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All About Alts

What is private credit (debt) investing?

July 14th, 2023 By Emily Norwood

When most people consider investing in private companies, they’re thinking of private equity and venture capital. Although very popular, these aren’t the only ways to invest in a privately owned company. Private credit also gives investors access to new opportunities with startups and promising disruptors, while offering different advantages for both investors and entrepreneurs.

In this article, we’ll cover the basics of private credit investing. You’ll learn the subtle differences between private equity (PE) and private credit, and see how it compares to other popular forms of alternative investment.

What is private credit?

Like PE, private credit (also known as private debt) is financing provided to a startup by an external investor, usually a private investment fund. Unlike PE, the startup borrows money from the investor in return for a favorable interest rate and loan repayment terms. 

Private credit investments typically come with more flexible terms than traditional bank loans. These loans are sometimes easier to secure through private credit than a traditional bank.

The sources of financing for these investments include:

Collateralized debt obligation (CDO): A type of structured finance that pools debt instruments from multiple sources and packages them into a single security. Individual investors are offered an opportunity to invest in the pool of debt instruments, with returns contingent on the performance of the underlying portfolio. 

Business development company (BDC): BDCs are more similar to venture capital than other forms of private credit. They are structured funds that issue debt and equity securities to investors in exchange for long-term commitments to finance businesses. BDC funds are often used as an alternative to bank loans, providing growth capital or working capital with terms more attractive than those offered by traditional banks. 

Hedge fund: An investment vehicle that’s made up of pooled funds from accredited investors or institutional investors. Hedge funds are often managed by professional financial managers who use a variety of strategies to produce higher returns than traditional investments. These strategies include investing in stocks, bonds, commodities, currencies, futures contracts, and other derivatives.

Why do businesses like private debt/credit?

Private credit is a popular alternative venture capital for entrepreneurs. Venture capital investments are equity-based, meaning the investor provides capital in exchange for ownership or an equity stake in the company. 

In contrast, private credit allows companies to borrow funds without giving up any ownership. This can benefit businesses that are not yet ready to take on venture capital investments but are looking for alternative ways to finance their operations. 

Also, private credit investments usually have shorter timelines than venture capital investments, which allows companies to access funds quickly and start making returns sooner.

Benefits & challenges of private credit investing

For investors with the funds and accreditation status to support this alternative asset class, private credit investing offers a variety of benefits:

  • Diversification: With opportunities available across industries, private credit provides a wide range of investment options. These include assets that would otherwise be inaccessible to investors, such as infrastructure.
  • Income generation: Private credit can play a valuable role in an income investing strategy. Investors may be able to negotiate an advantageous interest rate on the capital they’re prepared to lend and utilize the returns to supplement their existing income.
  • Lower volatility: The repayment of private credit is specified in a plan that is agreed to by both the lender and borrower, and investors’ potential returns are defined by a predetermined interest rate. This is in sharp contrast to private equity, in which returns for investors are solely dependent on the success of the company.
  • Hedge against inflation: Private credit as an asset shares little to no correlation with the stock market, which mitigates the impact of public market volatility and inflation. In private credit deals that are backed by floating-rate securities, investors are additionally secured with protection against rising interest rates.

With all its potential upsides, private credit is still a riskier investment than other options. It is an alternative asset, so you must be an accredited investor to take advantage of this investment vehicle.

  • Low liquidity: Private credit investments are illiquid, which makes it difficult to exit an investment before the maturity date.
  • Higher risk: One risk of private credit investing is its reliance on the success of the underlying borrower; failure to repay (or the company’s failure) will result in financial loss. Due to the higher risk associated with private investments like debt/credit, they are only suitable for seasoned investors.
  • Time investment: Private credit investments require significant due diligence to evaluate creditworthiness and assess repayment capabilities.

Trends in private credit investing

The popularity of private credit began to grow after the Great Recession, largely due to the tighter banking regulations that followed. Wealthy investors use private credit as a diversification tool along with other types of alternative investments.

Niche investments

Niche investments in private credit have increased in popularity as investors seek out better opportunities. By focusing on smaller investments that may not be attractive to larger funds, investors capitalize on unique opportunities with higher yields and potentially better returns. These niche investments include specialized loan structures, such as mezzanine financing and distressed debt, or investments in underdeveloped markets. 

Furthermore, many specialty debt funds are looking for investments that require a longer commitment period than traditional debt instruments. Such funds are often willing to accept higher-risk instruments in return for better returns over the longer investment period. 

Environment, Social, and Governance (ESG)

Impact-focused investment continues to rise in popularity for individual and institutional investors alike. Environment, social, and governance (ESG) investing centers around environmental sustainability, social responsibility, and good corporate governance of a portfolio company. The ESG investment approach provides investors with potential returns while also decreasing the risk posed by certain investments.

ESG will remain an important factor in 2023 and beyond. More investors will focus on companies that are committed to more sustainable practices to ensure their own long-term success. This is true of both institutional investors and individuals who want to align their investments with their personal values and beliefs. More government action around ESG initiatives may further encourage this type of investing and incentivize companies to adopt these standards.

Tech-enhanced investing

AI and predictive analytics use is increasing in financial services, especially for its predictive benefits in investing. Investment advisors use AI-driven algorithms to create portfolios more tailored to individual needs, and assist decision-making on investments based on market conditions. AI can also be used to analyze large amounts of data quickly and accurately, giving investors better insight into potential investment opportunities. 

How to invest in private credit

While individuals can negotiate private credit investments directly with the company or institution in need of capital, most investors participate in the space via private credit funds. Like private equity, private credit funds may specialize in a certain market or industry. Some funds focus on real estate development, others lend capital only to sponsor-backed borrowers, and still others work with distressed companies. Ares Capital Europe VI and Oaktree Lending Partners are currently the largest players in the space, while digital platforms like Yieldstreet enable investors to access other alternatives along with private credit.

Evaluating private credit opportunities

While credit managers who work with distressed companies have the benefit of media coverage to help source deals, it takes a bit more legwork to find other private credit investment opportunities. Once a potential borrower has been identified, the credit manager must perform thorough due diligence on the opportunity. This includes examining a litany of financial factors, including (but not limited to):

  • Advance rates
  • Amortization
  • Cash or payment-in-kind (PIK) interest rates 
  • Collateral
  • Covenants
  • Instrument tenor
  • Seniority

Provided the due diligence phase doesn’t reveal any glaring red flags, negotiations will ensue to develop a profitable arrangement for the borrower and lender. 

How private credit investing compares to franchise investing

Private credit and franchising are both popular options for investors who are looking to diversify, build long-term wealth, and harness the power of alternative asset classes. Both models provide opportunities for long-term investment and require similar initial investments depending on the franchise that’s chosen.

While private credit returns are attractive, franchising is a more stable, established investment approach. The business model offers several advantages that make it a more stable choice in the long term: 

The security of real assets: Real assets such as property and other tangible goods provide investors with a more secure form of capital. Unlike stocks or bonds, real assets are physical objects that do not fluctuate in value based on market conditions. Rather, these assets tend to appreciate steadily over time and can be used as collateral for further investment opportunities if needed. 

Real assets can often be used to generate revenue such as rent or lease payments, while also providing investors with income from their investment. This allows investors to benefit from both the appreciation of the asset and the cash flow from it. 

Superior recession-resistance: Franchising offers greater stability during downturns since the most successful franchise networks operate in recession-resistant industries that offer goods and services. This makes them better insulated from stock market volatility and other macroeconomic factors. Franchising also offers more control over their operations compared to PE firms, allowing them to make adjustments and cost-saving measures in response to changes in the economic landscape. 

Higher potential returns: Private equity/debt investments offer around 5- to 10-percent returns over the long term, with recent return rates of about 5 percent. By comparison, franchising offers returns of 25 to 50 percent. In select cases, depending on the location and industry, returns may be as high as 125 percent. Also, franchising is readily scalable. Many franchise operators choose to buy multiple locations or even invest in multiple, complementary franchise networks.

FranShares brings the ease of private credit investing to franchising

Until recently, franchising was a hands-on investment model. Investors had a choice between owning and operating directly, or hiring a management firm to handle the daily operations of their business. 

FranShares brings the passive power of private investing to the franchise model with a portfolio approach that lets individual investors add this valuable asset class to their asset mix without direct operation or location ownership.

Benefits of investing with FranShares

We combine deep industry expertise with a zero-fee approach to ensure our investors maximize their long-term returns – without the risk of losing their shirts. Our mission is to help investors reap the benefits of franchise investing with a unique business model that offers:

  • Passive income
    Our best-in-class franchise management team ensures that our investors enjoy truly passive income through quarterly distributions – without managing the franchise. In other words, we do the legwork while you sit back and enjoy the returns.
  • Equity appreciation
    The value of your franchise investment may increase over time and may provide secure, long-term passive income.
  • Flexible capital commitment
    We offer accredited and non-accredited investors the opportunity to invest for as little as $500, although our model also appeals to ultra-high-net-worth investors. Our platform allows everyday people to become fractional franchise owners with the ability to invest the right amount of capital for their own personal circumstances.
  • Diversification
    Diversify away from the stock market and other publicly traded assets while owning a portfolio of franchises across different geographies and industries, which creates an effective buffer against challenges that may shut down a single franchise or location, such as service franchises closing temporarily during pandemic lockdowns.
  • Low volatility
    Unlike other assets, which may experience considerable fluctuations due to investor sentiment, the growth in value and disbursements from franchise investments are determined over the longer term by the business operations of the franchises.

Ready to add franchise investing to your portfolio?

If you’re an investor who’s looking to incorporate alternative assets into your 2023 strategy, investing fractionally with a FranShares franchise portfolio offers high earning potential and diversification in a completely passive model. 

To learn more about FranShares and this unique opportunity, sign up to our platform on our home page.

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