Following the 2008 financial crisis, banks and lenders were heavily scrutinized by regulators for issuing loans to borrowers who were not creditworthy. This led to increased regulatory oversight, slowing down the speed at which loans could be financed and tightening the market as a whole, leaving many would-be borrowers out in the cold. In response, the market for private loans, which could be issued by individuals rather than banks, grew substantially. With private credit, investors lend capital directly to borrowers, earning the interest that normally would go to banks.
There are numerous types of private credit that investors can gain exposure to, some of which will be more suitable than others, depending on an individual investor’s risk tolerance. Some loans are “backed” by an asset, which means that the borrower offers something as collateral to ease the risk of the loan. If the borrower is unable to repay their loan, the lender can claim default and seize the ownership of the asset forever. Many investors prefer asset-backed debt because it limits their downside risk in the event of a default.
Investors can lend money straight to borrowers who need it for personal reasons, whether for auto loans, debt consolidation, medical bills or essentially for any reason. There are also opportunities to lend to students who then repay with a share of their future income. These tend to be the riskiest types of loans, particularly if they are not secured by any kind of collateral. Most individuals borrowing money this way are doing so because they are in financial distress or have low credit scores and cannot obtain capital in a more traditional way. In either case, the chance for default on these types of loans can be significantly higher than others.
Since commercial real estate transactions tend to be large in size, debt is almost always a part of financing the project. While a substantial part of that debt is often a traditional mortgage, there are still types of debt that private investors can get exposure to, such as bridge financing in a single project or a share of a portfolio of notes across several projects. There are numerous platforms that offer individual investors the opportunity to get exposure to commercial real estate debt in a way that was not available previously.
Private credit in real estate can also involve home renovation - either for the long-term homeowner themselves or for a short-term fix-and-flipper - and will be secured by the property itself. These are called “hard money loans”, which provides the borrower quicker access to capital with fewer restrictions based on the borrower’s financial position. Hard money loans tend to have a higher interest rate than a normal mortgage or home equity loan, and a lower loan-to-value ratio (LTV), reflecting the extra risk being taken by the lender. Typically, hard money loans are not offered through banks.
While personal home renovation loans are less risky than other types of personal loans because they are secured by collateral, generally the borrower is someone who cannot get funded via traditional methods. However, with ‘fix and flip’ lending, borrowers use the money to purchase and renovate a property in the hopes of flipping it for a higher return than purchased. Traditional lenders are not usually an option because of the short timeframe - flippers generally only plan to keep the property for as long as it takes to fix it up and flip it. Even successful and experienced flippers will use hard money loans, making flipping houses one of the most common situations for private credit. These loans can generate fixed income returns with the initial capital returned in a few months to a few years, depending on the size of the project.
Litigation finance is where a third party with no connection to the lawsuit lends the plaintiff capital before the case is resolved, which covers the plaintiff’s legal expenses in part or in full. It may also cover living expenses for victims of personal injuries. Litigation financing is not limited to individuals, as it can also cover companies through commercial legal financing.
Unlike a loan, the investor does not lend money which the borrower pays back with interest. Instead, it acts more like equity, where the investor receives shares of the profit once the legal claims are paid out. The payout for litigation finance investments can be huge, but if the plaintiff loses their case, investors get nothing. It may also take years to settle cases with no chance at liquidity beforehand. This makes it a particularly risky form of private credit that investors should mitigate by investing in multiple different cases.
Individuals can also make direct loans to businesses, who may be looking to expand existing operations or start a new endeavor altogether. Usually these are to small businesses, but some medium-sized and private corporations used this method as opposed to corporate bonds. Often, these are shorter-term loans with a fixed payback multiple.
Merchant Cash Advances
A merchant cash advance is an alternative lending option to traditional loans. Instead of going to a big bank, business owners can go to an accredited investor to secure a loan quickly. In return for the advance, the lender is paid back through a share of future sales from the borrowing business.
Private credit offers investors access to higher returns than many other debt instruments, but generally carries higher risk as well. This is because many borrowers cannot otherwise access traditional financing because of low credit scores or a lack of collateral. Private credit is a way for those who need funding to get it from places beyond banks, and a way for investors to diversify into a relatively stable asset class.