Private credit beckons, but advisors must be cautious

Private credit appears to be at another inflection point. 

At the moment, there seems to be no end to the runway for the asset class. Per a BlackRock analysis, private credit is forecast to grow to over $3.5 trillion by 2028. Investor interest has mirrored that meteoric rise. Buoyed by evolving market and regulatory trends, the search for alternative liquidity and steady manager supply, it's a trend likely to continue. 

At the same time, financial advisors should give the asset class careful consideration in order to mitigate emerging risks.

Success and its hazards

The rise of private credit in recent years can be credited to regulatory pressures that forced banks to be highly selective in their lending practices. Alternative credit funds, ranging from direct lending to sophisticated structured credit, filled the void in the form of easier-to-access vehicles such as interval funds. 

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Yet the increasing "democratization" of the asset class has thrown a variable into the growth equation. Perpetual funds, for example, have offered increased access to private credit investments, delivered additional transparency via more frequent net asset value pricing and offered the potential for quarterly liquidity. 

However, as has always been the case, the very success of those investments led to an influx of capital with the next dollar chasing less-attractive opportunities than the previous dollar, resulting in potentially weaker future returns. 

And herein lies the biggest challenge for the sector: As competition in the space rises, lenders may face pressure to lower underwriting standards in order to deploy their exploding capital and expedite fund launches. When this happens, the risk of diminishing returns only grows. 

Private credit in a new administration

Advisors and clients would also be wise to consider how deregulation policies under the current administration may affect the asset class. In theory, a reduction in regulations could catalyze additional lending and lead to public market growth, expedite IPO activity and, in turn, indirectly impact private credit. 

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At the same time, such moves could result in looser lending standards, bringing concerns about the quality of loans and defaults in the private credit space to the forefront. Simply put, though such policies fuel higher growth, they undoubtedly come with risk-management considerations.

This backdrop is further complicated by potential interest rate movements. Following the Federal Reserve's 50 basis point rate cut last September, the market anticipated a rapid easing cycle. Yet with slower-than-anticipated progress on inflation, longer-term yields have stayed stubbornly elevated. Lower short-term rates certainly provide a tailwind, though higher long-term yields could pressure borrowers and negatively impact default rates.

Balancing growth with stability

Despite these complex and interconnected variables, private credit continues to present a growing source of investment opportunities with the high potential for income generation. The sector will always benefit from its uncorrelated nature relative to public fixed-income markets and its ability to offer customized solutions unavailable in the traditional banking segment. 

However, investors and advisors must remain vigilant. We have seen slight upticks of delinquency rates in certain segments of the market. While this in no way merits pushing the  panic button, it's paramount to closely monitor the types of loans being issued and their associated terms. This becomes even more important when one considers that the surge in private credit assets has not been tested by a weak economy and rising default cycle.

That future hinges on balancing growth with stability. The key is to be proactive in addressing the durability of low default rates and the sustainability of returns. 

If achieved responsibly, private credit has the potential to assume a permanent place in the modern advisor's toolkit.