Explaining Private Credit's High Interest Rates

You might already be aware that interest rates on private credit loans are typically higher than those of traditional bank loans. Those high interest rates often benefit you, the investor, since you’re able to earn double-digit returns on your investment. 

Yet the question remains: Why are borrowers willing to pay such high interest rates? 

There are a few different answers–some have to do with regulatory changes that make it harder for certain borrowers to secure a bank loan, while others have to do with the added flexibility and customization of private credit loan structures. Those answers explain why private credit loans typically come with higher interest rates than bank loans, yet they require some deeper explanation (for more, see our article on why private credit has a higher APY than publicly-traded debt). 

As to why commercial lending in general (both bank loans and private credit) typically come with a higher APY than publicly-traded debt, there is a fairly prosaic explanation: the lack of a robust secondary market.

“If You Ain’t First, You’re Last.” 

Part of the reason stocks are so inexpensive to buy and sell (no fee trading), is that the stock market is arguably the most robust secondary market in the world. If you buy shares of Apple, for example, you can be certain that someone else is willing to take those shares off your hands should you decide to sell. 

There is such certainty around the repurchase of shares (of prominent companies, we’re not talking about penny stocks here), that your brokerage firm will actually purchase the shares from you on the assumption they can be offloaded onto another investor in rapid succession. 

That is what a robust secondary market looks like.

Unfortunately, there is no robust secondary market for private credit. Investors in private credit loans looking to liquidate their positions must find other investors willing to acquire some or all of those positions. Without the benefit of a public exchange, it is difficult for private credit investors to offload their positions. They must find other private credit investors–typically funds or large institutions–and negotiate a participation agreement. 

This is why private credit is an inherently illiquid asset class, and it’s a big part of the reason why interest rates are so high. Without the luxury of a robust secondary market, private credit investors must assume that their capital is locked up for long periods of time (until the loan matures). Hence, they demand higher interest rates from borrowers, to compensate for this extra degree of risk. 

In private credit parlance, this is known as the ‘illiquidity premium.’ Borrowers must pay a premium over what they would otherwise have paid on a bank loan, in order to compensate for the lack of liquidity in this market. 

Liquidity in Reserve 

Some say illiquidity is ‘baked in’ to the private credit investment model, given the lack of a transparent secondary market. But what if there were an alternative to a secondary market for private credit? 

Most private credit funds operate as closed-end funds (CEFs). This means that the funds raise money for a particular deal or portfolio of deals, and once the total fundraise is complete, the fund is closed for further investment. 

But Heron Finance is not a CEF. We are a robo-advisor, which means we accept investment from accredited investors without a specific end date. This affords us a unique opportunity to facilitate the sale of positions in private credit loans. 

How? 

When an investor on Heron Finance redeems a position, we may choose to use our own balance sheet capital to purchase their position. So now the investor just sold their position to Warbler Lending (an affiliate of Heron Finance).

Essentially, we are purchasing the investments from our clients when they request a redemption. The typical private credit fund doesn’t do this, because it looks to invest rather than hold a significant amount of assets in cash, which generates no return. Again, the typical private credit fund operates as a CEF, meaning it simply fundraises and deploys the capital. 

Heron Finance is the first robo-advisor exclusively focused on private credit. We are breaking the mold here, and this is one of our key differentiators. 

To be clear–this is not a secondary market. There is no peer-to-peer swapping of positions. Instead, we have allocated a portion of our own balance sheet capital specifically for the purpose of repurchasing positions that our clients would like to sell.

This is how we are able to target liquidity in as little as 30 days from the date of request (we are not guaranteeing 30-day liquidity, but will leverage our unique structure to attempt to liquidate positions at least 30 days from the date of request). 

For more information, check out our approach to liquidity. 

As we launch Heron Finance, we are proud to offer a novel approach to liquidity, which we hope will make Heron Finance an innovative solution for private credit investors concerned about locking up their capital for long periods of time.