MODULE 2: PUBLIC-PRIVATE CREDIT 2.2 Types of private credit

This video dives into the types of private credit and focuses on direct lending and asset-based finance as two categories which may be most appropriate for entry into private market investments.

Tal Reback

Global credit & markets investment strategist at KKR

4MINVIDEO

[upbeat music]

 

Tal Reback, Global credit & markets investment strategist at KKR

 

Interest in private credit is growing, and that’s no surprise. Private credit has the potential to provide higher yields and a useful source of diversification when compared to traditional fixed income assets.  

 

[upbeat music]

 

There are several asset classes within private credit, broadly classified into five major categories: secured direct lending, asset-based finance, junior and mezzanine debt, venture debt and distressed debt.

 

Two largest segments of the private credit market in terms of AUM are secured direct lending and asset-based finance. These investments, while certainly not without risk, tend to be lower on the risk spectrum than other categories of private credit.

 

These are the kinds of investments likely to appeal to some investors due to their potential, stable income and modest overall risk compared to mezzanine, venture and distressed debt. Direct lending and asset-based finance are areas of focus as Capital Group and KKR partner to bring private market investments to investment funds. Now, let’s take a look at these types of investments.

 

[upbeat music]

 

Secured direct lending, also known just as “direct lending”, consists of senior secured loans made directly to companies. Direct lending can serve business needs like buyouts, refinancing, recapitalization or growth initiatives.

 

Their senior secured status means that if there were a problem at the borrower company, this would typically be the first debt repaid and is backed by collateral in the event of a default. That’s not to say that the senior loans are without risk, but they are generally less risky than loans further down a company’s capital structure.

 

So, what makes direct lending an appealing investment? Private direct lending typically has had a higher interest payment advantage relative to certain comparable credit investments, due to cash flows generated from repayments dictated by contractual loan terms.

 

Part of this return advantage has been due to the illiquidity premium or additional yield often received for this type of loan as a part of the compensation for the illiquidity risk.

 

We’ll talk about this aspect of private credit a lot throughout these materials because it’s a key concept with your clients. Basically, these loans are less liquid than public credit so, they command higher yields. That suggests potentially greater returns, as well as risks, for investors that can hold them to maturity, which may be over a medium or long term.

 

Direct loans are typically held to maturity or refinanced rather than traded. Their value lies in the investment manager’s skill at originating, underwriting and managing the loans. Selecting private credit investments from established, experienced and well-resourced managers may help investors feel more confident in the potential these types of investments could provide in an investment portfolio. In addition, direct loans can offer floating rates that help adapt to changes in interest rates, which offers a hedge against interest rate risks. 

 

[upbeat music]

 

Now, let’s turn to asset-based finance, or ABF. ABF can encompass a diverse array of assets: leased aircraft and rail cars, mortgages and auto loans, rental equipment and even royalties from intellectual property. ABF has tended to have less exposure to the corporate credit cycle, since it derives its value from diversified collateral. 

 

As next steps, you might want to start thinking about which of your clients might be a good fit for these investments. Think about who might be interested in taking on some illiquidity and risk, in exchange for the potential long-term returns. Until next time.

 

[upbeat music]

 

Deepen your understanding

Select each resource below to learn more.

Direct lending and private asset-based finance (ABF)

 

A chart highlights the key differences between direct lending and private asset-based finance. Direct lending is typically dependent on the performance and enterprise value of a single corporate borrower. The corporation itself takes on the loan and is responsible for repayment. Interest and principal goes to investors. Investment considerations include cash flows and the overall health of the business. Private asset-based finance, or ABF, is typically backed by a pool of hundreds or thousands of underlying loans, leases or other financial assets or hard assets. In the event of default, the lender is typically entitled to the collateral. Interest and principal go to ABF investors. An investment consideration is the quality of underlying collateral.

 

What is senior direct lending?

 

Senior direct lending is a specialized form of private credit in which lenders provide senior loans directly to upper-middle and middle-market companies under mutually agreed terms, and are based on the business's cash flows, value and overall health. These loans can be made for various business needs, including buyouts, refinancing, recapitalization or to fund growth initiatives.

 

Senior direct loans sit on top of a borrower’s capital structure and are the first to be prioritized in the event of default, thus seeking to lower the potential for loss. Unsecured loan holders are repaid next. (You can learn more about a company’s capital structure in this lesson’s next reading.)

 

Direct lending’s potential benefits (to the different parties)

 

Direct lending is a private credit lending transaction that typically involves three parties: investors, a private credit investment fund and borrowers. Senior direct loans are mostly held-to-maturity, so value is created by a manager's ability to originate, underwrite and structure loan deals. The debt instruments purchased by the fund are subject to the risk that a borrower will default on the payment of principal, interest or other amounts owed. The benefits of direct lending to borrowers and investors include:

 

For borrowers:

 

  • Beyond the economics of the loan, borrowers may benefit from the support provided from the investment manager across the lifecycle of the loan. 
  • Direct loans typically benefit borrowers by providing liquidity, customization and additional loan opportunities — allowing borrowers the potential to access funds to support growth opportunities.

 

For investors:

 

  • Direct loans seek consistent returns relative to public debt.
  • Within a total portfolio, direct loans may provide diversification benefits like many categories of alternative investments.

 

What is asset-based finance?

 

Asset-based finance is a broad form of non-corporate lending backed by a variety of collateral, including tangible and financial assets. This collateral often generates cash flows and can act as a form of protection for the lender in the event a borrower does not meet its payment obligations. 

 

Four major categories of collateral within asset-based finance, include:

1. Consumer & mortgage finance:

Secured lending segments — like mortgages and auto lending — plus consumer lending.

2. Hard assets:

Aircraft leasing, green energy, rail cars and home rentals.

3. Commercial finance:

Lending to small- and medium-sized businesses, plus equipment leases and receivables financing.

4. Contractual cash flows:

Intellectual property, royalties and financial contracts.

A chart illustrates the diverse array of assets ABF can encompass, including: leased aircraft; rail cars; mortgages; auto loans; rental equipment and royalties.

 

The potential benefits of ABF

 

Backed by large pools of collateral, ABF may benefit investors with predictable cash flows and low correlations to a range of public and private assets. There are risks associated with ABF — including fluctuating collateral values that can shift with market conditions. ABF investments differentiate from traditional public market investments in that they are privately originated and negotiated and may benefit from the potential to be structured in many ways. 

How direct lending works

 

Private credit can offer potentially higher income than traditional fixed income investments, compensating for the increased credit and illiquidity risk. The largest part of the private credit universe is senior direct lending, and it is generally considered to be less risky than other types of private credit investments. 

 

Senior direct lending is a specialized form of private credit in which lenders provide loans directly to middle-market companies under mutually agreed terms and are typically backed by the financial health and cash flows of the borrowing company. These loans can serve business needs like buyouts, refinancing, recapitalization or growth initiatives.

 

Understanding the “capital structure”

 

What makes a loan “senior?” Senior loans sit atop a company’s capital structure — the hierarchy of claims on a company’s assets that is defined by the sources of a company’s financing, i.e., debt and equity. Not every borrower’s capital structure includes all the layers in the illustration, but senior debt sits at the top by definition.

A chart details different types of debt, their levels of risk and priority of payment. It includes: senior debt, unitranche debt, subordinated/junior debt, mezzanine debt and equity. Senior debt has the lowest risk and is repaid first, while equity has the highest risk and is repaid last.

The higher a source of financing sits in the capital structure, the higher its priority on claims in the event of default or liquidation — and the less risky it is generally to invest in.

 

For example, in the illustration, equity sits at the bottom of the capital structure. It’s the most financially risky of these layers but also has the highest return potential because it represents an ownership stake in the company. If the company were to liquidate its assets in bankruptcy, the equity shareholders would be the most likely to suffer the greatest loss.

 

Above equity sit various levels of credit. Subordinated debt ranks above equity but below senior debt. If a company goes bankrupt, subordinated debt holders are paid by remaining funds after senior debt holders and before equity holders. 

 

With senior credit at the top of the capital structure, this means that in the event of liquidation, the senior creditors would be the highest repayment priority, making holding senior credit the least risky layer of the capital structure. Senior debt is also typically secured by collateral, which means if the borrower cannot meet its obligations, the lender has the legal right to recover the outstanding debt by liquidating the collateral. 

 

“Least risky,” of course, does not indicate that there is no risk at all. Even senior creditors may suffer losses in a serious bankruptcy. However, if you’re investing in the private credit market, senior direct lending is normally among the less risky segment.

This video dives further into the appeal of private credit and addresses some common concerns that you or your clients might have.

Tal Reback

Global credit & markets investment strategist at KKR

4MINVIDEO

[upbeat music]

 

Tal Reback, Global credit & markets investment strategist at KKR

 

Now that you better understand what types of private credit are most broadly available, let’s focus on why these products have become appealing. 

 

Private borrowing has grown substantially, with aggregate capital in the sector growing fourfold since the financial crisis. In the event that that growth continues, we believe the asset class will continue to evolve, offering a broader and more diversified range of investment opportunities.

 

Since the global financial crisis, private credit has consistently had higher yields than most other types of fixed income assets, in large part due to the illiquidity premium. That’s the core appeal of private credit, potentially higher returns for investors who have the ability to take a long-term approach and are comfortable with the increased risks, compared to public debt investments. 

 

With the resurgence of inflation over recent years, we’ve seen an increased correlation between stocks and bonds. This has resulted in investors seeking new ways to diversify.

 

Private credit may help, since it typically has lower correlations to other asset classes vs publicly traded high-yield bonds and other forms of public credit. In short, if private credit meets the needs of your client’s portfolio, it’s a great option to consider. 

 

[upbeat music]

 

Many advisors have questions and concerns about private credit — and your clients probably will, too — such as product complexity, liquidity, fees and taxes.

 

Further, private investments may be riskier than more traditional investments. Private credit investments are not priced daily, as quarterly valuations are typical for the asset class. This may mute investors’ awareness that default is always a risk. Given private credit loans do not require a credit rating, most might be below investment grade if they underwent an official review by S&P or Moody’s.

 

Close vetting of the borrower and direct deal origination with them, along with the ability to work with the borrower directly in partnership to address any potential cash flow or repayment issues over the cycle, could help manage difficulties and reduce the likelihood of default. This underscores the importance of carefully choosing both the funds you select and the partners that you work with. 

 

We believe a way to address the concerns investors might have is by combining both public and private assets in a structure called an interval fund. We call these investments “public-private funds”. These can help demystify the world of private credit by including private credit investments as a part of broader fixed income strategy that may be more familiar to clients.

 

These funds benefit from the originators’ due diligence into the ultimate borrowers and take advantage of an interval fund that brings semi-liquidity, as well as a straightforward fee structure and simplified tax reporting, meaning investors receive a 1099, compared to investing directly into private credit.

 

The goal of these funds is to provide greater access to private markets. Aligned with a long-term strategy that can tolerate exposure to illiquidity risks, we believe public-private funds are a bright new opportunity for investors.

 

We hope this video has given you a clearer understanding of private credit and why we believe it’s an exciting investment opportunity. We also hope we’ve piqued your curiosity about using public-private funds to access private credit for your clients.

 

[upbeat music]

Checkpoint

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

 

  • Identify key types of private credit, including direct lending and asset-based finance. 
  • Be able to articulate to others why direct lending is generally considered less risky than other types of private credit investments.
  • Understand the potential appeal of private credit in modern portfolio construction.

Takeaways

Types of private credit

Download

End of lesson

The next lesson will cover how to allocate public-private credit as part of a portfolio.

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.