Private Credit: A Former Banker’s Guide to Unpacking the Risk and Reward Balance

This article is based on a table discussion led by Ryan Donnar at the 6th Annual Australia Investors Forum in Sydney on 25 March. 

Balancing Risk and Reward in Private Credit: A Guide for Wealth Advisers and Family Offices

Private credit has grown significantly as an asset class, attracting interest from wealth advisers and family offices seeking yield and portfolio diversification. While it offers compelling return potential, investors must navigate a complex risk landscape.

Understanding the interplay of credit risk, structuring, liquidity and macroeconomic factors is essential to making informed allocation decisions.

In this post, we’ll unpack how private credit managers mitigate risk, identify attractive investment opportunities and could position private credit within a well-balanced portfolio.

Understanding risk in private credit

1. Credit risk: The foundation of lending decisions

Credit risk—the possibility that a borrower defaults on their obligations—is the most fundamental risk in private credit. Skilled managers mitigate this through:

• Borrower quality: Rigorous due diligence assesses financial health, business model sustainability and management capability.
• Collateral: Secured loans, backed by tangible assets, provide downside protection. Common collateral includes receivables, inventory, equipment and real estate.
• Covenants: Loan agreements may include financial and operational covenants that serve as early warning indicators and allow lenders to intervene before a default occurs.

2. Structuring & security: Positioning in the capital structure

A loan’s position within the capital structure dictates the risk-return profile. Senior secured loans, which sit at the top, have the highest repayment priority, whereas subordinated debt or mezzanine financing carries higher risk but offers greater yield potential.

Managers structure deals to optimise risk-adjusted returns, ensuring protective mechanisms such as intercreditor agreements and priority claims.

3. Liquidity risk: The trade-off between yield and flexibility

Unlike publicly traded bonds, private credit investments are illiquid, typically locking in capital for 2 – 5 years. While this illiquidity premium contributes to higher returns, investors must consider:

Portfolio construction: Allocating an appropriate portion of capital to private credit while maintaining sufficient liquidity in other asset classes.

Exit strategies: How a manager structures loan terms can enhance liquidity including prepayment options and secondary market trading.

4. Regulatory & macro risks: Adapting to market shifts

Regulatory changes and macroeconomic cycles significantly impact private credit.

Key considerations include:

Interest rate sensitivity: Many private credit loans are floating-rate, providing a hedge against rising interest rates but increasing borrower costs.

Economic cycles: Downturns can increase defaults however experienced managers pre-emptively structure deals to withstand market stress.

Policy & trade regulations: Tariffs, tax reforms and industry-specific regulations can impact borrower cash flows.

Role of private credit in a portfolio

1. Diversification benefits

Private credit exhibits low correlation with traditional equities and bonds reducing overall portfolio volatility. This makes it a valuable alternative asset class in uncertain market conditions.

2. Inflation hedge

Floating-rate loan structures adjust to rising interest rates, preserving real return potential. This characteristic is particularly attractive in inflationary environments where fixed-income instruments may underperform.

3. Strategic allocation

Wealth advisers and family offices should consider:

• Investment horizon: Matching liquidity needs with private credit’s longer-term nature.
• Manager selection: Assessing track records, deal structuring expertise, risk management capabilities and work-out experience.
• Sector exposure: Avoiding over-concentration; for example, PPIF maintains zero allocation to property development & construction reducing exposure to cyclical downturns in these sectors.

Conclusion 

To balance risk and reward in private credit, investors should prioritise:

• Understanding the capital structure of loans to assess risk positioning.
• Transparency in sector exposure to ensure alignment with portfolio objectives.
• Selecting an experienced manager with a proven ability to structure deals, actively manage borrowers and mitigate capital loss.

Private credit is not just about earning a yield—it’s about navigating complexity, managing downside risk and leveraging opportunities. By aligning with the right manager, wealth advisers and family offices can unlock sustainable returns while preserving capital in a shifting economic landscape.