The Basics of Private Credit

The basics of Private Credit

The concept of private credit on its face seems simple, but in reality, private credit is quite complicated. Non-bank financial institutions (NBFIs) provide loans to companies negotiated directly, each with their own underwriting standards. When you offer a loan to a friend for starting his business, in a way, you are providing a private credit loan.

The advantages of private credit are that private companies and subprime borrowers have cheaper access to capital, and private investors can get higher yields than investing in bonds or banking. Since bank lending has gone out of vogue, NBFIs have picked up the slack. They risk investor capital to lend at higher rates of interest to private companies, usually backed by PE or VC funds.

There are some disadvantages, especially from the lender side . Firstly, if these Private Credit firms don’t communicate with each other as well as other lenders, including banks, they can risk a situation where their borrowers pledge the same collateral to multiple lenders. Due diligence becomes critical. You may need to have the same skills as a forensic accountant or a Hindenburg Research specialist. Lending isn’t a one man game, unless you have a skillset dedicated to researching your investments. If one fails at underwriting debt, one will suffer credit losses and may not even receive collateral, and even if one receives collateral, it might not be as valuable as one expects.

Private credit can be as simple as a person starting micro lending, or as complex as lending to a private equity backed software firm. The same underwriting principles apply to lending to a single individual as it does to a multinational, although the complexity differs. Private credit involves risking equity capital from private investors, and thus has fewer requirements than public bond offerings, or banks post 2008. However, that doubles the risks. Underwriting becomes essential.

How does underwriting for private credit work? This is the critical part of investing in debt, and private corporations and individuals have more opaque financial situations than public companies, who have audited disclosures of financials that can easily be seen using the relevant SEC website (or other securities regulator’s website). 

You need to verify your likelihood of profit indicated by the following questions:

Can they pay me back?

What history does the person or institution have about paying their loans? Do they pay late? On time? Early? How do they pay their bills, and do they pay it on time? Did any bills get sent to collections? All of these things must be looked at. A shorthand for a borrower’s history of repaying is often looking at their credit rating or credit score, as well as due diligence into hidden loans. 

What cashflow do they have?

What free cash flow does the person or business have? For business, look at financial statements, for individuals, look at bank statements and income after mandatory spending (depending on the loan). This is indicated by looking at their net cash flows, and see if they can cover debt service payments plus some cushion. Ideally, free cash flow shows a trend of growing.

What is their collateral?

You need to know what recourse you have due to non-payment. What collateral can you take? You need to figure out the essence of the customer’s assets, make sure they aren’t hiding assets from you so that when they default through trust and offshore methods, and make sure you get your money back. Lenders have to be sharp and merciless in order to defend their principal.

The importance of due diligence

Due diligence is critical. Fraudsters use lack of due diligence to scam  This will prevent the case where in bad times, you realize their income isn’t as real as previously thought, or even worse the collateral isn’t valued as much as you thought, or worse yet, the collateral was pledged to multiple lenders. In addition to that, you need to see where you stand in the capital stack. Who gets paid first in the case of bankruptcy? Without knowing this, you stand in a world of pain and losses.

Lending is a lucrative business, however it is important to know that it is cyclical. When the economy is good and credit expands, you make more profit. However, when the economy is doing poorly, that is when the struggle comes, and you see the effects of your due diligence. “Only when the tide goes out do you find out who’s swimming naked”. Those that keep excess reserves, lend conservatively, will be able to lend or invest and achieve high returns even in bad markets, compared to lenders who lower credit standards.

With capital, competence, and the right tools, you too can compete in the big leagues.

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