Private credit

In short

A friend of mine once asked me why her cousin was so pleased with a fund that paid a steady monthly check, and I told her I wanted to understand it before I praised it. Private credit means loans made by funds and firms rather than by banks, and those loans are not traded on an open market. If you are thinking about it, start by asking how and when you can get your money back, because many of these funds limit withdrawals. Next, find the total yearly cost, which often includes a management fee and a share of the profits. Then read what the fund says about its own risk, since a loan is only as good as the borrower who has to repay it. Ask whether you qualify to buy it at all, because some versions are open only to investors who meet income or wealth tests set by the Securities and Exchange Commission. Take your time. Nobody wins a prize for hurrying.

The whole of it

What it is

I once watched an old neighbor lend a few hundred dollars to a man down the road who needed a new transmission. He did not go through a bank, and he set his own terms. Private credit is that same idea, grown up and put in a suit. A fund gathers money from investors, then lends it directly to businesses, often mid sized ones that a bank passed over or that wanted a faster, more flexible deal. The borrower has to pay interest and repay the loan on a schedule. The fund passes the interest along to its investors, after taking its fees.

You have probably heard the phrase shadow banking, and it sounds spooky. It simply means lending done outside the traditional banking system. These loans are not traded on an open market the way a stock is. That is why the word private sits in the name. There is no daily price on a screen, and that single fact shapes almost everything else about this subject.

Many of these loans carry a floating rate, though a fund's documents say which kind it holds. A floating rate moves up and down with a benchmark rate, so the borrower pays more when rates rise. For the fund, that can mean more income. For the borrower, it can mean a heavier load. Both sides of the ledger matter, and a good investor looks at both.

How it works

A woman I know runs a small manufacturing shop, and she told me that getting a loan from a big bank took months and a mountain of forms. A private lender moved in weeks. That speed is part of the appeal for borrowers, and the lender is paid for it with a higher interest rate.

Here is the plain flow. Investors put money into a fund. The fund makes loans. Borrowers pay interest, and the fund collects it. The fund keeps a slice as fees and sends the rest to investors. Some funds also use leverage, which means they borrow money themselves to make more loans. Leverage can boost the payout when things go well. It can also deepen the loss when things go badly.

If you are holding or considering a share of one of these funds, the structure matters a great deal. Some are called interval funds or nontraded business development companies, and they offer to buy back a portion of shares at set times, such as once a quarter. The fund is not required to buy back everything that investors ask for. If too many people want out at once, the fund may pay out only part of each request. Others are drawdown funds, where the investor commits money up front and the fund calls it in over several years, with little chance to leave early. The fund documents spell out which type applies.

The numbers, and where to find yours

I like to tell people that the fine print is where the honest story lives. Start with fees. A fund may charge a management fee, often described as a percent of assets, and an incentive fee, which is a share of the profits above a set return. The fund must list these in its prospectus. That is the formal document describing the fund, and you can read it for free on the SEC's EDGAR database, which is the agency's public filing system.

Next, find the minimum investment and the rules on who may buy. The SEC defines an accredited investor, and the income and net worth tests change only when the agency changes them. The current income test is the current figure, which the official source publishes each year and the current net worth test is the current figure, which the official source publishes each year. Some funds are open to everyone and some are not, so check the fund's own page and its prospectus.

Then look at the withdrawal terms. Find how often the fund repurchases shares, what share of the fund it will buy back in a period, and whether it can pause. Look also at how the fund values its loans, since no market price exists. The fund's annual report and its filings on EDGAR describe the method. And check the tax form. Many of these funds send a Form 1099 or a Schedule K-1, and which one you get changes how and when you file, so ask before you buy and not after.

A worked example

Let me tell you about a retired schoolteacher named Walter. He had $100,000 he wanted to keep for a long stretch, and a fund offered him a 9 percent yearly payout. Walter was pleased. Then he sat down with the prospectus, the way a careful man should.

The fund charged a 1.25 percent management fee. On his $100,000, that came to $100,000 times 0.0125, which is $1,250 a year. The fund also took an incentive fee of 12.5 percent of income above a hurdle. Say the fund earned $9,000 on his money before the incentive fee. If the hurdle was $5,000, then the income above it was $9,000 minus $5,000, which is $4,000. A 12.5 percent share of $4,000 is $500. Add the other costs the fund listed, which came to $750 for the year. Walter's total cost was $1,250 plus $500 plus $750, which is $2,500.

So the $9,000 of income became $9,000 minus $2,500, or $6,500 after fees. That is a 6.5 percent return on $100,000, not 9 percent. Walter had counted on the bigger number. The smaller one is the true one.

Then he checked the withdrawal terms. The fund offered to buy back up to 5 percent of its shares each quarter. If every investor asked to sell at once, requests might reach 20 percent of the fund. The fund would buy back only 5 percent, so each seller would get about one quarter of the request filled. Walter, who asked to sell $20,000, might get back only $5,000 in that quarter. Nothing was hidden. It was all in the document. He simply had not read it until he did the math.

Where it goes wrong

I have noticed that the stories people tell after a loss usually begin with the words I did not know I could not get out. The first trouble spot is liquidity, which means how fast you can turn an investment into cash. These funds can be slow. A fund can limit or pause withdrawals, and the prospectus says so.

The second trouble spot is credit risk. A borrower may fall behind or fail to repay. When that happens, the fund may write down the value of the loan, and investors feel the drop. Because there is no daily market price, the loss may show up late, and the reported value may lag the real one. That delay can lull a person into feeling safe.

Fees are the third. They are real money, and they come out before you see a dime. A high stated payout can shrink once costs are taken out, as Walter learned. Leverage is the fourth. When a fund borrows, a small stumble in the loans can grow into a large hit to your share.

Last is concentration. If a fund lends heavily to one kind of business, a rough patch in that field can hurt many loans together. Spreading across many borrowers helps, but it does not erase the risk. Be kind to yourself and keep the amount modest, because a hard lesson hurts less when it is a small one.

Questions to answer before you leave this page

Can you explain, in your own words, who the fund lends to and how it makes money? Do you know the total yearly cost, with the management fee, the incentive fee, and every other charge added up in dollars? If you needed your money back in a bad year, how much could you actually withdraw, and how long might you wait? Have you read the fund's prospectus on EDGAR, and did you check how it values loans that have no market price? Does the fund use leverage, and what happens to your share if the loans lose value? Do you qualify under the SEC's accredited investor rules, or does the fund accept all buyers? Which tax form will it send, and have you planned for the filing? And have you decided how much you could lose without losing sleep?