The big idea and why it matters: Private credit involves making direct loans to borrowers. Properly executed private credit requires an impressive effort of coordinated skill and experience; it is in high demand because it provides significant value to investors and borrowers.
“He who would pry behind the scenes oft sees a counterfeit.” – John Dryden.
If you’ve been to NYC (or some other cities mentioned in this NYT article), you may have seen or even had a close encounter with a fake monk. They wear robes and appear to be Buddhist, but as I learned in my early goings in the city back in 2009 or 2010, they offer you a gift – usually a golden medallion. Once you accept, they demand payment. It’s a scam, very similar to the guys who aggressively hand an unsuspecting tourist a CD and then (again) demand money for the CD they just “gave” them (but at least the CD could be worth a listen).
Last week, I was reminded of the fake monk ploy as I caught a behind-the-scenes look of them getting ready to start their day. A group of men was behind a wall at the New York Public Library, near the corner of 42nd and 5th, getting ready for “work,” putting on the tan-robe uniforms. Similar to when I observed some panhandlers being given their “woe is me” cardboard signs and marching orders from their local leader for the day, the experience marred my worldview and left me with many questions.
It’s like a legitimate shift meeting that restaurant servers have before the Friday night dinner rush, and fake-monking (or panhandling) requires as much effort as many other jobs akin to the mental fortitude needed to overcome constant rejection in sales roles. So, why do people waste their capacity doing value-stripping tasks like these instead of just applying themselves to good old-fashioned jobs? Can they opt for a path of productivity, or is moral corruption the only option? Either way, my glimpse behind the façade leads me to believe these efforts are intentionally organized, and there’s more going on than I realize.
Now, for the opposite of that
I want to use the “behind-the-scenes” theme as a jumping-off point for the inner workings of private investments, specifically private credit – but this (unlike the above) will be a very positive endeavor. The topic was inspired by recent conversations/questions I’ve encountered with prospective clients or those newer to alternative investments. I think it can be short and sweet, but getting deeper into private credit will clarify its importance, which I can appreciate is not obvious at first glance. Here we go!
What is private credit?
I can easily fall into the trap of using financial jargon, so let me first clarify what I mean by “private credit.” Simply put, it is money lent directly (aka “privately”) to private borrowers (individuals or private businesses). The terms private credit, private lending, private loans, and direct lending are all used pretty interchangeably. Arguably (see here), the term “private debt” may include a much broader universe than private credit, but I think that’s an unnecessary game of splitting hairs.
Not 007
Unlike what we commonly call a “bond,” the terms of private loans are negotiated directly between the lender and borrower, and they don’t trade openly in public markets. Buying a bond is more of a take-it-or-leave-it proposition. The terms of the bond are pre-baked. The only decision for bond buyers is at what price they will accept the predetermined terms. In private credit, the lender has much more control over the rate, terms, and recourse (what happens when things go wrong).
Why does private credit exist?
This section gets right at the heart of the private credit topic, as many questions are related to “Why would borrowers pay such high-interest rates?” or “Is this too good to be true?” or “Why don’t banks just do this, instead?”
- Speed/certainty of execution: Have you ever gotten a mortgage? If so, then you know that banks are slow and sometimes fickle. They can go through months of vetting a loan only to deny a borrower the loan (or provide completely unpalatable terms) – and that’s just for what are relatively simple private individual borrowers with easily assessable collateral like a house. Good private credit teams are designed to provide very quick “NOs” for loans that aren’t of interest. If they are interested, they can get through highly complex underwriting processes in just a couple of weeks. Banks can’t do either. [Keep in mind that potential borrowers like private equity (PE) firms will need many loans over time. So don’t underestimate the value of the quick NO, as it still helps to build relationships with those PE firms and keep them coming back with future opportunities].
- Flexibility: The terms of deals can not only come together quickly, but they may also offer significant flexibility; this could be in terms of how the borrower/business/assets are viewed for the initial loan, but also for future adaptations (predetermined increases with future business growth, add-ons, refinancings, revolving lines of credit, etc.).
- Resources/Partnership: But wait, there’s more! Private credit firms may also provide resources and can be very hands-on in helping the borrowers grow and thrive.
- Confidentiality: Businesses often want to keep their dealings confidential, and it’s possible to accomplish that via private loans. Banks may have disclosure requirements that make information more publicly accessible. To be fully transparent, I’m often told this is a selling point by private credit firms, but I’ve never dug into the weeds of disclosure requirements of banks (I was able to find a little bit of information here). I don’t know how important this aspect is to most borrowers.
- Banks “don’t want none” (or can’t have any): In many cases, banks cannot hold private loans on their balance sheets because of collateral requirements and the illiquidity involved (at least partially stemming from post-GFC regulations). When banks can compete for these loans, I’m confident that the borrower will get a better rate than private lenders offer; however, the borrower may STILL opt for the non-bank loan for other reasons cited above. Rate isn’t everything.
How do they do it?
Concisely, private credit is properly executed via many skill sets and a lot of experience; these firms need to synthesize all of the following and more:
- Capital raising: gaining the trust of institutions, private individuals, and financial advisors to raise hundreds of millions of dollars to make loans.
- Deal sourcing: usually requires extensive careers at other large private equity/credit firms that allow private credit founders to leverage a robust professional network of potential borrowers.
- Underwriting: to quickly but accurately get through the underwriting process and determine on what terms a given loan makes sense (or doesn’t) is mission critical. Our confidence in private credit almost solely comes down to a team’s ability to underwrite and structure deals in a way that mitigates loss while providing attractive income.
- Monitoring: ongoing monitoring/management of and (if needed) intervention in loan situations is vital for managing risk. Like financial planning, lending is far from a set-it-and-forget-it endeavor (Ron Popeil’s slogan was great for rotisserie chicken but poorly suited for private lending).
The role private credit can play in portfolios is covered a lot, given its potential to generate high income with a low volatility profile. However, the underlying mechanics are often underappreciated. If you happen to have an extensive network of potential borrowers, the ability to raise many millions of dollars, and the experience to deploy and monitor loans while protecting capital for investors, then you can do it, too! Otherwise, let’s just say there is a lot that goes on behind the scenes, and I’m happy to pay private credit teams (often high) fees for the tremendous value they add to investors, borrowers, and the economy.
Until next time, this is the end of alt.Blend.
Thanks for reading,
Steve
