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What are the risks of private credit?
Updated over a month ago

Investing in private loans on Heron, also called “private credit”, provides a more predictable income stream compared to stocks, which can be highly volatile and do not guarantee dividends. This yield is also particularly attractive in a low-interest-rate environment, where traditional bonds may not offer sufficient returns to meet investors' income goals.

By including Heron Finance in your portfolio, you can achieve a more balanced risk-return profile, with the potential for steadier income and lower overall volatility compared to a portfolio solely composed of stocks and bonds.

While private credit returns are historically higher than traditional fixed-income investments like bonds, and more stable than stocks, they do come with some unique risks.

  1. Lack of liquidity:

    1. Private credit assets do not trade on an exchange like equities.

    2. Especially with respect to direct lending which has historically been the largest sub-strategy of private credit, these loans have multi-year duration and do not self-amortize. The only meaningful cash flows are monthly or quarterly interest payments, some of which may even be paid in kind (”PIK”) rather in cash.

    3. Investors generally must hold private credit assets until maturity or a refinancing, both of which can be several years from the date of origination.

    4. When accessing private credit via a commingled fund, the manager may implement various liquidity restrictions such as lock-up period, gate, notice period, and redemption frequency.

  2. Hard to value assets:

    1. Private credit loans (i) are difficult to value and (ii) lack comparable transactions; as a result, their valuations are subjective, and highly dependent on the credit opinions and valuation methodologies used by the fund managers.

    2. It is possible that the same loan is being valued very differently by different managers. Especially as loans become more distressed, such valuation discrepancy can increase. Such lack of price discovery makes it challenging for investors to accurately assess the true value and risk of their private credit holdings.

    3. Further, macroeconomic conditions and borrower-specific issues can lead to sharp valuation adjustments, especially in stressed economic environments where illiquidity exacerbates pricing gaps.

  3. Lack of transparency:

    1. Private credit borrowers tend to be privately-owned, and in many cases, smaller sized companies, where most borrower information is not publicly available, especially as compared to publicly listed companies.

    2. This makes assessing credit quality challenging, limits the extent of due diligence that can be conducted by lenders and investors, and increases the potential for unknown risks or misinterpretation of borrower stability, especially considering the aforementioned illiquidity and valuation challenges.

  4. Deal-structuring complexity:

    1. Unlike bank-led financing such as broadly syndicated loans or traditional asset based lending, private credit deals tend to be less standardized and more specific to the underlying borrower’s situation and the lender’s investing style and deal experience.

    2. Such unique deal structures make private credit assets complex to evaluate and monitor, potentially leading to unforeseen risks during the investment lifecycle.

  5. Servicing risks:

    1. Because private credit deals tend to be bespoke and less standardized as compared to typical bank-led financing transactions, loan servicing, which includes tasks such as covenant tracking and managing restructuring negotiations, can be complex, time-consuming, and costly.

    2. Private credit investors, therefore, have to rely heavily on the skills and network of the fund manager. Fund manager’s failure to promptly monitor or assess risk, or lack of resources to do so at scale, can impair their ability to recover from a loan default and result in credit losses.

  6. Sector and concentration risk

    1. Private credit often involves niche or specialized sectors, each with unique economic sensitivities. Concentrated exposures to specific industries or borrower types can amplify downturn risks.

    2. Additionally, exposure to borrowers across various legal jurisdictions can introduce complexities, particularly if local regulations change or legal disputes arise.

  7. Relatively short history:

    1. Private credit is a much newer asset class as compared to equities or high yield bonds; additionally, over 90% of credit fund managers were only formed after the GFC.

    2. Such short history, combined with its high historical growth rate, means there is a lack of historical data or reliable performance benchmarks, which makes it difficult to accurately assess the long-term viability of private credit.

    3. Separately, the buildup of "dry powder" in the last couple of years has created pressure to deploy capital, which may lead to compromised underwriting standards.

    4. These circumstances create a critical risk considering the fact that the industry has not experienced a systemic correction or significant downturn since its inception.

How Heron mitigates these risks

To help mitigate these risks, we implement a comprehensive strategy when creating portfolios for our clients, including:

  1. Our rigorous, consistent underwriting process, which screens out fund managers that lack credit-underwriting discipline or experience in managing downside scenarios;

  2. Our portfolio construction strategy, which emphasizes broad diversification to spread risk and minimize the impact of defaults from any single source;

  3. Our proactive risk monitoring and stress testing to identify early signs of portfolio distress or quality deterioration, thus informing decisions about whether we should continue relationships with specific managers; and

  4. Our risk-sharing approach, which involves co-investing alongside fund managers, ensuring they bear a disproportionate impact in the event of a default.

Additionally, we mitigate liquidity risk through the following:

  • Unlike most private credit funds, Heron Finance doesn’t require a multi-year lockup. There are no lockup periods, which means clients may request redemption at any time on a quarterly basis.

  • There are also zero penalties or fees for redemption.

  • Our goal is to process all withdrawal requests within one quarter, subject to available liquidity. It is important to note that we cannot guarantee redemption within the quarter.

  • There may be instances where one of the funds that Heron provides exposure to suspends redemption during a given quarter, delaying a withdrawal. We aim to provide efficient processing of redemption requests, and if we anticipate a delay in fulfilling a request beyond one quarter, we will proactively notify our clients.

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