Private credit has emerged as an attractive investment opportunity for those seeking stable, long-term returns. It has unique characteristics that make it particularly appealing in today's market environment. Focusing on the infrastructure sector, the following guide explores what private credit is, how it works, and why investors should consider it as part of a balanced portfolio.

Private credit is defined as non-bank lending, where investment firms such as asset managers lend directly to companies or projects. In the infrastructure space, these investments typically involve lending money directly to projects, such as energy facilities, including power plants, transmission lines, and renewable energy projects; digital infrastructure, which comprises data centres, fibre networks, and telecommunications systems; and social infrastructure, such as hospitals, schools, and government buildings.

Private credit is not traded on public markets. Because of this lack of trading and liquidity, private credit comes with an illiquidity pick-up and complexity premium, providing investors with an opportunity to capture higher yield. It also provides downside protection because unlike traditional bank loans or public bonds, private credit agreements are negotiated directly between lenders and borrowers, which allow for customised terms and enhanced security features and financial covenants, therefore giving a higher degree of control for investors and improving the recovery value of the loan.

Last but not least, private credit allows investors to diversify their portfolio with exposure to economic drivers which are not available on the public credit market. Because private credit deals are idiosyncratic, they can also result in significant diversification benefits.

Private credit is often associated with middle-market lending but it includes a much wider range of asset classes with different risk and return profiles. This is the beauty of private credit : managers can tailor solutions to any desired risk profile from strong investment grade to distressed debt and with different investment horizons from 2yrs to 40yrs maturity. It is therefore accessible for all investors who do not need daily liquidity.

When we talk about private credit it includes a broad range of debt financing strategies such as fund finance , commercial real estate debt, private placement, infrastructure debt, asset backed lending, middle market lending, or specialised finance. These strategies are appealing for different types of investors depending on the risk and duration desired.

Private credit operates through a complex but well-established framework. Lenders can provide financing at different stages of a project’s lifespan. This can be at construction, all the way through to operational phases. The loans are usually secured against the project's assets and cash flows, with detailed covenants and monitoring rights that provide protection for lenders.

These investments often use project finance structures, where a special purpose vehicle (SPV) is created to own and operate the asset. The SPV's revenues come from long-term contracts, concession agreements, or regulated tariffs, which provide predictable cashflows to service the debt. This structure helps isolate the project's risks and ensure that loan repayments have priority over other claims.

Private credit has several compelling characteristics. When it comes to infrastructure, it typically generates stable and predictable returns, due to the essential nature of assets in the sector and their long-term contracted or regulated revenue streams. It can also often provide yields that exceed those available in public fixed-income markets.

In addition, the defensive nature of infrastructure can provide natural protection from economic downturns. This is because essential services like power generation, water supply, and transportation will be needed regardless of economic conditions. This leads to relatively stable cash flows throughout market cycles. Furthermore, many infrastructure assets have built-in inflation protection through contractual provisions or regulatory frameworks that allow for periodic price adjustments.

Portfolio construction is another important characteristic to consider. The most successful private credit portfolios typically maintain diversification across geographic regions, infrastructure sectors, and individual positions.

In the current environment where rates are coming down but will stay elevated, this is an opportunity to lock-in attractive yield. This is why there is a shift from both sides - fixed income as well as private equity - into private credit. Traditional fixed-income investors are seeking to capture these higher yield, lower risk and diversification benefits. Alternative managers who initially invested in private equity are shifting to this lower risk asset class as they want more stable cash flows, lower risk profiles and the ability to get a similar yield to some private equity strategies.

The environment remains supportive. With inflation under control, more rate cuts are expected, which means less pressure on cash flow generation - this is a credit positive. We should see more opportunities on the refinancing side as borrowers have been waiting for lower rates to refinance their loans or fund capex. M&A activity is slowly coming back which will also bring new transactions.

We expect the ESG investment trend to accelerate. With investment required by the government for decarbonisation, digitalisation, supply of more housing, improving care, and a focus on the circular economy, it will continue to bring a great breath of opportunities in the infrastructure space. The UK alone will need over £50 billion of private infrastructure investment per year to reach net zero by 2050 so there is plenty of capital to be deployed in infrastructure.

Like all investment sectors, private credit comes with its own individual risk factors. Illiquidity is a primary consideration, as these investments typically require capital commitments of several years, with limited secondary market trading opportunities. However, this illiquidity is commonly compensated through higher yields.

Construction risk presents another significant consideration. New infrastructure developments can face delays, cost overruns, and technical challenges. However, experienced managers typically structure investments with various protections, such as completion guarantees, cost overrun facilities, and performance bonds to mitigate these risks.

Regulatory risk also requires careful attention, as changes in government policies or regulations can impact project revenues and asset values. However, most private credit funds will structure their investments in such a way that they are protected against adverse regulatory changes.

There are four different fund structures for private credit, each having pros and cons and designed for different types of investors, with different liquidity and reporting requirements.

The most common fund structure is that of a closed-ended private fund. It is designed for patient investors such as institutional investors who do not need liquidity. In this structure, fund managers raise capital for a short period of time – typically 12 to 24 months – and then close, so the capital of the fund is fixed and there is no liquidity offer- no new capital and no redemptions are possible. It provides a stable capital base and helps portfolio managers to focus on maximising returns while not having the pressure to meet redemption demands as the fund has a fixed lifespan which is aligned with the investment horizon of the assets. Investors get their money back as the loans mature.

As some investors have sought greater liquidity, we have seen the emergence of open-ended funds where there is no finite lifespan, and the fund can accept subscriptions and redemptions. As well as providing some liquidity, fund managers can also adjust their asset allocation over time in response to the changing environment. However, there is usually a cap on redemptions per quarter with minimum notice periods and the ability to defer redemptions to the following quarter. These funds typically hold cash and more liquid instruments to allow for possible redemptions, which could potentially limit the returns of the fund.

A new type of UK authorised open-ended fund has also recently emerged : The LTAF (Long Term Asset Fund) is a semi- open-ended structure designed for Defined Contribution pension schemes so they can invest in long-term and illiquid assets such as private credit, venture capital, private equity, real estate, and Infrastructure. At least 50% needs to be invested in unlisted assets. LTAFs are a suitable structure for a sticky investor base such as DC schemes, given employees participating into these pension schemes typically do not change their default allocation. We wait to see if it can be expanded to a broader retail base.

The fourth type of fund are closed-ended investment companies which are listed on the London Stock Exchange and have a fixed number of shares. They have daily pricing and can invest in a wide range of assets. Because they are publicly listed, there is a lot of transparency around reporting and performance. An independent board of directors is also in place to ensure investors’ interests are aligned with the investment manager, ensuring strong governance and an extra layer of security and confidence. However, shares have limited liquidity and might not reflect the true value of the assets. In this scenario they may, at times, trade at a discount to net asset value, which would be negative for existing shareholders but an opportunity for new investors.

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