While private credit offers attractive returns, it comes with distinct risks that investors must understand and manage carefully.
Credit Risk
The primary risk is that borrowers may default on their obligations. Private credit investors mitigate this through:
Thorough Due Diligence: Extensive analysis of borrower financials, industry dynamics, and management quality
Covenant Protection: Financial and operational requirements that provide early warning signals
Seniority and Security: Structural protections including collateral and priority in capital structure
Illiquidity Risk
Unlike publicly traded bonds, private credit investments cannot be easily sold:
- Lock-up Periods: Capital is typically committed for 5-7 years
- Limited Secondary Market: Few venues exist for selling positions
- Valuation Challenges: Mark-to-market pricing is less transparent
Investors are compensated for this illiquidity through higher yields—typically 2-4% above comparable public debt.
Interest Rate Risk
Most private credit loans use floating rates, which means:
Rising Rates: Benefit lenders as interest income increases
Falling Rates: Reduce interest income but may improve borrower health
Floor Rates: Many loans include minimum interest rate thresholds
Concentration Risk
Private credit portfolios may be exposed to specific risks:
- Sector Concentration: Overweighting certain industries
- Sponsor Concentration: Too much exposure to single private equity firms
- Vintage Risk: Loans originated during market peaks
Operational Risk
Working with private companies requires:
- Ongoing Monitoring: Regular financial reporting and covenant compliance
- Relationship Management: Direct interaction with borrowers
- Workout Capabilities: Ability to restructure troubled credits
Risk Management Best Practices
Leading private credit managers employ:
1. Diversification: 50-150 positions across sectors, geographies, and deal types
2. Stress Testing: Modeling portfolio performance in various economic scenarios
3. Active Portfolio Management: Continuous monitoring and risk rating updates
4. Reserved Capital: Dry powder to support struggling borrowers or capitalize on opportunities
Understanding these risks is essential for investors considering private credit allocations.