An investor's guide to private credit

After months of alarming headlines, you may have a sense that something big is going on with private credit—but don’t know what it all means for you.

That’s understandable: Private credit is notoriously opaque, and one of the most complex areas of finance. Just as retail investors are closer than ever to getting access to private credit within their own portfolios, the asset class is facing even more scrutiny. Just the other day, we wrote about how funds overseen by major players like Blue Owl and Ares Capital Management are seeing their highest levels of default since 2021.

We spoke with two private credit experts at PitchBook, Senior Director of US Credit Research Kenny Tang and Senior Private Credit Analyst Sebastian Kian, to pick their brains about what they think of private credit now, and how to navigate the complex landscape.

The following conversation has been edited for length and clarity.

What are the current risks to the private credit market, and why are we seeing investors rush to withdraw capital from these funds?

Kian: Essentially, software risk is definitely showing up more and more within the underlying portfolios.

The underlying BDCs (business development companies) are hugely exposed to software, and our analysis showed that among the largest publicly traded BDCs, almost a quarter of their portfolio is software. If you separate software debt, that’s higher. The private credit firms have also started to cut their valuations for their software positions.

Retail investors definitely need to know a BDC like Sixth Street. They have high exposure to software, but others might be closer to average or below average.

Another risk is the amount of distressed debt these companies are taking on. We define “distressed” as the debt portion that is valued below $0.80 on $1. That portion suddenly jumped in the first quarter.

The third factor is the level of nonperforming loans. So these are borrowers that have either defaulted on their interest rate or are expected to default on their interest rate. That amount is also on the rise: We saw that around 4.5% of all the borrowers within the largest BDCs are now nonperforming borrowers.

Editor’s note: Business development companies are publicly traded investment companies that lend to small and midsize businesses, giving investors a door to get exposure to private credit.

Do you see these issues as specific to a few companies, or applicable to the private credit market as a whole?

Tang: Generally across the market, what we’re seeing is investors are looking at all the particular credit risk concerns hitting the private credit space, and really reallocating their positions across the board.

In terms of the redemptions, I think this will probably continue for the next quarter or two at least. What we’re seeing is that the redemption requests are much higher than what’s actually being withdrawn because there’s a 5% limitation across these fund structures. So it isn’t exactly easy to get out of positions. But Q1 levels have been really high in terms of actual redemptions.

But then you also have to think about inflows, which is the amount of proceeds received from investments coming in. From a net perspective, it’s still positive, but the gap is closing up quite a bit last quarter—almost even, but I think inflow is a little bit higher in general.

Where do you stand on the issue of private credit being added to 401(k)s?

Tang: One of the things about private credit is that investors should have some level of knowledge about this market and understand it in order to invest in it. You need to know the length of the investment hold period, and how, if you’re a short term investor, it’s probably not your cup of tea.

There has to be an understanding of what risks investors would face going in, especially when you’re putting it into a 401(k) vehicle, or even on a regular basis, right? So it is important to understand the risks that come with this, and obviously the benefits too.

But it’s definitely not an investment that you can go in and out of. As we’ve seen, it becomes difficult.

What do you think is important for retail investors interested in private credit to understand?

Kian: For retail investors, something that folks might miss is that in a private credit business model, they earn income by lending money, but they are also borrowers themselves.

So a BDC borrows money from, let’s say, a bank; Wells Fargo. You really need to pay attention to the rate that the BDCs borrow from the bank and the rate they lend to. So if that differential gets compressed, that will put pressure on a metric called net interest income. Basically, the difference between the borrowing cost to the BDC and the rate that they earn money by lending.

If their borrowing cost increases for any reason, such as increasing interest rates, such as the BDCs being perceived as riskier, it means higher costs of borrowing. But if they can’t find higher-yielding loans, then that net interest income will shrink, and that will hit the equity prices of these BDCs.

So if you’re a BDC investor, you might earn a 10% dividend, and you realize: Oh, that’s amazing—but then the price depreciation is probably going to be more than 10%, so net-net you might lose money.

Some BDCs have much lower costs of borrowing. Some BDCs have higher costs of borrowing. So a retail investor really needs to dig down and separate a good BDC from a bad BDC.—LB