Private credit - bringing an investment approach into lending

Highlights

• Fundamental approach of lending is to focus only on increasing the probability of money coming back while Investment approach looks at ability of the money to generate more value.
• High importance is placed on financial covenants in Lending vs More importance given to Business level performance covenants and control in Private Credit.
• The biggest strength of Private Credit lies in its ability to work across the entire spectrum of capital solution between traditional Debt and Equity and by combining the Lending and Investment approach to convert itself into the most suitable solution for a specific situation presenting a strong case for it to be a permanent part of any capital structure.
• In Investing, eventual goal is to act / adapt and regularly monitor to get the best outcomes in all situations. This means it is customized based on the situation, experience, and human judgment. Therefore, no two investments look exactly the same since no two situations are exactly the same. This allows the strategy to work across all business cycles.

Downside protection scenarios vs Value Enhancement opportunities

So, what is the difference between the Lending approach and Investment approach to debt. Let's list a few which makes Credit Investment different than a Debt Lending, and it is not to follow one at the expense of the other but combining both the approaches for the optimum outcomes.
Downside protection scenarios vs Value Enhancement opportunities
Fundamental approach of lending is to focus only on increasing the probability of money coming back while Investment approach looks at the ability of the money to generate more value. This means how and for what purpose money is used is equally important because if the value of the business goes up, all stakeholders get paid. This is a classic case of increasing the size of the pie rather than only focusing on taking a share of the pie.

Borrower-Lender relationship vs Investor-Business relationship

Generally, in lending, a slightly distant approach is employed where roles of both the parties (Borrower and Lender) are clear, and Lender doesn’t get involved in Borrowers’ business unless it sees a Payment risk. While in Investing, investor is always engaged with Promoter or a company to make sure business is running properly and is more concerned about the Business risk as it will turn into a financial and payment risk at a later point in time and therefore focuses on problem solving with proactive management. This requires a Partnership approach between an Investor and a Company.

Focus on Past performance vs Future Potential

In Lending, you generally assume Past performance to be a base line for future performance without much divergence, and all decisions are taken assuming future will follow past with limited degree of deviation. This doesn’t allow for nonlinear situations to be analyzed properly and could hinder the right decision. In Investment, focus is more on Future potential basis current situations and validated assumptions which allows more relevant solutions to be given.

Reliance on Plan B vs Plan A

In Lending, security / collateral becomes the most important aspect thinking it is difficult to take a call on future business performance and if Business doesn’t perform as per expectation (Plan A) then there is something else through which money can be recovered (Plan B). However, investing takes a Conviction based approach where investment is done only after thorough level of Due diligences / understanding with comfort / confidence being established on Business working out as per the expectation (Plan A).

Standardized vs Customized

Eventual goal in Lending is to move to a stage where as much as possible is standardized with clear rules and parameters to make it an objective exercise to the extent possible and reduce the human element. In Investing, eventual goal is to act / adapt and regularly monitor to get the best outcomes in all situations. This means it is customized based on the situation, experience, and human judgment. Therefore, no two investments look exactly the same since no two situations are exactly the same. This allows the strategy to work across all business cycles.

Difference in features 

Apart from the difference in approach, there are also differences in the features of Private Credit vs Debt Lending Like

• High importance is placed on financial covenants in Lending vs More importance given to Business level performance covenants and control in Private Credit.
• Lending considers lot of Macro and industry level data along with regulatory constraints while Private credit is much more micro driven with Business level understanding and Risk appetite levels
• Lending terms are more generalized vs Private Credit terms which are very situation specific and nuanced
• Lending derives lot of comfort from external factors also like Credit rating, industry trends, research reports vs Private Credit which is based on more internal parameters like Due diligence, views on future, level of understanding and comfort.
• Lending is typically available at a certain stage of business lifecycle when it meets the criteria while Private Credit is available across business life cycles with different types of solution / structure.

Conclusion

In the end, the biggest strength of Private Credit lies in its ability to work across the entire spectrum of capital solution between traditional Debt and Equity and by combining the Lending and Investment approach to convert itself into the most suitable solution for a specific situation presenting a strong case for it to be a permanent part of any capital structure.