Private credit funds have exploded recently, with billions of dollars raised for private credit from U.S. investors in 2023 alone, following a decade of strong growth. According to PitchBook, the market grew from roughly $500 billion in 2012 to $1.75 trillion in 2022. Last year, Harbor Group International (HGI), a real estate investment and management firm, announced that its multifamily credit fund had reached a new milestone of $1.6 billion in capital commitments.
The rise in popularity of private credit funds can be attributed to a surge in businesses seeking new and alternative avenues to capital in a high interest rate environment. HGI’s fund invests in US multifamily credit opportunities, including senior mortgage loans, Freddie Mac K-series bonds, preferred equity and mezzanine debt investments, and investments in securitized multifamily mortgage products.
Private credit funds offer investors access to non-public markets and present a range of benefits not offered by traditional and public market investments, and through strong recent fundraising, have been able to enter the lending market with a focus on high‑yield deals.
While traditional banks are required to hold comparatively higher levels of capital to what they lend and are subject to rigorous regulatory scrutiny, private credit has greater flexibility in these areas. Private credit funds have also been outperforming traditional private equity ventures. In 2023, the private credit portfolios of seven listed private equity managers achieved a median gross return of 16.4%, compared to 9.8% for their private equity strategies, making private credit an attractive investment opportunity.
Private credit funds’ popularity is also due to the advantages they offer investors, especially at a time when markets are uncertain and overall dealmaking has slowed to the point where many private equity firms are struggling to get funding for leveraged buyouts. Some of these advantages include:
• Diversification – Spreading exposure across multiple sectors and credit profiles is key to mitigating portfolio risk. Private credit funds work across a diverse range of credit instruments, including senior secured loans, mezzanine, and distressed debt, to offer higher yields than other types of investments.
• Risk Mitigation – Private credit funds can take advantage of the risk mitigation strategies many companies have in place when they assess the viability of an investment. Asset managers can consider a company’s reputation, position in the market, longevity, risk mitigation and response strategies, and past financial performance when considering offering private credit. To take on the appropriate amount of risk and capture returns, long-term, fund managers must put each investment prospect through rigorous due diligence and risk management testing before committing.
• Custom Structures – Private credit funds can be highly flexible, creating customized investment structures to generate alpha for investors. Often, private credit funds can offer value-added features that traditional banks cannot, including warrant coverage, equity kickers, revenue or profit-sharing agreements, and performance-based incentives. Investors concerned with preserving capital can opt for senior secured loans, for example, while those seeking higher returns may opt for higher risk alternatives like distressed debt.
• Conversion to Equity – Credit facilities and loans provided to companies by private credit funds often come with covenants setting out terms for the lender in case of a breach. In certain circumstances within a private credit fund, when a borrower defaults on a loan or breaches a covenant, the credit facilities can be turned into equity.
Financial firms considering private credit funds as part of their overall investment strategy should seek to establish an investment strategy, develop a sound strategic approach to the size of companies the fund will target, and establish risk management and compliance protocols.
In April 2024, the International Monetary Fund (IMF) published the second chapter of its Global Financial Stability Report, which called for greater regulation and oversight of the private credit market. Consulting regularly with legal and tax advisors can help asset managers head off risk from potential regulatory overhaul while maintaining the flexibility that makes private credit attractive. Sound management remains the key to driving return on investment by addressing potential tax implications and avoiding the fines, litigation, and reputational harm that may arise from non-compliance.
This material has been prepared for informational purposes only, and is not intended to provide or be relied upon for legal or tax advice. If you have any specific legal or tax questions regarding this content or related issues, please consult with your professional legal or tax advisor.
