Demystifying private credit amid a frozen IPO market

I started working on Wall Street in the late 1990s, and it was the heyday of the initial public offering fever.

Those IPOs peaked in 2020. To that point, there were 480 IPOs on the U.S. stock market in 2020, which was an all-time record. This was 106.9% more than in 2019, with 232 IPOs. It was also 20% higher than the previous record year of 2000, which had 397.

However, in the last several years, fewer companies have gone public. Data from Stockanalysis.com shows just 181 companies went public in 2022, compared to more than 1,000 in 2021 — a drop of more than 80%. The result, according to Torsten Slok, Apollo’s chief economist, is that there are now “about three times as many private equity-backed firms in the U.S. as there are publicly held companies.”

More companies are choosing to stay private because they can — firms can pay out initial investors using venture capital and other means. Gone are the days when firm founders needed to list their company on the New York Stock Exchange on the corner of Broad and Wall Streets to cash out.

While a sparse IPO market is bad for investment bankers, it can be a boon for retail investors like you. More companies staying private and deciding against going public means there is a growing opportunity to invest in private credit.

The term “private credit” can be confusing and a little intimidating, and it is also often misunderstood by the average investor. So, let’s talk about what exactly private credit is — and is not — by addressing common myths and misconceptions.

Private credit refers to private companies, as in “not public.” Private companies are those whose stock does not trade on public exchanges. As fewer companies have gone public in recent years, the number of private companies has grown commensurately, providing a larger pool of private firms looking for access to capital.

Turning next to the credit part of the term, this refers to debt or a loan. Just like a bond, an investment in private credit is the process of lending money to a private company that in turn pays interest payments on that debt.

Private credit has been gaining popularity among investors; however, there are several myths surrounding this asset class that can prevent investors like you from taking advantage of its benefits.

Let’s examine some of the common myths.

Private credit has recently become more popular, but it is not new. In fact, it has been around for decades. Companies have long relied on private credit for financing when they are unable to access capital from traditional lenders. This area of the market grew rapidly out of the 2008 financial crisis as banks became more restricted in their lending.

Recent bank failures at SVB, Signature Bank and First Republic sent ripples through the lending market, making it even more difficult for mid-sized and small organizations to gain access to the capital they need to grow. Instead of looking to small banks for financing, middle-market companies are turning to private credit lenders. Even with growth in private credit, this part of the marketplace makes up just a small percentage of the total U.S. debt.

However, the private credit asset class will not stay small for long, says Matthew Haertzen, certified financial planner and chief investment officer here at Francis Financial in New York.

“We are going to see more private credit investment opportunities in the future,” he says, noting that the decrease in traditional lending options is pushing companies to seek alternative funding sources. “Private credit is an effective way to secure the funds needed to grow businesses, and this is one of the most exciting opportunities for investors out there.”

There are a couple of reasons why investors may perceive private credit as being more risky than other assets: liquidity and transparency. Private credit is less liquid than regular stocks and bonds as the loans are directly negotiated and not as easy to sell to another investor. Because of this, it is crucial to view private credit as a long-term investment.

Also, private credit is less transparent than bonds, as it is not rated by credit rating agencies. To mitigate these risks, private credit investments are typically secured by assets or collateral, which reduces the risk of default.

“You could liken this to a bank offering you a mortgage and they use the home that you are purchasing as collateral, says CFP Avani Ramnani, director of financial planning and investment management at Francis Financial. “The bank is protected if you do not pay your mortgage by being able to take your home.

“Private credit has similar types of protections for their investors,” she adds.

Additionally, strong private credit managers perform extensive due diligence on potential borrowers, building relationships and negotiating protective covenants with the companies they finance to understand them, assess their creditworthiness and ultimately do their best to protect fund investors.

“Deep access to company records enables fund managers to have just as strong due diligence as public companies, and all this detailed research results in better returns for investors,” Ramnani explains. “In fact, private credit has historically experienced loss ratios that are less than half of those sustained by publicly traded high-yield fixed income bonds. When I share this with clients, they are astonished and happily surprised.”

Private credit can provide financing for distressed companies, but it also finances healthy businesses that need funding for growth and expansion. With banks being subject to tighter regulations after the 2008 financial crisis, many companies don’t qualify for traditional bank loans. Most companies relying on private credit fall into these categories:

• Mid-sized companies: These are the largest type of private credit borrower, with annual revenue between $10 million and $1 billion. They typically have lower cash flows than large corporations and use the funds to expand.
• Small businesses: These are small companies, sometimes owned by individuals, with revenue of less than $10 million. They may be newer and don’t have an established credit history.
• Distressed businesses: Although facing financial trouble, these companies still have the potential to generate products or services. Creditors may get involved in the restructuring of these companies along with risk mitigation. “Our analysis shows that investing in private credit funds that focus primarily on middle-market companies provides the most compelling returns for the risk that you are taking,” Haertzen says. “Companies with revenue between $10 million to $1 billion have typically been around for a long time and have a strong track record of solid investment returns that have fueled their growth.”

Because private credit is less liquid and has more credit risk, there is often a premium earned, which in turn equates to higher returns when compared to public debt investments.

Private credit funds typically target net returns in the mid-to-high single digits, which can be higher than the returns offered by public fixed income securities. Of course, higher returns come with higher risk, and private credit investments are not without risks.

We view private credit as a valuable asset class that can provide investors with higher returns and diversification benefits. As with any investment, risks accompany returns.

As such, it is important for investors to understand what private credit is and the role it plays in investment portfolios. Informed investors, along with their advisor, can then make sound investment decisions.

— By Stacy Francis, a certified financial planner and the president and CEO of Francis Financial. She is a member of the CNBC Financial Advisor Council.