Private credit is a form of lending in which investors provide capital directly to borrowers (who are most often businesses). This alternative asset class offers the allure of high yields and low correlation with traditional markets, but comes with challenges such as illiquidity and default risk.
This article provides comprehensive guidance on how individual investors can invest in private credit effectively and responsibly.
Why Invest In Private Credit?
Once strictly the domain of institutional investors, private credit has recently become more accessible to individual investors. Regulatory changes and the emergence of crowdsourced platforms like Percent, Yieldstreet and Fundrise have broadened the audience for this investment avenue.
The shift towards private credit is part of a larger trend in the investment world.
According to a 2019 BlackRock report:
“Over the past 25 years or so, alternatives have evolved from a small part of the portfolios of the world’s largest investors into a core holding. As the graphic below shows, alternative investments — which include non-traditional asset classes such as private equity, private credit, real estate, infrastructure and more — represented just 5 percent of global pension portfolios in 1996. In 2019, they accounted for more than 25 percent.”
Private credit’s allure lies in its potential for high yields, especially in the current economic climate, which is marked by rapid interest rate changes and a decline in traditional bank lending.
This decline means that traditional lenders often turn down many businesses, even those with solid credentials. As a result, those businesses turn to the private credit market.
Interestingly, while yields on private debt have risen, the relative risk hasn’t increased proportionately. In fact, in some cases, the risk profile has even improved. Many businesses that would have previously been approved by banks are now available as opportunities in the private credit market, suggesting that the market is capturing not just higher-risk borrowers but also those that are relatively stable.
That said, investing in private credit presents a series of unique hurdles.
Traditional lending institutions, after thorough underwriting, have likely declined many private borrowers because of their risk. So there must be a high level of diligence performed when making such an investment, especially when it comes to understanding the legalities and options available when a borrower defaults.
Ways to Invest In Private Credit
Here’s a closer look at some of the more popular ways to invest in private credit.
#1. Investment Platforms
Investment platforms — mainly platforms geared towards accredited investors — have played a significant role in opening private credit investments to individual investors, providing access to opportunities once exclusively reserved for institutional investors.
Depending on the platform and the investment opportunity, you may have the option to invest directly in specific loans or projects or, alternatively, in a diversified fund composed of various private credit investments.
- Accessible to a broad range of investors.
- Clear information about investment opportunities.
- Ability to invest in different types of loans with funds.
- Platforms may charge significant fees.
- Dependence on the platform’s stability and reliability. (One popular company in the past, PeerStreet, filed for bankruptcy in 2023.)
Examples of private credit investment platforms include:
- Percent. This is the one platform that exclusively specializes in private credit. Percent offers opportunities to invest in asset-based notes, merchant cash advances and more. It’s open to accredited investors only, with minimums as low as $500. Read our full Percent review.
- YieldStreet. Provides alternative investment opportunities in multiple asset classes, including private credit. On their platform, they offer a private credit fund to accredited investors composed of portfolios of 200+ senior secured corporate loans. Read our full YieldStreet review to learn more.
- Fundrise. Focusing on real estate investments, Fundrise specializes in different types of real estate debt, including senior and mezzanine debt, and is open to non-accredited investors. Read our full Fundrise review.
#2. Publicly Traded Business Development Companies
Publicly traded business development companies, or BDCs, are investment vehicles that provide capital to small and mid-sized businesses. These are open funds available to the public and are regulated by the U.S. Securities and Exchange Commission (SEC). BDCs are traded on various stock exchanges.
- BDCs often have low minimum investment requirements, and since you’re investing in a share, you can often buy fractional shares, making them highly accessible.
- As publicly traded securities, you can sell your shares at any time.
- As publicly traded stocks, BDCs come with appreciation risk, with value fluctuations that can lead to potential losses.
- The fee structures of BDCs can be complex and hard to identify, with management fees, incentive fees, and other charges that can erode returns.
Examples of publicly traded BDCs and related investment products include:
- GSBD. Goldman Sachs BDC (GSBD) is a publicly traded BDC that provides capital to middle-market companies.
- PSP. Invesco Global Listed Private Equity ETF (PSP) holds a variety of BDC companies, providing diversified exposure to the private equity and business development space.
#3. Wealth Management Firms
Investment institutions like Fidelity, Franklin Templeton and OakTree have funds available for individual investors. Here, you’re typically working with a broker or advisor to access these funds (and you sometimes even have to pay an upfront load to invest).
- Personalized strategies with professional expertise.
- Diversified investment opportunities in private credit.
- Potential for relatively high fees.
- Limited accessibility for smaller investors.
- Possible conflicts of interest with an advisor.
Where Does Private Credit Fit Into Your Portfolio Strategy?
While viewing private credit as a replacement for bonds may be tempting, especially in traditional portfolios like the 60/40 model, this perspective overlooks essential differences.
Although offering higher yields than typical bond index funds, private credit investments are inherently riskier and often speculative.
They may also not provide a long-term solution to a portfolio, given the potential interest rate risk associated with floating rates and the shorter investment durations of private credit investments compared to a longer-term bond fund.
Liquidity concerns also arise, as some private credit investments (unlike bond funds) can’t be readily sold.
On top of this, there are a lot of risks in choosing the right fund to invest in. A recent paper in the Financial Analysts Journal found that a relatively small number of top-performing funds has been responsible for much of the asset class’s overall outperformance.
Putting this all together, it becomes clear that private credit should be seen more as a speculative investment than a fixed-income alternative.
Tax Implications and Considerations of Private Credit Investing
When you invest in private credit, the interest generated is typically taxed as ordinary income, much like bond interest. However, how it’s taxed can vary depending on the type of private credit instrument and the investment structure.
Since private debt funds are often tax-inefficient, it’s usually best to hold them in tax-advantaged accounts, especially if you’re in a high tax bracket.
Retirement accounts seem like a good fit for these funds, but there’s a catch: you need to be in the withdrawal stage to take advantage of the income these funds generate in the short term.
Suppose you decide to invest outside of a retirement account. In that case, you’ll need to consider your investment’s tax implications, ensuring that your after-tax returns are aligned with your financial goals and risk tolerance.
Alto IRA is a self-directed IRA custodian working with various alternative asset providers, including private credit investment firms. Read our full Alto IRA review to learn how they can help you invest in private credit through a retirement account.
Expected Fees for Private Credit Investments
Investing in private credit can come with various fees. The most common types of fees include management fees, which are ongoing charges for managing the investment, and performance fees, which are additional costs based on the investment’s success.
These fees are often higher than what you’d pay for traditional investments like bond funds and will significantly impact your overall returns.
A recent study by Cliffwater revealed that the average fees for private credit investments, including all factors, exceeded 3%.
This is a substantial difference from traditional investments and must be carefully factored into your investment strategy.
Investing In Private Credit: Final Thoughts
Private credit investing offers a unique opportunity for individual investors to explore an alternative asset class that was once primarily the domain of institutional investors.
With the allure of higher yields and the potential for diversification, private credit has become an increasingly popular investment avenue. However, its challenges include higher fees, illiquidity, default risk and complex tax considerations.
There are various ways to invest in private credit, from investment platforms to publicly traded business development companies (BDCs) and wealth management firms. Each comes with its own pros and cons, and understanding these is vital to making informed investment decisions.
The average fees for private credit investments can exceed 3%, a substantial difference from traditional investments, and must be carefully considered in your investment strategy.
Whether you’re drawn to the potential for higher yields or seeking to diversify your portfolio, it’s essential to approach private credit investing with caution and diligence.