Exploring Different Types of Private Credit

Exploring Different Types of Private Credit
Photo by Scott Graham / Unsplash

In our previous article, we went through various tips on identifying top private credit investment opportunities for investors like you. In this article, we will discuss the different types of private credit investments, including direct lending, mezzanine financing, and distressed debt, among others. In future articles, we will be discussing in-depth about each form of private credit.

Direct Lending

Direct lending is a form of private credit investment where investors provide loans directly to small and medium-sized enterprises (SMEs) or other borrowers without the involvement of traditional banks or financial intermediaries. These loans may be with or without collateral and can be structured as term loans [1] or revolving credit facilities [2].

Direct lending offers investors the opportunity to generate higher-than-fixed-deposit yields, with indicative annualized returns ranging from 6–9%, while providing much-needed capital to businesses seeking to grow or refinance existing debt. Some of the risks associated with direct lending include credit risk [3], interest rate risk [4], and concentration risk [5].

Mezzanine Financing

Mezzanine financing is a hybrid form of debt and equity financing that fills the gap between senior debt [17] and common equity. It is typically subordinated to senior debt but has priority over common equity.

Fig: Where mezzanine debt sits in a company’s capital structure

Mezzanine financing often comes with higher interest rates and may include equity components, such as warrants or conversion rights, which allow the investor to participate in the potential upside of the borrower’s business. This type of financing is particularly suitable for businesses undergoing expansion, acquisitions, or recapitalizations.

Investors in mezzanine financing can expect indicative annualized returns in the range of 10–14%, reflecting the higher risk profile compared to senior debt. Some of the risks associated with mezzanine financing include credit risk [3], subordination risk [6], and equity dilution risk [7] if the equity components, such as warrants or conversion rights [8], are exercised by the investor. Additionally, the investor may face increased volatility due to the equity-like features of the investment, particularly if the borrower’s business performance does not meet expectations.

Distressed Debt

Distressed debt investments involve purchasing the debt securities of financially troubled companies at a significant discount to their face value. Investors in distressed debt are betting on the potential for a successful turnaround, restructuring, or liquidation, which could lead to the appreciation of the debt’s value.

Distressed debt investing requires a deep understanding of the borrower’s financial situation, industry dynamics, and potential recovery scenarios.

Distressed Debt is considered a higher risk investment compared to other private credit strategies, it offers higher potential returns, with indicative annualized returns ranging from 12–18%. Risks associated with distressed debt investing include credit risk [3], business turnaround risk [9], and potential litigation risk [10] during the restructuring process.

Asset-Based Lending

Asset-based lending (ABL) is a type of secured lending where the loan is backed by the borrower’s assets, such as accounts receivable, inventory, or real estate. ABL provides borrowers with working capital based on the value of their collateral, and the lender typically has a legal claim over the borrower’s pledged assets (i.e. security interest).

Fig: Collaterals that are generally being used in Asset-Based Lending

This type of lending can be attractive to investors due to its secured nature and the ability to closely monitor the value of the underlying assets, with indicative annualized returns of 7–11%. Risks associated with asset-based lending include credit risk [3], collateral valuation risk [11], and asset liquidation risk [12] if the borrower defaults.

Real Estate Debt

Real estate debt investments involve providing loans for the acquisition, development, or refinancing of commercial or residential real estate properties. These loans can take various forms, such as senior mortgages [15], bridge loans [16], or construction loans, and are typically secured by the underlying property.

Real estate debt investors may benefit from the predictable income streams and the potential for capital appreciation from the underlying properties, with indicative annualized returns ranging from 8–12%. Risks associated with real estate debt investments include credit risk [3], property valuation risk [13], and market risk [14] related to the real estate sector’s performance.

Specialty Finance

Specialty finance encompasses a wide range of niche lending opportunities that cater to specific industries or borrower needs. Examples of specialty finance investments include consumer finance (e.g., auto loans, student loans), trade finance, and equipment leasing, among others.

These investments may offer attractive yields and diversification benefits due to their unique risk-return profiles and low correlation with traditional asset classes, with indicative annualized returns ranging from 9–13%. Risks associated with specialty finance investments depend on the specific strategy but can include credit risk [3], regulatory risk [15], and industry-specific risks.

Specialised Funds vs Diversified Funds

Most institutional and high-net-worth investors access private credit opportunities through private credit funds, which are alternative investment vehicles that provide debt financing to borrowers that are not readily served by traditional banking channels.

These funds may specialize in a specific type of private credit strategy, such as distressed debt to capitalize on the expertise and experience of the fund manager and to cater to a particular risk appetite and return objective of their investors.

Alternatively, some private credit funds may employ a multi-strategy approach (e.g. Bluejay’s Pool #2), blending different types of strategies to achieve diversification, reduce risk, and enhance risk-adjusted returns. This approach allows fund managers to adapt to changing market conditions and leverage opportunities across various sectors and credit cycles, thereby providing the potential for more consistent performance.

Investing in private credit funds typically involves certain requirements, including a minimum investment amount, a commitment period, and accredited or sophisticated investor status. By removing these barriers, Bluejay Finance is enabling investors with varying levels of capital to access this asset class

Always Perform Due Diligence

Due diligence is crucial for investors considering private credit funds, as the complexity and bespoke nature of the underlying assets necessitate thorough assessment of the fund manager’s expertise, track record, and investment process, as well as the overall risk-return profile of the fund. Over the next few weeks, we will be deep diving into each type of private credit strategies to understand more about their pros, cons, and risks.

As always, conducting thorough due diligence and seeking professional advice is essential when considering private credit investment opportunities. When you are assessing opportunities available to you on Bluejay.finance, always check out the information pack available in the data room to uncover the information mentioned above.

Glossary

[1] Term Loan: Fixed-term, lump-sum loans with a set repayment schedule and interest rate.

[2] Revolving Credit Facilities: Flexible financing arrangements that allow borrowers to access funds up to a pre-approved limit, repay, and re-borrow as needed during a specified period.

[3] Credit Risk: The risk of borrower default

[4] Interest Rate Risk: The potential impact of changes in interest rates on the value of the loan

[5] Concentration Risk: The risk stemming from a lack of diversification.

[6] Subordination Risk: The risk that a debt instrument ranks lower in priority compared to other debts in the event of a borrower’s bankruptcy or liquidation, potentially resulting in reduced or delayed recoveries.

[7] Equity Dilution Risk: The risk that existing shareholders’ ownership stake is reduced when additional shares are issued, which may lead to a decrease in the value of their shares.

[8] Conversion Rights: A feature in certain debt securities that allows the holder to convert the debt into a predetermined number of shares of the issuing company, potentially participating in the company’s equity appreciation.

[9] Business Turnaround Risk: The risk that a struggling company may not successfully implement a restructuring plan or improve its financial performance, leading to potential losses for investors.

[10] Litigation Risk: The risk associated with potential legal disputes or proceedings that can arise during business activities, such as debt restructurings or contract disputes, which may result in financial losses or reputational damage.

[11] Collateral Valuation Risk: The risk that the value of the assets used as collateral for a loan may be overestimated or may decline over time, leading to insufficient coverage in the event of borrower default.

[12] Asset Liquidation Risk: The risk that the proceeds from the sale of a borrower’s assets in the event of default may not fully cover the outstanding loan balance, resulting in losses for the lender.

[13] Property Valuation Risk: The risk that the value of a real estate property may be overestimated or may decline due to market factors, which can negatively impact the returns on a real estate debt investment.

[14] Market Risk: The risk that changes in market conditions, such as interest rates, economic growth, or sector performance, can negatively affect the value of an investment or its potential returns.

[16] Senior Mortgage: Primary loan secured by real estate, which holds priority over any other debts or liens on the property in case of default or foreclosure.

[16] Bridge Loan: Short-term financing solution used to cover immediate cash needs, typically during a transition period, such as the time between buying a new property and selling an existing one.

[17] Senior Debt: A type of debt that has priority over other debts in the event of a borrower’s bankruptcy or liquidation, ensuring that senior lenders are the first to be repaid before other creditors.