Investing in Private Credit: What are the Risks?

Private credit investment carries many inherent benefits. According to Blackstone: “From 2015 to 2023, a portfolio that added a 20% allocation to private credit reduced volatility, increased annualized returns, and added 140 basis points of income.”^[1]

Stats like that are helping propel this asset class into the mainstream, as more and more investors look to diversify away from traditional stocks and bonds. Yet sophisticated investors understand there is no such thing as a free lunch–and many are asking about the risks of investing in private credit.

In this article, we’ll dive deep into four of private credit’s key risks, and explore the strategies Heron Finance employs to address and mitigate them.

Key Highlights

• Private credit can provide meaningful and consistent returns, yet the asset class has very real risks associated with investment
• Default risk, macroeconomic risk, interest rate risk, and liquidity risk all have the potential to significantly impact private credit returns
• Heron Finance takes numerous steps to mitigate each of these risks. Our experienced credit team and strict investment criteria underscore our commitment to providing users the best possible investment experience.

Default Risk

When a loan is issued, the borrower assumes control of the principal amount, and pays interest to the lender until the maturity date (the date the principal is to be fully repaid)

Given this dynamic, the #1 priority for private credit lenders is recouping their principal, which makes the prospect of a borrower defaulting on the loan a paramount concern.

When issuing private credit loans (or investing in them), one must be cognizant of a borrower’s current financial health, as well as the borrower’s plans for growth and how they are positioned in the market vis-a-vis competitors. Assessing a borrower across a variety of financial and market indicators can help private credit investors understand the likelihood of a borrower defaulting.

Heron Finance takes several steps to mitigate default risk, including:

• Stringent Investment Criteria: We maintain strict investment standards, only approving approximately 1% of the deals we see.
• Consistent Monitoring: Each month, we review our borrowers’ financial statements, sales forecasting and position within the market.
• Rigorous Borrower Due Diligence: Having originated and structured over $4 billion of private credit transactions, our credit team has the expertise needed to conduct a thorough credit analysis.

Private credit loans typically come with higher interest rates than bank loans, partly due to the incremental return required by private credit lenders. One reason for these higher rates is that private credit lenders maintain smaller portfolios of borrowers than banks, and are therefore more exposed to default risk than banks are.

Those higher interest rates are what enable Heron Finance users to obtain a higher net APY than if they had invested in corporate or public bonds.

Macroeconomic Risk

Macroeconomic conditions impact every investment (to one degree or another). Private credit is no exception. Fluctuations in economic growth, interest rates and inflation can improve private credit’s performance, or trigger higher default rates (see above).

Unfortunately, the prospect of a recession or persistent inflation is unclear and difficult to accurately predict. Yet investors in private credit can adopt strategies to counter these risks. Heron Finance, for example, mitigates macroeconomic risk in the following ways:

• Diversification: We allocate investments across different industries and geographic regions in order mitigate the impact of adverse economic events.
• Borrower Selection: Focusing on borrowers that are not already highly-levered (are not encumbered by debt) and offer higher-quality collateral (such as real estate or other assets) can buffer against the prospect of downward economic pressure should a recession (or other unforeseeable circumstances) strike.
• Limited Lifetime Loans: Our investments typically have a life of approximately 18 months, and may contain call options that repay our principal within 18 months. This mitigates the impact of macro risk by minimizing the amount of time borrowers will hold our capital. Should a downward economic cycle strike, there will only be a limited time before borrowers need to pay back the loan.

By proactively managing macroeconomic risks, investors in private credit can navigate market complexities more effectively and help secure consistent returns.

Interest Rate Risk

Private and public credit markets maintain different degrees of sensitivity to interest rate changes. Public bonds are usually (though not always) fixed rate, and private credit loans are usually (though not always) floating rate.

The term ‘floating rate’ means that the interest rate on the loan increases or decreases as the benchmark rate moves up or down. So the interest rate on floating rate loans increases as benchmark rates increase, and decreases as the benchmark rate decreases.

The interest rate on fixed rate loans stays the same, no matter what happens to the benchmark rate. Therefore, fixed rate loans may be more advantageous when interest rates decrease (since the fixed rate stays the same, investors are earning a premium over the decreasing benchmark rate), and floating rate loans may be more advantageous when interest rates increase (since they rise in tandem with the benchmark rate).

Interest rate moves are extremely difficult to predict (just ask all of those ‘experts’ who have been predicting a Fed rate cut for about a year now). For that reason, Heron Finance takes steps to mitigate interest rate risk, including:

• Mix of Fixed and Floating Rates: We employ a hedging strategy whereby we invest in both fixed and floating rate loans, to protect against interest rate risk in either direction.
• Diversification: Diversifying across industries and geographic regions helps mitigate interest rate risk, as rising rates affect sectors and countries differently.
• Limited Lifetime Loans: Similar to macroeconomic risk, limiting the lifetime of our loans mitigates against interest rate risk. If rates rise or fall, our short-duration loans have less time to be negatively impacted.

Liquidity Risk

Private credit investments typically carry extended lockup periods (the amount of time after investment that you have to wait before requesting a withdrawal), and liquidity concerns (funds may take longer than expected to actually liquidate your investment, once you make a redemption request).

Private credit is an inherently illiquid asset. Unlike stock and bond investments, investor capital is locked up for a period of time as borrowers invest that money in their business operations. This makes liquidity risk management a key determinant in many investors’ decisions about whether to invest in this asset class,

Some say that illiquidity is ‘baked in’ to the private credit investment model, because of the lack of a transparent secondary market. In the public markets, investors can purchase stocks or bonds and resell them instantly on a public exchange to liquidate their position. In the private markets, reselling an investment is much more time consuming, hence exiting a private credit investment ‘early’ (before the maturity date) is more difficult, which makes liquidity tougher to come by.^[2]

Of course, the lack of a secondary market is predicated on the fact that 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.

Heron Finance is not a CEF.

We are a robo-advisor, which means we accept investment from accredited investors without a specific end date. When an investor on Heron Finance redeems a position, we use our own capital to purchase their position. An affiliate of Heron Finance maintains an inventory of deals for clients of the RIA to purchase as they invest on the platform.

To be clear–this is not a secondary market. There is no peer-to-peer swapping of positions. We have allocated a portion of our own balance sheet capital specifically for the purpose of “smoothing out” potential liquidity challenges. This internal liquidity reserve is used to purchase a portion of our client’s investments, allowing us to quickly respond to certain liquidity needs, and ensuring that our clients have the option to liquidate a portion of their portfolio. This structure is a unique alternative to a secondary market, and 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 make a best effort at liquidating positions at least 30 days from the date of request).

For more information, check out our approach to liquidity.

In Conclusion

Private credit offers a compelling opportunity for investors seeking to diversify their portfolios and enhance returns. Of course, no investment comes without risk–and private credit is no different. Default risk, macroeconomic risk, interest rate risk, and liquidity risk are all genuine concerns of investors in this asset class.

Heron Finance is taking steps to address each of these risks by employing strategic risk mitigation measures such as portfolio diversification, thorough due diligence practices, a unique investment structure, and a reliance on seasoned credit professionals with a wealth of experience in the sector.

For specific questions about investing on Heron Finance, check out our FAQ page.