MODULE 2: PUBLIC-PRIVATE CREDIT 2.1 Private credit fundamentals

This video provides an introduction to private credit. You’ll learn what private credit is, why private credit is a growing opportunity and how access to this market is expanding.

Bryan Favilla

Director of fixed income markets at Capital Group

3MINVIDEO

Bryan Favilla, Director of fixed income markets at Capital Group

 

[upbeat music]

 

In its simplest form, private credit refers to loans made directly from non-bank lenders to private borrowers. This diagram helps illustrate how that process works: Investors pool their money into an investment fund. The fund identifies opportunities, negotiates terms and loans money to private borrowers. Borrowers repay the loans with interest over time. The fund then returns principal and interest to investors, minus management fees.

 

This model offers investors the potential to seek higher returns and aims to provide borrowers with more tailored and flexible financing options. You can see why private credit can be attractive for lenders, investors and borrowers alike. But, what exactly has been the fueling behind private credit’s growth over the last several years?

 

[upbeat music]

 

There was a sharp decline in the number of banks due to failures and mergers in the wake of the crisis, as well as a fall in new bank charters. The banks that survived this crisis then had to contend with new regulations that increased reserve requirements and disincentivized riskier loans. Banks responded by increasing their working capital and taking on less risk.

 

The decline in the overall number of banks, combined with a reluctance or inability to lend to riskier borrowers, created a gap in lending to small and medium-sized borrowers. As this bank lending receded, private lenders stepped in to fill the void. They started offering flexible and customized financing that banks could no longer provide. As a result, the private market grew substantially in years after the Global Financial Crisis.

 

Private credit’s ability to bridge the lending gap transformed it from a niche area of investment into a critical part of the financial landscape. And over time, private credit has evolved to include a greater proportion of more senior direct lending and asset-based finance — giving investors opportunities to seek higher and consistent income while meeting the needs of underserved borrowers.

 

[upbeat music]

 

As the private credit market has grown, more investors have been wondering how and why they might want to invest in private credit assets. Such assets are typically held to maturity by the originator, not publicly traded, so access is difficult, and liquidity is typically less than that of traditional assets. Private credit also involves a separate set of regulations and tax implications, as well as deep vetting of lenders and borrowers. It’s no wonder that so many find private credit intimidating.

 

Luckily, there are vehicles entering the market that make private credit and other private assets more accessible to a greater population of investors. One such vehicle, an interval fund, can mix both public and private assets and seeks to improve the opportunities for investing in private credit. Thank you for watching!

 

[upbeat music]

 

Deepen your understanding

Select each resource below to learn more.

Item 1: Growth of private credit

 

The private credit market has grown substantially in the years since the Global Financial Crisis. Banks traditionally provided most credit to small and medium-sized borrowers, but the Crisis led to widespread bank failures and mergers and a decline in new bank charters. The remaining banks had to comply with new regulations and, as a result, took on less risk and offered fewer loans to middle-market companies.

 

The private lending market grew to fill this gap. Between 2006 and 2023, global private credit assets under management increased each year, from $176 billion in 2006 to $1,667 billion in 2023.

 

Mouse over each bar in the chart below to view the total global private credit AUM for that year.

 

 

Item 2: Private credit’s yields

 

Over the period of its expansion, the private credit market has offered greater yields than high-yield public debt and the leveraged loan market. This higher yield compared to public debt compensates investors for both the greater risk from credit spread and the private assets’ illiquidity.

 

Mouse over the graph below to view yield data over time.

 

 

Item 3: Private credit for diversification

 

One of the benefits of investing in private credit is that it may help diversify your portfolio. In recent years, private credit has demonstrated a lower correlation to the S&P 500 Index (U.S. equities) and Bloomberg Aggregate Index (U.S. public fixed income) than high-yield public debt and leveraged loans, which are comparable forms of credit.

 

This means that investment in private credit may potentially dampen the volatility of a portfolio.

 

Checkpoint

Now that you have completed this lesson, you should be able to confidently:

 

  • Distinguish between public and private credit instruments.
  • Summarize for your clients the potential benefits of integrating public-private credit solutions into portfolios. 

Takeaways

Introduction to private credit

Download

End of lesson

The next lesson will cover the types of private credit.

NEXT LESSON

For financial professionals only. Not for use with the public.

Investments are not FDIC-insured, nor are they deposits of or guaranteed by a bank or any other entity, so they may lose value.
Investors should carefully consider investment objectives, risks, charges and expenses. This and other important information is contained in the interval fund prospectuses, which can be obtained from a financial professional and should be read carefully before investing.
For Public-Private+ Funds: Capital Group KKR Core Plus+ and Capital Group KKR Multi-Sector+ are interval funds that currently provides liquidity to shareholders through quarterly repurchase offers of up to 10% of its outstanding shares. Capital Group KKR U.S. Equity+ is an interval fund that currently provides liquidity to shareholders through quarterly repurchase offers of 5% of its outstanding shares. To the extent a higher percent of outstanding shares are tendered for repurchase, the redemption proceeds are generally distributed proportionately to redeeming investors (“proration”). Due to this repurchase limit, shareholders may be unable to liquidate all or a portion of their investment during a particular repurchase offer window. In addition, anticipating proration, some shareholders may request more shares to be repurchased than they actually wish, increasing the likelihood of proration. Shares are not listed on any stock exchange, and we do not expect a secondary market in the shares to develop. Due to these restrictions, investors should consider their investment in the fund to be subject to illiquidity risk.

- Investment strategies are not guaranteed to meet their objectives and are subject to loss. Investing in the fund is not suitable for all investors. Investors should consult their investment professional before making an investment decision and evaluate their ability to invest for the long term. Because of the nature of the fund's investments, the results of the fund's operations may be volatile. Accordingly, investors should understand that past performance is not indicative of future results.

- Investing outside the United States involves risks, such as currency fluctuations, periods of illiquidity and price volatility. These risks may be heightened in connection with investments in developing countries.

- Illiquid assets are more difficult to sell and may become impossible to sell in volatile market conditions. Reduced liquidity may have an adverse impact on the market price of such holdings, and the fund may be unable to sell such holdings when necessary to meet its liquidity needs or to try to limit losses, or may be forced to sell at a loss. Illiquid assets are also generally difficult to value because they rarely have readily available market quotations. Such securities require fair value pricing, which is based on subjective judgments and may differ materially from the value that would be realized if the security were to be sold. Situations involving uncertainties as to valuation of assets held by the fund could have an adverse effect on the returns of the fund.

- The fund is a non-diversified fund that has the ability to invest a larger percentage of assets in the securities of a smaller number of issuers than a diversified fund. As a result, poor results by a single issuer could adversely affect fund results more than if the fund were invested in a larger number of issuers.

 

For Public-Private Credit+ Funds:

- Bond investments may be worth more or less than the original cost when redeemed. High‐yield, lower‐rated, securities involve greater risk than higher‐rated securities; portfolios that invest in them may be subject to greater levels of credit and liquidity risk than portfolios that do not.

- The funds may invest in structured products, which generally entail risks associated with derivative instruments and bear risks of the underlying investments, index or reference obligation. These securities include asset-based finance securities, mortgage-related assets and other asset-backed instruments, which may be sensitive to changes in interest rates, subject to early repayment risk, and their value may fluctuate in response to the market's perception of issuer creditworthiness; while generally supported by some form of government or private guarantee, there is no assurance that private guarantors will meet their obligations.

- While not directly correlated to changes in interest rates, the values of inflation-linked bonds generally fluctuate in response to changes in real interest rates and may experience greater losses than other debt securities with similar durations. The use of derivatives involves a variety of risks, which may be different from, or greater than, the risks associated with investing in traditional securities, such as stocks and bonds.

- The fund invests in private, illiquid credit securities, consisting primarily of loans and asset-backed finance securities. The fund may invest in or originate senior loans, which hold the most senior position in a business's capital structure. Some senior loans lack an active trading market and are subject to resale restrictions, leading to potential illiquidity. The fund may need to sell other investments or borrow to meet obligations. The funds may also invest in mezzanine debt, which is generally unsecured and subordinated, carrying higher credit and liquidity risk than investment-grade corporate obligations. Default rates for mezzanine debt have historically been higher than for investment-grade securities. Bank loans are often less liquid than other types of debt instruments and general market and financial conditions may affect the prepayment of bank loans, as such the prepayments cannot be predicted with accuracy.

 

For Public-Private Equity+ Funds:

- The fund also intends to concentrate in the financial services group of industries, and to invest at least 80% of its assets in securities issued by companies based in the United States.

- K-PEC and co-investment risks: The fund's investments in KKR Private Equity Conglomerate LLC (“K-PEC”) and co-investments alongside K-PEC or one or more other KKR vehicles that pursue private equity strategies entail additional risks. Private equity investments are typically illiquid, speculative, and difficult to value, often requiring multi-year holding periods with returns generally realized only upon sale or refinancing of a portfolio company. These investments depend on access to financing, and market disruptions or increased competition may limit opportunities and affect performance. The fund's significant investment in K-PEC creates concentration risk and a decline in K-PEC's value could materially impact the fund's returns. Co‑investment opportunities are competitive and limited and there is no assurance the fund will receive allocations or comparable terms and will generally have less information than for public companies. Through its investments in K-PEC or other KKR Vehicles and co-investments, the fund may have exposure to portfolio companies with limited operating histories, evolving markets, unproven technologies, and inexperienced management, which may require significant capital and create heightened vulnerability to downturns. Most holdings are illiquid, subject to resale restrictions and may require consents or be sold at a discount. Costs associated with investments in private equity are generally greater than those of investments in other asset classes. In addition to bearing their portion of the fund's fees and expenses, shareholders in the fund will indirectly bear a portion of the asset-based fees, incentive fees and other expenses incurred by the fund as an investor in K-PEC or other KKR Vehicles and in co-investments. Incentive fees are paid to KKR when the fund's investments in K-PEC or other KKR Vehicles and/or co-investments deliver returns in excess of a specified hurdle; when paid, these fees reduce the net realized returns of such investments.

This material does not constitute legal or tax advice. Investors should consult with their legal or tax advisors.
Statements attributed to an individual represent the opinions of that individual as of the date published and do not necessarily reflect the opinions of Capital Group or its affiliates. This information is intended to highlight issues and should not be considered advice, an endorsement or a recommendation.
Capital Group and Kohlberg Kravis Roberts & Co. L.P. (“KKR”) are not affiliated. The two firms maintain an exclusive partnership to deliver public-private investment solutions to investors. KKR serves as the sub-adviser of Capital Group KKR Core Plus+ and Capital Group KKR Multi-Sector+ with respect to the management of each fund's private credit assets. KKR is not a sponsor, promoter, investment adviser, sub-adviser, underwriter or affiliate of Capital Group KKR U.S. Equity+.
All Capital Group trademarks mentioned are owned by The Capital Group Companies, Inc., an affiliated company or fund. All other company and product names mentioned are the property of their respective companies.
Use of this website is intended for U.S. residents only. Use of this website and materials is also subject to approval by your home office.
Capital Client Group, Inc.
This content, developed by Capital Group, home of American Funds, should not be used as a primary basis for investment decisions and is not intended to serve as impartial investment or fiduciary advice.