Ask Your Advisor These Questions Before Investing in Private Credit

Key Takeaways

• Private credit can take a lot of forms, but mostly what people are talking today is direct lending.
• For an investor, you’re getting paid a higher amount of income for these loans than you would be in the public market.
• The diversification bent case for private credit is a little overstated because it is still credit.
• One of the most common ways that advisors are providing their clients with access to private credit is through interval funds and nontraded BDCs.
• Firms offering BDCs and interval funds include all big credit players, like BlackRock, Pimco, Blackstone, Fidelity. Firms like Apollo and Cliffwater that are maybe not as well known to retail investors have interval funds.
• Most private credit is floating rate, which means it’s tied to a short-term reference rate.
• Investors need to question their advisors if and why private credit should be in their portfolio.

Susan Dziubinski: I’m Susan Dziubinski with Morningstar. Today, more financial advisors are offering their clients pathways to invest in private credit. So what are the pros and cons of investing in private credit? How do you go about doing it? And what do you need to know about it before investing?

Joining me today to share the key questions to ask your advisor about investing in private credit is Jason Kephart. Jason is Morningstar’s director of multi-asset ratings. Good to see you, Jason.

Jason Kephart: Good to see you.

What Is Private Credit?

Dziubinski: So let’s start at the beginning. What is private credit?

Kephart: Sure. Private credit can take a lot of forms, but mostly what people are talking about when they’re talking about private credit today is direct lending. Direct lending is—let’s take your local pizza shop, for example. In the past, when it wanted to take out a loan to either expand, maybe buy a new oven, it would go to its bank and it would get the loan and go invest the money however it wanted to. But now with the regulations we’ve seen post financial crisis, there’s only so many local pizza shops the banks are willing to have on their balance sheets. So that’s where direct lenders come in. And typically that’s when a fund will be making a loan directly to a business. And that’s the direct lending we’re usually talking about today.

Why Investors Want Private Credit Compared With Publicly Traded Investments

Dziubinski: Why would investors want to invest in private credit rather than, say, in bonds that are traded publicly on the market?

Kephart: The downside for our pizza shop is when it’s going to a direct lender instead of the bank, they’re having to pay a higher interest rate. And that’s not great for the business, but for an investor, you’re getting paid a higher amount of income for these loans than you would be in the public market. So that’s kind of the allure. It’s really all about the income. And so when we look at private credit funds today, we’re seeing distribution rates around 10%. Public high-yield bond funds, it’s more around like 6%. So there is a pretty big significant pick up in income there.

Does Private Credit Offer Diversification Value to a Portfolio?

Dziubinski: One of the reasons that people add alternatives, let’s call these “alternatives,” to their portfolio is for some diversification value. Does private credit offer any diversification value to a normal portfolio of, say, stocks and bonds?

Kephart: I think the diversification bent case for private credit is a little overstated. It is still credit. Think of our pizza shop. If you go into a recession, and people have to cut back on spending, it’s not going to be any easier for that pizza shop to pay back its direct lending loan than it would a public loan. And also because the direct lending has higher interest rates, that makes it even harder still. So if you get into a recessionary period, everyone might be stressed to be able to make their credit payments. So I think in that case, it’s not really diversifying. It’s still credit. It should probably be part of your fixed-income portfolio, part of your credit bucket there. But you wouldn’t use it to really add diversification. You’re really looking to increase returns.

How to Invest in Private Credit Through Your Financial Advisor

Dziubinski: Access to private credit markets was once limited to institutional investors or individuals with really high net worths. But that’s been changing. So what are the most common ways that advisors are providing their clients with access to private credit?

Kephart: Where we’re seeing a lot of product development that’s kind of really bringing private credit downstream is in interval funds and nontraded BDCs. At the high level, these things both are very similar. They offer limited liquidity. So with an interval fund or nontraded BDC, you can invest money anytime, but at the end of each quarter, they might only offer 5% of the fund for liquidity. So if everyone’s rushing to the exits at the same time and you’re trying to get out then, you might not be able to pull out as much money as you think you had. So you really need to plan around that limited liquidity. The other key difference is interval funds are regulated in a 1933 Act, while nontraded BDCs are not. So nontraded BDCs can use a lot more leverage, so that creates higher income from the nontraded BDCs.

Why Nontraded BDCs Are More Popular Than Interval Funds

Dziubinski: Is there one that’s more popular right now with investors who are working with advisors: interval funds or BDCs? And what’s BDC stand for?

Kephart: Business development company.

Dziubinski: Is one more popular than the other right now and why?

Kephart: I think assetwise, from what we could tell, and it’s a little opaque in the nontraded space, but from what we could tell, there’s more assets going into the nontraded BDCs because they can offer these higher yields. Whereas interval funds, they have less, a bit of a leverage cap on them. I think it’s 33%. So the yields are going to be a little bit lower. And the other big trend we’re seeing in interval funds is kind of this mix of public and private credit together. Whereas the nontraded BDCs are in very pure private credit. We’re seeing firms like Fidelity, American Funds, Pimco, BlackRock have these hybrid interval funds where it’s like 60% to 70% public and 30% to 40% private. So you get that kind of in-between space. That might make it easier to allocate to credit, but I think in general what we’ve been seeing is people love income so the nontraded BDCs have the higher income. So vehicles like BCRED, Blackstone’s very popular nontraded BDC, are attracting a lot of assets.

Which Firms Are Offering BDCs and Interval Funds?

Dziubinski: Talk a little bit about these managers that are offering both of these type of products. You talked about some really familiar names in Fidelity and others when it comes to interval funds. So if you could give us a rundown of who’s offering the interval funds and then who are some of these other firms that maybe are a little less familiar to an individual investor, say, but that are bigger players when it comes to BDCs.

Kephart: In the BDC space, what you’re seeing is all big credit players, BlackRock, Pimco, Blackstone, Fidelity, they have those, too, but then also have interval funds so you kind of get pure-play private credit, hybrid private credit, and then they also have their public private credit things.

But we’re also seeing other firms like Apollo has interval funds—very well known in the alternative space, maybe not as well known to retail investors. Cliffwater is a firm that we’ve seen raise a lot of assets in the interval fund space, and they do almost pure direct lending. And that’s why I think they’ve been a winner in the interval fund space. They do tend to have higher yields than the hybrid ones. So I think that’s one of the reasons they’ve been able to be a winner in that space so far.

How Interest-Rate Cuts Affect Private Credit Investments

Dziubinski: Jason, now that we might be entering a period of where we’re going to see interest rates falling as opposed to rising or staying kind of high where they were, are these private credit investments any more or less attractive?

Kephart: A little bit less. Most private credit is floating-rate, which means it’s tied to a short-term reference rate. So as rates are going down, the overall income level is going to go down, too, but that’s going to happen to all the fixed-income investments. So you should still get a premium for investing in private credit over public credit. So there’s still going to be a yield advantage, though the absolute yield number is probably going to be a little lower going forward than we’ve seen in the past.

Questions to Ask Your Advisor Before Investing in Private Credit

Dziubinski: It seems like an obvious pro here is that you have this opportunity to generate higher income through either a BDC or an interval fund. Seems like the con would be less liquidity than you’re going to have in a product that is trading bonds that are on the public market. So given that, what are some of the questions that investors should be thinking about when they’re talking to their advisor about these products?

Kephart: I think if an advisor approached me and said, “We need to put private credit in your portfolio,” the first question I would have is, “Why me? What’s the problem we’re trying to solve here? Do we not have enough income already? Do we not think we’re on track to hit our goals in terms of total returns and income?” And that’d be the first question—why do we need this? I think private credit for most retail investors probably falls much more in the nice-to-have bucket than a must-have. If you really need that higher income, maybe there’s a case for it, but I think you should always approach any kind of alternative investment with some trepidation and really do your homework. The other thing I would think about is, What’s our exit strategy? These things have limited liquidity, so you can’t expect to get your money back in a short period of time. So what is the time horizon we’re looking at? What’s the end? What is our exit strategy there? And then also because of the limited liquidity, that could create some challenges around rebalancing. If everything’s falling off and your semiliquid fund is staying stable because maybe its prices aren’t updated as regularly as public market ones, then maybe it’s growing as part of your portfolio. And if you can’t sell out of there to buy other stuff, it might become a bigger part of the portfolio and maybe something you’re not comfortable with. So I’d ask and want to know how the advisor plans to manage around that risk.

Dziubinski: Jason, this sounds like an interesting new opportunity for income investors, so I think that’s something you and I will talk about again. Thanks for your time today.

Kephart: Thanks for having me.

Dziubinski: I’m Susan Dziubinski with Morningstar. Thanks for tuning in.

Watch Ask Your Advisor These Questions Before Investing in Model Portfolios for more from Jason Kephart.