Security Blanket: The Features and Benefits of Senior Secured Loans

Not all loans are created equal.

As new investors enter the private credit sector, it becomes important to understand the distinctions between senior secured, junior secured, and unsecured loans, and how investing in these loan types can potentially impact your expected returns.

In this article, we'll delve into the essence of secured loans in private credit, exploring the advantages and risks for lenders, borrowers and investors. We’ll examine the role of collateral, and the distinctions between different types of loans, and we’ll uncover the benefits of investing in secured loans, highlighting how they can be a cornerstone for achieving financial stability and growth.

Key Takeaways:

• Secured loans in private credit are backed by collateral, offering lower risk for lenders and potentially more favorable terms for borrowers
• The type of collateral used can significantly influence the loan's terms, including interest rates and borrowing limits
• Investing in senior secured loans offers strong returns along with enhanced security relative to investing in junior or unsecured loans, and secured loans also provide investors with compelling options for portfolio diversification and customization

What is a Secured Loan?

Secured loans are guaranteed by collateral, offering a safeguard for lenders and potentially more favorable terms for borrowers.

Lenders of senior secured loans are afforded the highest repayment priority, resulting in lower interest rates due to reduced risk.^[1] Junior secured loans, while also collateral-backed, rank below senior secured loans in the repayment order, leading to slightly higher interest rates. Unsecured loans, lacking collateral, pose the highest risk to lenders and thus command the highest interest rates.^[2]

Borrowers of senior secured loans might pledge substantial assets in order to obtain the loan, yet they benefit from lower interest rates relative to junior or unsecured loans. Conversely, unsecured loans, though potentially easier to acquire for those with strong credit, carry higher interest rates, reflecting the greater risk to lenders.^[3]

From an investor’s perspective, secured loans in the private credit market offer a blend of higher returns and enhanced security. The collateral backing these loans provides a safety net, ensuring a first claim on assets in case of default, which significantly reduces potential losses.^[4] This security feature makes secured loans particularly appealing for those prioritizing stability in their investments.

This framework is crucial for informed decision-making in the private credit market, guiding both lenders and borrowers in their financing choices, as well as investors in their search for opportunities.

What Types of Collateral Can Be Used to Secure a Loan?

Collateral, ranging from specialized assets to contractual revenue streams, is the cornerstone of secured loans, offering lenders a layer of protection and enabling more attractive loan conditions.

In essence, secured loans strike a balance in private credit, where collateral mitigates lender risk and can lead to better terms for borrowers. However, the potential devaluation or loss of collateral necessitates careful consideration from both parties. Securing a loan in private credit typically involves a variety of assets being used as collateral, which not only secures the loan but also influences its terms. From physical assets to financial accounts, the range of acceptable collateral is broad and impacts the lending process significantly.

The value of the collateral (often negotiated between the lender and borrower) influences the loan's interest rate, amount, and loan-to-value ratio. High-value collateral can result in lower interest rates and larger loans, while lower-valued assets may lead to less favorable terms.^[5]

This understanding of collateral types and their effects on loan terms is essential for informed decision-making in the private credit market, ensuring both lenders and borrowers are aware of the associated risks and benefits.

Advantages of Investing in Secured Loans in Private Credit

The key benefit of investing in secured loans within the private credit sector is added security in case of a borrower default. However, investing in secured loans also presents investors with opportunities for diversification and customization.

• Diversification: Investors can achieve portfolio diversification through secured loans by spreading their risk across various assets. For example, investors might invest in loans backed by real estate, inventory, and accounts receivable–thus diversifying their collateral risk in case the value of any one of those asset types plummets.
• Customization: Investors can also customize their secured loans based on collateral type, interest rates, and loan structure. The private credit market is known for its streamlined investment process and the flexibility it offers in loan structuring. This efficiency and adaptability provide a competitive edge over traditional bank financing, especially in changing market conditions.

According to Blackstone: "Private credit has historically outperformed traditional credit segments like high yield bonds and leveraged loans, offering investors the benefits of efficiency, confidentiality, certainty in execution, and flexibility in terms of structure."^[6] A big part of that historical outperformance is the diversification and customization afforded by secured loans.

That is exactly why Heron Finance works with credit managers to access and invest in secured loans. Our experienced credit team takes steps to analyze and diligence each borrower’s collateral to ensure that we are mitigating risk as much as possible when investing.

For more information on our investment process, read our article on how we select deals.