We are an SEC-registered investment advisor. That means we are open to investment from accredited investors, with no fundraising end date. Therefore, we can invest in private credit deals and purchase positions in those investments for new investors as they come on the platform.
This enables us to offer something unheard of in the private credit space: Liquidity in as little as 30 days.
To be clear, this is not a guarantee of liquidity in 30 days (as there may be instances where liquidity takes longer to produce), but rather a commitment by Heron Finance to make its best effort to provide liquidity to our users at least 30 days from the date of their redemption request. For more information, please read our approach to liquidity.
Of course, Heron Finance still benefits from the illiquidity premium that borrowers must pay, as the private credit loans we invest in still maintain those healthy double-digit interest rates. As a result, we are able to target an 11-16% APY for our users (that is net of all fees).
We believe our platform offers the best of both worlds–higher interest rates than traditional debt investments, and the comfort of knowing that we are striving to provide liquidity to our users. If you’re an accredited investor, click the link below to create a Heron Finance account.
