Should I include private credit as part of my investment portfolio?
The below advice is general in nature, and you should speak to your financial planner or wealth manager first.
Why family offices invest in private credit?
Private credit investments, specifically mortgage baked private lending has been a stable investment for family offices and HNW investors for as long as they have existed. So, if its good enough for the smart money, why not you?
The family offices and professional investors we work with both directly lend themselves and passively invest capital into private credit funds. This gives them constant returns through other private credit funds they invest in, higher returns when they are the direct lender (using us as originators) and diversification across transactions.
The reason private credit is a favourite for family offices is because it provides a fixed interest return that counters the effects of inflation, security and certainty. Family offices will also use private credit as means to make more money through private credit market arbitrage (you can read our article here on this unique investment strategy).
Should I include private credit as part of my portfolio?
This is a common question that many investors will ask, and despite us specialising in private credit, the answer is some private credit products may be suitable for you and others not.
The reality is that certain private credit investments such as mortgage-backed private lending have always been in our opinion one of the best investments anyone can make. However, other more exotic forms of private credit with higher returns and alternative securities require deep expertise by the investor.
To determine if private credit is for you, there are several considerations you should take into account first.
Capacity to invest in private credit
How much investable capital you have will determine if you’re best to be a passive investor (investing in a fund) or if you meet the ability to be a direct lender yourself and the higher returns that come with it.
Secondly different private credit funds, have different minimum investment amounts that you may or may not meet. Most start at $50k, with some requiring minimum amounts of $500k.
Thirdly you must determine if you’re using private credit to help fund your lifestyle or simply to outperform a term deposit. If you are relying on it for income, this will also determine how much you need to invest to realise the net returns you need.
Return and risk requirements
Different private credit products have different levels of risk and return, you’ll need to work out what returns you are targeting, and the level of risk your portfolio is willing to accept.
For private credit transactions that take assets as security the main risk will be the quality of the security, valuation of the security and LVR. More below.
For private credit transactions such as private corporate debt and corporate bonds etc, the main risk will be the quality and financial performance of the borrower.
For private credit transactions such as the provision of lender warehouse facilities, the main risks are the quality of the loan book, loan LVR and the ability of the lender borrowing funds to manage the risks of the loan book.
Passive vs active investmentsin private credit
Whether you invest in a fund or become a direct lender yourself is determined by your financial capacity, as being a direct lender requires you to have a significant amounts of capital.
Not all private credit funds / investments are equal. Strong due diligence should be done before parking money into a private credit fund as you are inherently reliant on an investment manager.
To read more about passive investments vs active investments in private credit click here.
Your life stage
Do you require capital growth or fixed income for your current life stage? Do you require a fixed income to fund your lifestyle?
Private credit investments as part of your diversification strategy
Diversification strategy
One of the tenants of portfolio diversification strategy is that you have investments that that are not highly correlated with one another. In other words, there is a low correlation or an inverse correlation (they move in opposite directions).
One of the benefits or private credit is because it is a debt instrument focused on private markets; it has a low correlation with public equity markets.
Because most private credit transactions work on a fixed interest rate, this leaves very little room for variance in returns once transactions are entered into.
Critical elements that effect private credit returns and diversification
We strongly suggest you read our article on alpha returns in private credit to understand what can impact your returns.
The underlying reserve bank rate
Typically private credit works on a margin above the bank rate. The margin is subject to the risk and premium that can be achieved. Therefore movements in the bank rate, will effect pricing and returns of private credit.
Supply of tier 1 and tier 2 capital
Private credit provides liquidity to the market, when tier 1 and tier 2 lenders are unable to provide sufficient credit to markets. Either due to self-imposed lending restrictions or regulatory reasons. The restraint or lack of restraint in tier 1 and tier 2 lending criteria, then impacts the demand for private credit.
Market economics
During tough economic times when more borrowers are unlikely to meet bank criteria, private credit can boom, but also so too can defaults if not properly managed. During strong economic times, private credit can also excel in providing credit beyond what tier 1 or tier 2 lenders can provide.
Product offering
The more unique the private credit offering, the higher the returns are to investors. Secondly the less capital there is being offered for a particular private credit product, the higher the returns will be for investors providing that capital.
What portion of my portfolio should I invest in private credit?
In our experience family offices typically allocate 3% to 20% of their portfolio into private credit, however these families have portfolios in the hundreds of millions to billions of dollars.
Whilst professional investors who are reliant on fixed income investments to fund their lifestyles, will allocate 30% to 50% of their portfolio. These higher concentrations are typical of our clients who are directly lending their own funds and who have direct deal oversight helping them to reduce risk.
In both cases, capital is typically spread across different transactions and or private credit funds to further reduce risk.
What are the benefits of having private credit as part of my portfolio?
There are three main benefits of having private credit as part of your portfolio.
Diversification to your portfolio
This will provide you with the peace of mind that a portion of your portfolio isn’t subject to capital volatility like equities are.
Fixed income
Private credit should provide you with a fixed income (subject to the investment type).
Security
Thirdly, security for your money. A private credit fund, or private credit investment is only as good as the underlying security that is being relied upon to underwrite the transaction. As this is the main benefit of private credit, it is integral you fully understand this as an investor.
What is the security for private credit investments?
Private credit transactions cover a very broad range of transactions / loans. Each type will have its own set of characteristics and parameters. Therefore, it is imperative that you as an investor deeply study the risks and benefits of each product. Below we’ve listed just a few of the different private credit products.
Different transaction types
Second mortgage private loans.
Construction loans.
Equipment finance loan books.
Debtor finance loan books.
Lender warehouse facilities.
These are just a few examples of private credit investments, and the underlying security that can be used.
Security ranking
You must evaluate what ranking the private credit transaction / fund will have. Will it be first ranked, second ranked, third ranked or is it unsecured?
Asset valuation
Is the underlying security for the transaction / fund have its asset value based on the fire sale value of today? Or a future value, when the asset is complete such as is the case with construction loans?
Depreciation of asset value
For private credit transactions that involve lender warehouse facilities or loans against exotic assets. Asset value preservation is integral. In the event a warehouse loan book facility is being provided to an equipment financier for example. You’ll need to make sure that the P&I repayments of the loan book outpace the depreciation schedule of the underlying security. Because in a worst case scenario, the fire sale value of the assets in the loan book, could be worth less the funds loaned.
LVR
Knowing the underlying LVR for the transaction type is integral, as it will give you some understanding of the of the buffer level the investment has should things go wrong.
Can the private credit fund use leverage
Are fund managers allowed to use the fund itself as security for borrowed capital, or have it rank behind other facilities being provided to the fund?
Private credit direct lending vs investment in a fund
If you wish to be a direct lender yourself like our family office or professional investor clients that we originate for. This first thing you will need to consider is your financial capacity to fully fund a deal. Minimum transactions are $200k for second mortgages, $800k for first mortgages and $5m for warehouse facilities.
However, just because you have the financial means does not warrant you should be a direct lender. Direct lending comes with the responsibility of actively managing your own investments, making decisions and having oversight.
The main reason our clients are direct lenders, is because they have direct security for their money and they can generate alpha returns through our unique investment strategies (you can read more here on how we achieve alpha returns in private credit).
To read more about our private credit investments click here.
To have a confidential discussion click here.
