Education | Ultimate Fixed Income 101: Private Credit vs. Public Credit

Hi All,

In this post, I wanted to go over the difference between private and public credit markets. As a recommended reading, I suggest the Preqin Academy.

The credit market is a vast ecosystem comprising various types of financial instruments and investors. Two broad categories of credit markets are the private credit market and the public credit market. The private credit market involves non-bank lenders providing debt financing to private companies that are not publicly traded, whereas the public credit market includes publicly traded bonds and other debt securities.

Today's Key Concepts

1. Private Credit Market vs. Public Credit Market
2. Why Companies Would Choose Private Credit Market
3. Types of Instruments in Private Credit Market
4. Typical Investors in Private Credit Market
5. Conclusion

☘️ 1. Private Credit Market vs. Public Credit Market

Private credit has grown quickly, hitting $1.4 trillion of assets under management globally at the end of 2022, up from about $500 million in 2015, putting it on par with the US junk bond market. Research firm Preqin expects private credit to grow to $2.3 trillion by 2027.

It's worth noting that the private credit market has grown significantly in recent years due to increased demand from borrowers seeking alternative sources of financing and investors looking for higher yields. However, the public credit market remains much larger due to the greater availability and accessibility of public debt instruments.

Here's a brief overview of each market:

• Definition of private credit market: The private credit market involves non-bank lenders providing debt financing to private companies that are not publicly traded. Private credit lenders may offer senior secured debt, mezzanine debt, unitranche debt, or other types of instruments.
• Definition of public credit market: The public credit market involves the issuance of publicly traded bonds and other debt securities by corporations, governments, and other entities. These securities are bought and sold by investors through the public markets.
• Key differences between the two markets: One of the key differences between private credit and public credit is the level of regulation and transparency. Public credit securities are typically subject to more regulation and disclosure requirements than private credit instruments, which may have less transparency. Additionally, the private credit market may offer more flexible terms and customized structures to borrowers, while the public credit market may have more standardized terms and higher liquidity.
• Advantages and disadvantages of each market: Both private credit and public credit have their own advantages and disadvantages. Private credit may offer more personalized attention and customized terms for borrowers, potentially leading to better financing solutions. On the other hand, public credit offers higher liquidity and may be subject to more regulatory oversight, potentially making it a safer investment for some investors. However, public credit may also have more volatile pricing and lower returns compared to private credit.

☘️ 2. Why Companies Would Choose Private Credit Market

The private credit market offers a number of benefits to both borrowers and investors. Here are some key advantages of the private credit market:

• Why companies choose private credit over public credit: Private credit may be an attractive option for companies that are unable or unwilling to tap the public credit markets. Private credit lenders may be more willing to provide financing to companies that are not yet generating significant revenue or profits, or that have unique financing needs that cannot be met through public credit instruments.
• Advantages of private credit, including flexibility and customized terms: Private credit lenders may offer more flexible terms and structures compared to public credit instruments. For example, private credit lenders may be more willing to provide covenant-lite loans or loans with non-traditional collateral. Additionally, private credit lenders may be able to offer more customized financing solutions to meet the specific needs of borrowers.
• Comparison of returns in private credit vs. public credit: Private credit has historically offered higher returns compared to public credit instruments. According to a report by Cambridge Associates, private credit funds had a median net internal rate of return (IRR) of 8.8% as of the end of 2020, compared to a median IRR of 5.5% for high yield bonds and 3.5% for investment grade bonds over the same period.

☘️ 3. Types of Instruments in Private Credit Market

The private credit market offers a variety of debt instruments that investors can use to provide financing to borrowers. Here are four common types of instruments in the private credit market:

• Senior Secured Debt: Senior secured debt is typically the safest and most senior form of debt in a company's capital structure. It is backed by specific assets of the borrower, and in the event of default, the lender has the first right to seize and sell those assets to recover their investment. Senior secured debt usually has lower interest rates compared to other forms of debt, such as mezzanine debt, but may also have more restrictive covenants.
• Mezzanine Debt: Mezzanine debt is a form of subordinated debt that is higher risk than senior secured debt but lower risk than equity. Mezzanine debt may be unsecured, but it is often backed by a pledge of the borrower's equity interests. Mezzanine debt is typically more expensive than senior secured debt, but it may have fewer restrictive covenants and may provide a higher potential return to investors.
• Unitranche Debt: Unitranche debt is a hybrid form of debt that combines senior and subordinated debt into a single loan. It provides a simplified capital structure for borrowers and investors, and it may offer more flexible terms compared to traditional bank loans. Unitranche debt may be more expensive than senior secured debt but less expensive than mezzanine debt, and it may be an attractive option for borrowers who need a quick and flexible financing solution.
• Direct lending: Direct lending is a type of private credit investment that involves providing loans directly to companies or individuals, bypassing traditional financial institutions such as banks. In this way, direct lending can provide borrowers with access to capital that may be difficult to obtain through traditional financing channels, while also offering investors the potential for attractive yields and diversification benefits. Direct lending can take many different forms, including senior secured loans, mezzanine loans, and unitranche loans. These loans are typically customized to meet the specific needs of the borrower, such as financing for a new project, acquisition, or working capital. Because direct lenders have the ability to underwrite and structure loans on a case-by-case basis, they may be able to offer more flexible terms and pricing than traditional lenders.

Here are some pros and cons of each type of instrument:

• Senior Secured Debt: Pros include lower interest rates, more seniority in the capital structure, and typically fewer covenants. Cons include less potential return compared to other forms of debt and potentially less flexibility.
• Mezzanine Debt: Pros include potential for higher returns, less restrictive covenants, and a subordinated position that may allow for more leverage. Cons include higher interest rates, higher risk, and less seniority in the capital structure.
• Unitranche Debt: Pros include simplified capital structure, potentially lower cost compared to mezzanine debt, and more flexible terms. Cons include potentially higher cost compared to senior secured debt and less seniority in the capital structure.
• Direct Lending: Pros include the potential for higher returns than traditional fixed-income investments such as bonds. Since direct lending involves lending to companies that may not have access to traditional sources of capital, direct lenders may be able to command higher interest rates on their loans. Additionally, direct lending can provide diversification benefits to investors, as the loans may be spread across multiple borrowers and industries.
• Cons include direct lending does come with some risks. Because direct lenders typically do not have the same level of regulatory oversight as banks and other financial institutions, they may be exposed to higher levels of credit and operational risk. In addition, direct lending investments can be illiquid and may be subject to changes in interest rates and credit conditions.

Here are some typical use cases for each type of instrument:

• Senior Secured Debt: Senior secured debt is often used to finance acquisitions or to provide working capital for a company.
• Mezzanine Debt: Mezzanine debt is often used to finance growth initiatives, such as new product development or market expansion.
• Unitranche Debt: Unitranche debt is often used to finance sponsor-backed transactions or to provide a flexible financing solution to companies that may not meet the underwriting standards of traditional lenders.
• Direct Lending: Direct lending is often used to provide financing to companies that may not meet the underwriting standards of traditional lenders or to finance sponsor-backed transactions. This type of lending can also be used to fund growth initiatives, such as new product development or market expansion. In addition, direct lending can be used to finance acquisitions or provide working capital to a company. Since direct lending typically offers more flexibility than traditional lenders, it can be an attractive option for companies that need customized terms or a more tailored approach to their financing needs.

☘️ 4. Typical Investors in Private Credit Market

Private credit investments are typically available to institutional investors, such as pension funds, endowments, and insurance companies, as well as high-net-worth individuals and family offices. These investors often have significant capital to invest and are looking for higher yields than those offered by traditional fixed-income investments.

In contrast, the public credit market is generally more accessible to retail investors, who can invest in publicly traded bonds through mutual funds or exchange-traded funds (ETFs). Institutional investors also invest in public credits part of their portfolio construction. Public credit investments are typically more liquid and offer greater transparency compared to private credit investments, but they also tend to have lower yields.

Here are some advantages and disadvantages of investing in private credit:

Advantages:

• Higher yields: Private credit investments generally offer higher yields compared to public credit investments.
• Diversification: Private credit investments may provide a diversification benefit to an investor's portfolio, as they may have different risk-return characteristics compared to public credit investments.
• Flexibility: Private credit investments often offer more flexible terms compared to public credit investments, which may allow investors to structure their investments to meet specific investment goals.

Disadvantages:

• Illiquidity: Private credit investments are often illiquid, meaning that it can be difficult to sell them before their maturity date.
• Lack of transparency: Private credit investments are often not publicly traded, and therefore may not have the same level of transparency as publicly traded bonds.
• Higher risk: Private credit investments are generally higher risk compared to public credit investments, as they often involve lending to smaller, less established companies or companies with weaker credit profiles.

☘️ 5. Conclusion

In summary, private credit and public credit markets represent two distinct areas of the credit market. Private credit provides flexibility, customization, and the potential for higher yields to investors, while public credit offers greater liquidity, transparency, and lower risk.

💯 Key takeaways:

• Private credit investments are typically only available to institutional investors and high-net-worth individuals, while public credit investments are more accessible to retail investors.
• Private credit investments often involve higher risk and illiquidity compared to public credit investments, but may offer higher returns and diversification benefits to a well-diversified portfolio.
• Different types of private credit instruments, such as senior secured debt, mezzanine debt, unitranche debt, and direct lending may offer different benefits and use cases to investors.

In conclusion, the choice between investing in private credit vs. public credit ultimately depends on an investor's risk tolerance, investment goals, and overall portfolio diversification strategy. While private credit may offer higher potential returns and greater customization, investors should carefully evaluate the risks and benefits before making any investment decisions.