Private Credit (Direct Lending): Why HNW Portfolios Are Becoming “The New Banks”
Private Credit (Direct Lending): Why HNW Portfolios Are Becoming “The New Banks”
๐ WHO THIS IS FOR (Prerequisites)
- Required Profile: Accredited Investors or Qualified Purchasers seeking high single-digit to double-digit yields (8-12%).
- Primary Objective: Income Generation (Replacing volatile Public High Yield Bonds with Senior Secured Private Loans).
- Disqualifying Factor: Investors requiring daily liquidity (Private Credit typically has quarterly liquidity caps of 5%).
โ ๏ธ STRATEGY ELIGIBILITY CHECK
Private Credit trades liquidity for yield. You are the lender; you cannot “sell” the loan instantly.
- โ๏ธ Liquidity Tolerance: Must accept “Interval Fund” or “BDC” structures where withdrawals are limited (e.g., 5% per quarter).
- โ๏ธ Rate Environment: Works best in higher-rate environments due to floating rate structures. (Yields drop if Fed cuts rates aggressively).
- โ๏ธ Credit Cycle Awareness: Must understand that defaults rise during recessions. You are taking credit risk, not interest rate risk.
- โ๏ธ Vehicle Selection: Access via Public BDCs (Liquid but volatile) vs. Private BDCs/Interval Funds (Stable NAV but illiquid).
*Warning: In a severe liquidity crisis (like 2008), private credit funds may “gate” redemptions entirely to protect remaining investors.
EXECUTIVE SUMMARY
- The Shift: Since 2008, regulations (Basel III) forced banks to stop lending to mid-sized companies. Asset Managers (Blackstone, Ares, Apollo) stepped in to become “Direct Lenders.”
- The Asset: You are buying Senior Secured Loans made to private companies. These are at the top of the capital structure (paid before equity/bonds) and are secured by assets.
- The Yield: Unlike fixed-rate bonds, these loans are Floating Rate (SOFR + Spread). As interest rates rise, your coupon rises. Current yields often target 10-12%.
- The Trade-off: You get the “Illiquidity Premium.” You earn ~3-4% more than public bonds because you cannot sell the loan tomorrow.
Public Bonds are traded; Private Credit is originated. By removing the ability to panic-sell, Private Credit offers a smoother volatility profile (stable NAV) while delivering equity-like returns. It has become the “Core Fixed Income” replacement for institutions. Source: Cliffwater Direct Lending Index / Preqin
- Benchmark: Cliffwater Direct Lending Index (CDLI).
- Comparison: Bloomberg US High Yield Bond Index (Public Junk Bonds).
- Structure: Senior Secured First Lien Loans.
- Default Recovery Rate: Assumed 60-70% for Senior Secured vs 40% for Unsecured Bonds.
- Fee Drag: Assumed net of typical management fees (1.25% on assets).
Yield & Volatility Comparison (5 Year Avg)
| Asset Class | Annualized Yield (%) | Standard Deviation (Volatility) |
|---|---|---|
| Public High Yield Bonds | 6.5% | 9.0% |
| Private Credit (Direct Lending) | 10.2% | 3.5% |
*Chart Note: Private Credit shows artificially low volatility because the assets are not marked-to-market daily. However, the income spread (+3.7%) represents the “Illiquidity Premium” paid to patient investors.
Structural Comparison Matrix
*Why Private Credit is structurally different from buying a Corporate Bond ETF.
| Feature | Public Corp Bonds (Fixed Income) | Private Credit (Direct Lending) |
|---|---|---|
| Interest Rate Type | Fixed Rate (Price drops when rates rise) |
Floating Rate (Coupons rise when rates rise) |
| Capital Priority | Often Unsecured (Junior) | Senior Secured (First Lien) |
| Covenants | “Covenant-Lite” (Weak protection) | Robust Covenants (Lender control) |
| Liquidity | Daily (T+2 Settlement) | Quarterly (5% Cap) or Multi-Year |
*Operational Note: “Senior Secured” means if the company goes bankrupt, you get the building and the inventory. Bondholders get what’s left.
Duration Risk is Near Zero:
- Mechanism: Private loans reset their interest rate every 30-90 days based on SOFR (Secured Overnight Financing Rate).
- Outcome: If the Fed hikes rates by 1%, your yield increases by ~1%. Unlike bonds (specifically TLT), the price of the loan doesn’t crash because the yield adjusts to the market automatically.
- Caveat: If rates go too high, the borrower might default because they can’t afford the higher interest payments (Credit Risk).
โ BOUNDARY CLAUSE: Structural Limitations
- The “Gate” Mechanism: In times of panic (like March 2020), funds like BREIT or BCRED hit their quarterly repurchase limits. You may ask for your money back and be told “Wait until next quarter.” This is a feature, not a bug, preventing fire sales.
- Fees: Private Credit is expensive. Expect total expense ratios (TER) of 2-4% (Management + Incentive Fees + Interest Expense). The net return matters, but the fees are high.
๐ค DECISION BRANCH (Logic Tree)
IF Need = Emergency Fund / Short-Term Goal:
โข Input: Money needed in < 12 months.
โข Output: Avoid Private Credit. Use T-Bills or Money Market Funds. Illiquidity risk is unacceptable here.
IF Need = Income Replacement / Retirement Cash Flow:
โข Input: Holding period > 3-5 years; desire for steady 8%+ yield.
โข Output: Allocate Core to Private Credit. Use diversified Interval Funds or Private BDCs to replace the “Fixed Income” bucket.
Private Credit is the “industrialization” of lending. It allows individuals to act like banks, earning the spread that banks used to keep. Just ensure you are paid enough (the spread) to lock up your money.