Private credit in the investing space is a growing market where senior secured debt, asset-backed lending, structured and project finance, mezzanine debt and other forms of unsecured debt happen and exist across a wide range of underlying asset classes.
Attractive returns are available in private markets through simply providing the capital quickly, while banks and large institutions can be difficult and slow to work with. It can take three months to be approved for a loan from a bank, whereas private markets can approve a loan within days or weeks.
Here’s what you need to know about private credit in the investing space.
1. Senior secured loans
A senior secured loan is ranked the highest in the capital structure, so if something goes wrong, you are the first to receive money in any wind-up event. You also tend to get paid the lowest return if there are other more junior forms of debt in the capital stack. This type of loan is also the lowest risk form of debt from an investor’s perspective. ‘Secured’ means the loan has security attached to it, which means if something goes wrong, the person who loaned the funds has a claim against an asset to recoup their money.
For an investor, a senior secured loan can be a boring investment: you invest the money, and you typically receive monthly or quarterly coupons (interest) and your money back on maturity. Boring or not, there’s still a risk that it might not go well, so you will want to ensure that it is well documented, your charge is registered on the Personal Property Securities Register (PPSR), and the value of any tangible security that can be sold for the recovery of your investment, in the worst-case scenario, is enough to cover the loan repayment and the interest.
2. Unsecured loans and the risks
Now we are at the bottom of the capital stack. Unsecured debt is riskier for the investor, and because of this, the borrower usually pays a higher interest rate because this loan has no security. The investor can only expect a positive outcome through the business generating enough cash flow to fund the interest and repay the loan over time.
The downside here is that you have no control – someone else secures the security. However, where you lack legal security through registered charge (that is, security registered on the PPSR), you do have practical security, even though this is not registered, and protection because the business has excess assets and cash flow, providing structural protection. This would be more than enough to get a full return of capital.
3. Asset-backed lending
An asset-backed loan is at its best when you are lending to a segregated company. This is typically called an SPV (Special Purpose Vehicle), and it is usually a stand-alone company or trust that holds all the assets but does not have the operating costs of a business because it can be a more controlled and predictable outcome for investors.
The risk for investors is greatly diluted by lending small amounts to lots of borrowers, and there are assets sitting behind the loan you have claims to. This is the true benefit of asset-backed lending over a portfolio of assets: your single investment is diversified across lots of small loans.
4. Asset-backed senior, junior and mezzanine debt
The logic behind these different types of loans is simply that they create different investable assets, depending on the risk profile of the investors. Let’s say the company has $10,000 of equity and $90,000 of debt, meaning there’s $100,000 of capital that can be deployed for the company to run. That $90,000 of debt can be tranched for different types of investors. With a junior secured loan of $10,000, the junior secured lender is potentially exposed if there are losses greater than that number. A mezzanine tranche, which is a loan in the middle from $20,000 to $40,000 has exposure of any losses from $20,000 to $40,000. When you take the senior secured position in that transaction, there is $40,000 of capital sitting below you before your first dollar of loss. That’s the senior security, taking that 40 per cent to 100 per cent.
Offering investors the choice to invest across different parts of the capital stack can create a more efficient and lower average interest rate for the borrower because tranching lowers the risk of the senior secured tranche to the point that investors are happy to receive a lower return.
There’s money to be made for investors in private credit. If you can understand the complexity and simplify it so the product becomes investable, you can generate attractive returns for the risks because other parties either don’t have the experience or the knowledge to simplify it in a way that makes sense to investors.
This is an edited extract from Grow Your Wealth Faster with Alternative Assets by Travis Miller. Travis is co-founder and CEO of iPartners, a leading Australian alternative asset marketplace with approximately $5B in funds under management. He is passionate about improving access to alternative asset investments and educating everyday investors about a broader range of investment options.