While we’ve previously written about the risks associated with the private credit space, it’s important for investors interested in the space to also be aware of how these opportunities aim to generate income for your portfolio.
The most common way private credit opportunities generate income is through regular coupon payments that the borrower contractually pays to the lender under the loan terms. Similar to a mortgage payment, it consists of an interest component and may also include a portion that pays out principal based on the loan agreement. This income payment can be in the form of cash, or may be structured as a “payment in kind”, meaning a portion or the full periodic payment is not paid in cash. Rather, the amount paid in kind is added to the overall loan balance. The balance increases and the periodic interest payment may increase slightly. Payment in kind often provides necessary flexibility to borrowers experiencing a temporary cash flow shortfall, and for the lender, the increased loan balance and, conceivably, growing interest payments provide compensation for the cash interest payment that is foregone.
Additionally, interest on an underlying loan may be structured as fixed over the life of the loan, or floating. .
The floating rate is set in reference to a certain benchmark or reference rate and, as that reference rate changes, so too will the rate of the loan. Floating rate loans were commonly set against LIBOR, or the London Interbank Offered Rate, a reference rate established by major global financial institutions. This reference rate has recently been replaced by the Secured Overnight Financing Rate, which you can learn more about here.
Beyond charging regular interest payments, private credit opportunities often charge a variety of fees on their structure to help generate regular payments. A common example is an origination fee, which is based on the negotiated agreement between the borrower and lender. In the case of an origination fee, the lender may receive a fee that is either paid directly or that enhances the yield generated by the loan.
Because private credit loans tend to come at a higher cost to borrowers than traditional lending, borrowers will normally aim to refinance out loans as quickly as possible. To protect lenders, loan documents will often include redemption premiums or minimum return provisions so the lender can achieve a reasonable return for their effort of underwriting and providing a loan. This may take the form of a repayment premium, a minimum rate of return, or a minimum profit on the loan.
Additionally, loans can be structured with equity kickers in which the lender will receive some rights for the ownership interests in the underlying asset being financed. While often nominal, these kickers can provide some additional return if the company or underlying asset performs well.
Finally, it’s important for investors to remember that private credit does not only include loans that are newly originated, but can include strategies around existing loans. For example, a lender may sell an underperforming loan if they aren’t best positioned to work out or restructure the loan to solve for the underperformance. Often in these cases, the loan is then sold to a buyer at a discount to the principal value of the loan. However, if the new buyer is able to secure a repayment in excess of the price paid for the loan, that buyer has realized a gain because the loan was purchased at a discount. While this is a more unique type of income that can be generated from private credit opportunities, realization of discounts is primarily achieved by acquirers of single loans or portfolios of loans, often with a focus on special situations or distressed investing.
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Private credit opportunities have a variety of methods for generating returns for investors. Between regular interest payments, payments in kind that add to the balance and a myriad of other ways to incorporate fees, there are a number of ways that deals can be structured.
While the above list is by no means exhaustive, it should help any investor understand some of the methods private credit can generate income for investors — especially during periods of market volatility. Private credit opportunities often benefit from low market correlation, and thus won’t experience the same adverse effects during downturns, but they can come with their own risks that investors should make themselves aware of.
Yieldstreet enables access to Private Credit investment opportunities which have traditionally been inaccessible to everyday investors. There are two ways to access the asset class on Yieldstreet – through single offerings, a curated list of individual private debt investment offerings with varying return profiles, or through private credit funds sponsored by leading private credit fund managers, which Yieldstreet carefully selects.
In addition to the offerings available at this point, Yieldstreet is looking into the space to identify further opportunities across diversifying strategies, including sports, media and entertainment, global dislocation and venture/growth.
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