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Accessing Private Credit: Specialty Finance & Trade Finance

What Is Private Credit?


Private credit refers to a growing sector within the financial market that provides capital to companies outside of traditional banking channels. Unlike public credit, which is typically offered by banks and other large financial institutions, private credit is provided by non-bank lenders, such as specialized credit funds.



Private Credit And Trade Finance Versus Other Asset Classes


Private credit and trade finance offer unique characteristics compared to other asset classes across returns and volatility or risk. Private credit investments have the potential to provide higher yields than publicly traded bonds or fixed-income instruments. This is due to the higher interest rates offered by private borrowers to compensate for the lack of liquidity in the private market. Trade finance involves financing the working capital constraints that occur in a company's supply chain and the time to convert a sale to a client into cash. In terms of volatility or risk, private credit investments have the potential to offer lower volatility compared to public markets. This is because they are less susceptible to market fluctuations and investor sentiment.


On the other hand, trade finance can be subject to the financial and operational risks of companies as well as geopolitical risks and fluctuations in global trade conditions. However, trade finance investments are often secured by underlying assets that form part of the security package provided by a company, which can help mitigate risk. Overall, private credit and trade finance provide investors with the opportunity to diversify their portfolios and potentially achieve attractive returns.

Returns and Risk by Asset Classes, fixed income, private credit, venture capital

Note: Figures are intended to be directional.


Why Do Investors Want To Access Private Credit Fixed Income Investments?


Investors are increasingly drawn to private credit for several reasons, such as higher yields, lower volatility, downside protection, and diversification. This offers attractive fixed-income investment opportunities.


Higher Yields

Private credit investments typically offer higher yields than publicly traded bonds or fixed-income instruments. This is because private borrowers often pay higher interest rates to compensate for the lack of liquidity in the private market and the inability to access capital from public markets and traditional lenders.


Lower Volatility

Private credit investments may offer lower volatility than public markets since they are less susceptible to market fluctuations and investor sentiment. However, it is important to note that private credit investments are not without risk, and investors should be aware of the potential for interest rate risk.


Diversification

Investing in private credit can provide diversification benefits since it offers exposure to different borrowers and companies compared to public markets. This can help to reduce overall portfolio credit risk.


Tailored Investment Structures

Private credit investments can be structured to meet the borrower's specific needs, which can result in more favorable terms for investors, including receiving collateral to provide downside protection.


Illiquidity Premium

Private credit investments are illiquid, meaning they cannot be easily sold or traded. This illiquidity can result in a premium for investors who are willing to hold their investments for longer periods. However, it is important to note that illiquidity can increase risk if the assets are not self-liquidating in nature.

Access alternative fixed income.

Can Anyone Invest In Private Credit?


Private credit fixed income investments are typically unavailable to the general public and are generally only accessible to institutional investors, high net worth individuals, or family offices. This is because private credit investments are not traded on public markets, are often less liquid, and are more complex. There are many options within private credit with varying returns, lock-up periods, and risk profiles. It is important for investors to carefully examine their options and choose investments that align with their investment objectives and risk tolerance. Investors should also consider how private credit fits within their overall portfolio and how it measures against other asset classes in terms of returns, liquidity, and risk. For example, trade finance, a part of specialty finance within private credit investments, may be appropriate for investors seeking higher yields and diversification. Still, they may not be suitable for investors who prioritize daily liquidity or low risk or those looking for outsized returns willing to invest in opportunities with long lock-up periods (several years+) at higher risk.


Why Is It Hard To Access Trade Finance?


Trade finance can be difficult for investors to access for several reasons.

  1. Opaque market: Trade finance investments typically involve smaller and less well-known companies that may not have the same level of public visibility or access to capital markets as larger companies. This can make it harder for investors to find and evaluate investment opportunities in trade finance.

  2. Complex Evaluation: Investing in trade finance requires specialized knowledge and expertise to evaluate, underwrite, and structure investment opportunities. This is because trade finance transactions can be complex and involve various risks, including credit, political, and currency risks.

  3. Diligence Demands: Trade finance investments often require significant due diligence, which can be time-consuming and costly for investors. This can make it more challenging for investors to access trade finance investments, particularly if they lack the necessary resources or expertise.


What Are The Ways Of Investing In Private Credit?


As investors set their sights on the growing universe of private credit, a pivotal decision is required: whether to opt for direct investment or embrace the structured path of fund investment. Both avenues offer unique advantages and challenges, catering to a diverse range of investor preferences and risk appetites. Below are the pros and cons of each approach. In essence, choosing between direct investment and fund investment in private credit hinges on your risk tolerance, financial acumen, and desired level of involvement.


Direct Investment

Pros:

  • Control and Customization: Opting for direct investment grants unparalleled control over your portfolio. You can meticulously select individual private credit opportunities that align with your specific investment goals, risk tolerance, and strategic preferences.

  • Potential for Higher Returns: Direct investments can yield higher returns if chosen judiciously. Bypassing the fees and management costs associated with funds, you stand to capture a larger portion of the investment gains.

  • In-Depth Engagement: Direct investors often enjoy a closer connection to the underlying assets, fostering a deeper understanding of their investments and the industries they're tied to.

Cons:

  • High Stakes and Concentration Risk: The potential of higher returns comes hand in hand with heightened risks. A concentrated portfolio can amplify losses if a particular investment turns sour, making diversification a formidable challenge for individual investors.

  • Expertise and Due Diligence: Successfully navigating the labyrinth of private credit requires specialized expertise. Research, analysis, and due diligence demand considerable time and knowledge, which might be beyond the scope of individual investors.

  • Liquidity Challenges: Many private credit investments entail longer lock-in periods, restricting your ability to swiftly access your invested capital compared to more liquid assets.

Fund Investment


Investing in private credit through a fund such as a trade finance fund is a more common approach for individual investors who want to gain exposure to the asset class. Private credit funds pool capital from multiple investors to invest in a diversified portfolio of private credit opportunities. These funds are typically managed by experienced professionals with the expertise and resources to source, underwrite, and manage private credit investments. This approach offers a distinct advantage: the ability to mitigate risk by spreading investments across various assets, thereby cushioning potential downsides that might arise from a concentrated portfolio.


Pros:

  • Diversification: One of the standout benefits of fund investment lies in diversification. By pooling resources from multiple investors, funds can spread investments across a range of private credit opportunities, effectively mitigating the impact of potential losses.

  • Professional Management: Funds are managed by seasoned experts with specialized knowledge. Their ability to source, evaluate, and manage private credit investments can provide a layer of reassurance and expertise that individual investors might lack.

  • Access and Convenience: Fund investments provide a gateway for individuals who lack direct access to private credit markets. This accessible route enables a broader range of investors to tap into the asset class.

Cons:

  • Fees and Costs: Fund investments typically involve management fees and other associated costs, which can eat into your potential returns over time.

  • Limited Control: While funds offer diversification, they also relinquish some control over specific investment choices. Decisions are made collectively, potentially leading to investments that don't perfectly align with your personal preferences.

  • Performance Dependency: Fund returns are subject to the performance of the collective portfolio. A single underperforming investment within the fund can impact overall returns.


When Comparing Asset Classes Across Returns And Volatility, What Are The Factors To Consider?


Examine the criteria below for each asset class individually and in the context of the overall portfolio. This approach ensures alignment with investment goals and the potential for enhanced risk-adjusted returns across the collective asset classes.


Assess Past And Potential Performance

Assess the past performance of each asset class to determine its average return over a given period of time. This will provide insight into the potential gains that can be expected from investing in that particular asset class.


Volatility And Risk

Analyzing the volatility and risk associated with each asset class is crucial for developing an investment strategy. Volatility refers to the degree of price fluctuation an asset experiences over time, and it is often measured by standard deviation. Risk is defined as a material loss of capital. By comparing the volatility and risk of different asset classes, investors can assess the level of risk they are willing to allocate to a particular investment within their investment portfolio.


Correlation

Correlation measures the relationship between the returns of two assets. If two assets have a high positive correlation, their returns tend to move in the same direction. On the other hand, if two assets have a negative or low correlation, their returns move in opposite directions or are not closely related. By understanding the correlation between different asset classes, investors can determine how effectively they diversify their portfolios. Diversification helps reduce risk by spreading investments across various asset classes that exhibit low correlation with each other. This means that if one asset class experiences a downturn, the impact on the overall portfolio will be minimized because other asset classes may perform well or remain stable.


Liquidity

Liquidity refers to how easily an asset can be bought or sold without significantly impacting its price. Some asset classes, like stocks and bonds, tend to have high liquidity because they are traded on public exchanges with a large number of buyers and sellers. On the other hand, alternative investments such as private credit may have lower liquidity because they are not as widely traded. Real estate, real assets, private equity, and venture capital tend to have the longest hold duration.


Costs

Costs associated with investing in different asset classes should also be considered. These costs can include transaction fees, management and performance fees, and taxes. It is important for investors to understand the impact of these costs on their overall returns. Some asset classes may have higher costs than others, which can eat into potential profits.


Investment Time Horizon

Different investments may be suitable for different time horizons. For example, long-term investments like real estate or private equity may be more appropriate for investors with a longer time horizon, as they could have higher potential returns but may require locking up capital for many years of up to 14 years (private equity typically have a 10 year with 2+2 year options). On the other hand, short-term investments like money market funds or treasury bills may be better suited for investors who need liquidity and are looking for more stable returns in the short term. The illiquidity premium has to justify the lockup time horizon.


Lower correlation in private credit

Building Your Portfolio For Diversification Considerations


Diversification is key in managing risk and driving risk adjusted returns. By spreading your investments across different asset classes, industries, and regions, you can reduce the impact of any one investment or sector on your overall portfolio. Diversification can help protect against market volatility and potential losses. To determine the appropriate asset allocation for your portfolio, several factors should be considered.


Assess Your Risk Tolerance

This refers to your ability and willingness to withstand fluctuations in the value of your investments. If you have a higher risk tolerance, you may be comfortable with a larger allocation to stocks or other higher-risk assets. Conversely, if you have a lower risk tolerance, you may prefer a more conservative allocation with a higher percentage in bonds or cash.


Investment Goals

Your investment goals will depend on what you are trying to achieve with your portfolio. Are you looking for long-term growth, regular income, or a combination? Your time horizon refers to how long you plan to invest before accessing the funds. If you have a longer time horizon, you may be able to take on more risk and potentially earn higher returns.


Make sure to review and rebalance your portfolio regularly. As market conditions change and as you approach different stages in your investment journey, it may be necessary to adjust your asset allocation to ensure it aligns with your financial goals and risk tolerance. Regularly reviewing your portfolio allows you to identify any areas that may be overweight or underweight and make the necessary adjustments.


Investment Knowledge And Expertise

If you have a deep understanding of a specific asset class, such as stocks or real estate, you may feel more confident allocating a larger portion of your portfolio to that particular asset. On the other hand, if you are less familiar with certain types of investments, it may be wise to seek professional advice or consider investing in a diversity of funds that offer exposure to multiple asset classes, which can help reduce the risk associated with concentrating your investments in one specific area.


Stay Informed About The Current Market Conditions And Economic Trends

Keeping up-to-date with financial news and understanding how different factors can impact various asset classes will enable you to make more informed decisions when allocating your portfolio.

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