How to Invest in Private Credit / Direct Lending
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Welcome to Money for the Rest of Us. This is a personal finance show on money, how it works, how to invest it, and how to live without worrying about it. I'm your host, David Stein, and today is episode 509. It's titled, Should You Invest in Private Credit? A week or so ago, I was on a Zoom call with a number of financial advisors, and a number of them mentioned

They had personally invested in private credit or they were putting their clients in private credit. Now, what is private credit? Sometimes it's called direct lending. And we've talked about it in the past, but we've not done a dedicated episode on it. So I'll certainly describe what it is, its characteristics, how to invest in it.

But first, one of the trends that has been going on for a number of decades now that we have mentioned on the podcast is the number of publicly traded companies that have publicly

public stock that we can purchase on an exchange, that's dropping. Back in 1996, there were about 8,000 firms that made up the U.S. stock market. Now there's less than 4,000, even though the overall economy in the U.S. is bigger. There are fewer publicly traded firms. Now, partly that's been a shift in the economy as it's become more service-oriented.

service-based, that generally leads to smaller companies, fewer manufacturing firms, but there's also been more taking public companies private. And startups that are private, that grow to a size where they typically would have gone public, they haven't, they remain private. And so there are just more private firms, fewer publicly traded firms. Now, for most of the past few decades, the opposite trend was

was in the debt world. Historically, companies took out loans from banks, and then over the past few decades, we've seen banks syndicate those loans. This is called the leverage loan market. Sometimes it's called floating rate loans or bank loans, senior loans. There are ETFs that invest in that. We've talked about leverage loan investing in a

a number of episodes. I've participated in this market for over two decades now, both individually as well as allocating institutional clients' money toward the leveraged loan market. Now, these syndicated bank loans, they're liquid or semi-liquid. They trade in the secondary market and they have been packaged into other securities called collateralized loan obligations.

CLOs were first introduced in the late 1980s, and a manager selects numerous bank loans and then divides this package of loans into tranches. And so back in Episode 423, we talked about CLOs and specifically AAA CLOs, which is the highest rated tranche, has never had a default.

And we can get attractive yields investing in CLOs. And I did so shortly after that episode for the first time. I invested in CLOs and continue to do that today.

Now, generally, these leveraged loans, if they're packaged into CLOs, they were larger loans. So bigger companies could be for a leveraged buyout. It could be a publicly traded company that's taking out debt. Now, generally, the leveraged loan market were non-investment grade loans, but many of them were publicly traded companies. Now, some were not. Some are private companies.

And still go to banks, borrow money, and then those banks sell those loans and they're syndicated into the marketplace and they can create CLOs out of these loans to private companies. But again, it's done through the syndicated loan market.

But there's a separate type of lending, and it's private credit direct lending, where a lender lends to a private company, and there's just one lender. So the loan is not parceled out, not packaged into CLOs. There's not multiple lenders. There's just one lender.

And the loan to these companies is not traded at all. Typically, the lender will keep the loan on their books. The term is typically three to six years. And this is the private loan market. These loans are not rated by credit agencies like leverage loans are, and they're not regulated in any way.

And so that gives the lender greater flexibility. In fact, since there's typically only one lender, there's not any separation between senior debt or subordinated debt. There's just lending to a private company.

These lenders, these direct lenders, become very involved in the company. They see themselves as partners and they're able to structure covenants and restrictions, become very involved in the company and provide a great deal of oversight to the companies they lend to. Now, because the

The lenders are holding onto the loans. They're illiquid. They can typically charge more in terms of the interest rate than what the company could borrow in the leveraged loan market, assuming the company was large enough to even

access the leverage loan market. So this debt is more expensive, but the borrowers like it. They like the flexibility. They appreciate the confidentiality and the ability to just deal with one lender that can help structure terms that

meet both the lender's need as well as the borrower's need. And typically, they can get access to the debt capital much faster than they could if they went through a traditional going directly to a bank and having the loan syndicated. It's just easier to participate in the private loan market. And that market's growing.

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So if we look at the size of leverage loans, syndicated bank loans, about $1.4 trillion. Commercial bank loans, outstanding. And so this would be loans that banks in the U.S. keep on their books. Oftentimes it lines of credit, about $2.8 trillion. But this private credit lending, direct lending, it's bigger than the leverage loan market now, about $1.6 trillion. That's up from $3 billion in 2010.

The attractiveness of direct lending has led to accelerated growth. The lenders like it because they can get higher returns because of that illiquidity premium. And the investors that invest in these private credit funds get those higher returns. They also get the greater protection because there's just one lender. They can put the restrictions on that they want. They're partners in the business. They're very much involved. And

And this is an important distinction. If there's a bankruptcy, there's fewer debt or undetter conflicts in the leveraged loan market or even the non-investment grade bond market. When a company defaults on the loan or files for bankruptcy, oftentimes the different creditors fight amongst themselves for the collateral, for the terms of the restructuring. But in the direct lending space and private credit, because there's typically only one or maybe two creditors,

or three lenders, there's just not that level of infighting. Lenders in these private credit funds like the higher fees they get. If they've structured a private credit fund for outside investors and then they're doing direct lending, they can earn 15 to 20% of the profits. That's called the carry. And oftentimes it's above some certain return threshold that's called the hurdle rate, could be 5% to 8%. And the

And these private debt lenders also get loan fees, origination fees, or placement fees. So it's a very profitable business, and there's some other attractive elements to it. As I mentioned, the yield or the interest rate is higher, and typically it's 3% to 6% higher than syndicated loans.

and the borrowers are willing to pay it because they're either too small to access the leveraged loan market, or two, they want the money faster. They want to be able to customize the terms more and perhaps take on more leverage than they would otherwise be able to do in the leveraged loan market. Investors that are in these private funds

Some of them, certainly they benefit from the illiquidity, but they also like the appearance or even the experience of less volatility. Because these loans are held on the books and they're not mark-to-market daily, they don't trade on a secondary exchange, they don't change in value very much. And there's some discretion as to what the value should be. And that can lead to more patient investing. And because these are typically held temporarily,

to maturity. They're within some type of private structure. There's liquidity constraints often for the underlying investors to pull their money out. And so the lenders and the private credit funds aren't forced to try to liquidate these illiquid loans in a fire sale.

So there's lots of benefits to private credit, which is why it has grown so dramatically. The lenders like it and the borrowers like it. Some other potential benefits across the entire economy. This could lead to greater productivity because oftentimes you have the same firm investing in equity of the company as well as lending to the company. There's a lot of skin in the game.

And so the capital gets used and allocated efficiently in order to generate a positive economic return. There's stakes there. Now, the downside is perhaps the focus is almost exclusively on generating profit.

And because these are private companies funded with private debt, maybe there are costs or negative externalities being passed on to others that might not occur if there was the greater scrutiny of the private sector.

the public stock market with regulations, regulators, the need for more transparency in terms of what the company is doing. I mean, there's a reason that companies are staying private, and it isn't nefarious necessarily. It's difficult to be a publicly traded company with a short-term focus on earnings, whereas private companies can take their time

There isn't this quarter-to-quarter earnings cycle, but there is the potential downside is just the lack of transparency as more and more of the economy are private companies. There's also the potential downside of less diversity in terms of how capital is allocated because many private equity funds have a 10- to 12-year life cycle because it's

A private debt fund could be eight to 10 years. The loans are three to six years. There's a certain type of company that fits the profile what these funds are looking for. High growth, ability to generate sufficient cash flow to service the debt, to reward the shareholders. And it could perhaps lead to a lot of debt.

leave out some companies that don't quite fit the mold, so we get less diversity. But by and large, private credit, direct lending has mostly positive benefits, fewer negative benefits, and that's why it's growing so much. So how do we invest in it? Before we continue, let me pause and share some words from this week's sponsors.

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Well, we've actually talked about ways to invest in it in the past. We just probably, we didn't necessarily call it direct lending. Back in episode 382, we discussed business development companies. These are also known as BDCs. They were created in the early 2000s as part of the Small Business Investment Incentive Act. A BDC is a publicly traded vehicle that provides

provides lending, direct lending to private companies and potentially some equity to those private companies. And these tend to be smaller companies that can't always access the syndicated loan market. BDCs essentially act like a private direct lender, except we can invest in this BDC. So the

An example of a way we can invest in BDC, we can obviously buy individual ones, but there's ETFs that invest in BDCs. The VanEck BDC Income ETF is one of the largest. The ticker is BIZD. Its return, annualized return over the past decade to the end of 2024 has been 9.7% annualized. That's the simplest way to invest in direct lending through a ETF that invests

in BDCs. It's liquid. The fees are low. Another way to invest in one of the ways that I have invested in direct lending is using a closed-end fund. A closed-end fund is like an ETF in that it trades on an exchange, but there isn't necessarily a mechanism to keep the price of

of the closed-end fund in line with the net asset values. So oftentimes, the closed-end fund can trade at a discount to the net asset value or a premium. With the closed-end funds, though, it can be very long-term capital. And so it's

A closed-end fund can do direct lending, lend for three to six years, and not have to worry about having to return capital to shareholders because there's a fixed number of shares outstanding. The closed-end fund does an IPO, maybe it does a follow-up offering, but there are not new shares being created and redeemed daily like you see with an ETF or an open-end mutual fund. So I've invested for the past three years,

in the Barings Corporate Investors Fund. Ticker is MCI, and it invests primarily in private debt. Direct lending can get some upside potential. It's a direct lender. This closed-end fund's been around since the early 1970s, and returns have also been solid. If we look at the return on a net asset value basis for the past 10 years, ending December 2024, return 9.3% annualized. About

about the same as the BDC ETF by VanEck. So both of those options are liquid. We can participate in the direct lending market. I'm sure there's other, and I know there's other ETFs that just paid in BDCs as well as other closed-end funds. Those are just two that I've spent more time with and invested with in the case of MCI.

A less liquid way is in some type of private fund. So the BDC, BDC ETF, the direct lending closed-end fund, we have daily liquidity there. Whereas I've also had exposure to private credit, direct lending through in the funds of funds I've been invested in with my old firm.

firm FEG Investment Advisors. About 25% of my allocation there is in private credit funds. And the returns have been between

between 7% to 13% internal rate of return. And so FEG is allocated to private credit funds like Falcon, Canyon, Yukon, Strategic Value, and I've participated that way. Now, there are other fund-to-funds that individual investors can participate in because FEG is focused on institutional investors. But last week in PLUS episode 507 for our premium members that are members of Money for the Rest of Us PLUS, we discussed...

The Cliffwater Enhanced Lending Fund. Cliffwater is a firm that works with financial advisors and creates products that financial advisors can use with their clients. And one of these products is a direct lending, a private credit fund.

Fees are higher, about 2.25%. The challenge with this is the only way to invest in it is you have to have a relationship with a financial advisor that can place you in the fund. But one of the advisors that was on this conference call or the Zoom call I had last week was very positive about this fund and participated in it directly. I have not invested in this fund, nor did I look at it that close, but I just was putting it out there as an example of a fund.

Now, another opportunity is from a former sponsor of our show, Long Angle. Long Angle is a free membership community geared toward very high net worth individuals with investable assets greater than $4 to $5 million. And their group is always researching funds in the private capital space, including direct lending. They've participated in a number of direct lending private credit funds. Typically, the minimums are about $100,000. But

You can check out Long Angle if you meet that investable asset threshold. For those that do not, another option is the BlackRock private credit fund. The ticker is BDET. That fund has a billion dollars in assets. In that case, you just need a net worth of at least $250,000 or income greater than $70,000. And in BlackRock, it's a firm that I...

have used for decades as an institutional manager. They're a bond firm, but they've also do direct lending. They've obviously bought iShares many years ago, so they're big in the ETF space. But they launched a fund back in 2022 that does direct lending. The management fee is 1.25%. They have an incentive fee that they get 12.5% of the income and gains above a 5% hurdle.

hurdle rate. Their S-class shares, the minimum is $2,500. Now with that, you got to be careful because there can be a placement fee of 3.5%. But since June 2022, the inception of this fund, the institutional shares, it's returned 10.2% annualized. And it's a benefit as an investor, you get a 1099. So with

With the long angle funds that you're involved with there, you would get a K1 and I believe the Cliffwater Fund, you also structured as a 1099. Now, with these private opportunities, they're less liquid. If you're in a direct lending fund, they'll call capital and you might not get any money back for the first three to four years. And you won't get all the money back for potentially eight, 10 or 12 years with the

the cliffwater fund or with B debt, the BlackRock private credit fund, they have rolling redemptions. These are called interval funds and they limit the amount of capital that can be removed on a quarterly basis. Typically it's 5% of the outstanding shares. And so this is not something you can call up and get all your money back. You have to be very patient, but that's understandable given this is direct lending where the loans are

are not traded in the secondary market, and we don't want the direct lender to have to be selling loans or liquidating loans to meet redemptions. Now, with the options with the closed-end fund, BDCs don't have to worry about that. It's capital that's not leaving. But these other vehicles, they have to worry about that, so they put up gates and they put up restrictions to keep the money invested. The final category is...

is a little confusing. There are two brand new ETFs. One is the BondBlocks Private Credit CLO ETF, PCMM, and the other is the Virtus.psychs AAA Private Credit CLO ETF, ticker is PCLO.

I hadn't heard of the term private credit CLO. We've discussed collateralized loan obligations, these securities that are packaged tranches of leverage loans. These leverage loans can be made to public companies, they can be made to private companies, and others.

And I don't even know if this is an official term, but Bondblocks and VirtuSykes decided that if a CLO, if the underlying loan is to a private company, even though that loan was packaged into CLO and it was initiated in the leveraged loan market through banks, that that's still considered private credit. And so they've launched, they both say they launched the first private credit CLO ETF. Now,

The strict definition of private credit, it would be oftentimes a private fund or a public fund lending to a private company directly and not using the leveraged loan market or the CLO market. But it's all definitional in their case. They're saying if the underlying company is private, if it was a leveraged loan or a CLO, then it's now a private credit CLO. And that's an example of...

Private credit direct lending is kind of all the rage right now. And so now they're using the terms where it typically would not have been used. So these are brand new, but there's just another way to participate in the CLO market. And we'll have to see how the funds do or the ETFs do in the structure. But it shows there's some confusion there, which is one of the potential risks when we think about private lending.

direct lending. As it has become more popular, there is the risk that there's just more leverage out there, that more companies are able to borrow. They potentially take on more debt. And so if we get into a recession, there could be more distress. The mitigating factors is the

The direct lenders are very involved with these companies. They have skin in the game. Their underlying investors have skin in the game. So hopefully that minimizes the distress. But private credit is becoming more popular and there's some risk to that.

The other thing to consider is that most of the loans, most of the direct lending, that certainly lending in the leveraged loan market, CLOs, they're variable rate loans. So it's some spread above cash yields or whatever the Federal Reserve's policy rate is. And so as short-term rates come down, the yields aren't

on these leveraged loans, CLOs, and lending by BDCs and other direct lending, those yields have come down. And so when we look at a 10-year annualized return, part of that return was generated by a period where we've had much higher cash yields the last few years as the Federal Reserve raised its policy rate to over 5%. Now for something like MCI, the

The VanEck BDC ETF, that 10-year return includes a number of years where shorter-term interest rates were much lower. And so they've still been able to generate that 10% annualized return. But we need to recognize that that is a risk. Lower short-term rates means lower potential returns on direct loans.

Now, one of the challenges, because these are private loans, is we don't have a real indication of what the default rates have been. Historically, we can just look at the returns of various funds in the space. And again, my experience has been 7 to 13 percent turnover rate of returns, 10 percent type returns.

nominal annualized returns. Other considerations for how you invest in this, if you choose to do so, is how much liquidity do you need? You want daily liquidity, then you use an ETF or a closed-end fund. If you prefer a less liquid vehicle, then there are private funds for that, including the interval funds that we've discussed. You'd

You'd recognize with a publicly traded vehicle, particularly a closed-end fund, it's going to be more volatile than the return smoothing you get with a private fund because they only value it quarterly. But certainly, we also need to recognize and understand the fee structure. What

What is the fee? What's the expense ratio, the ongoing management fee? Is there a carry or percent of profit shared? And what is the hurdle rate? But overall, this is an attractive area to invest, to allocate some capital. It's one that I've successfully invested in for almost 15 years now. So hopefully you have found this discussion helpful. This is episode 509. Thanks for listening.

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