The Pros and Cons of Investing in Private Debt

For decades, only financial institutions, such as banks and insurance companies, and wealthy investors got to collect the double-digit interest rates on loans made to small and midsize private companies.

Now, however, a growing number of investment firms and entrepreneurs are working to help regular investors gain access to those attractive yields. At least six new publicly traded funds specializing in private credit launched in the first 11 months of 2024, gathering about $8 billion in assets. In all, publicly traded funds giving investors access to private credit now hold more than $355 billion, up from $190 billion in 2019, according to research firm CFRA.

And investors can expect more opportunities. Early December saw the launch of two exchange-traded funds specializing in private collateralized loan obligations, or securitized pools of private loans. And several major fund companies have applied to the Securities and Exchange Commission for permission to launch other funds in 2025 that attempt to offer more private investments to the general investing public.

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The democratization of private credit opportunities “represents a ton of potential for investors,” says Elliot Dole, a certified financial planner in St. Louis. “There are very compelling reasons to invest in them,” he says. For example, the values of private investments don’t necessarily follow the same daily up-and-down patterns of publicly traded stocks and bonds, so these alternative investments can diversify portfolios.

And the returns are attractive, adds Dole, especially compared with other income options. Many private-credit funds were boasting yields in excess of 10% at the end of November. And they notched an average one-year total return of 10.9% for the 12 months ending June 30 (the most recent date for which private return data was available), according to data firm Pitchbook. In comparison, the Bloomberg Aggregate Bond index reported a current yield of 4.7% and a total return of 2.6% in the year ending June 30.

These alternative investments have risks. Many analysts warn that the flood of investor money pouring into this sector can’t help but push returns down, as the expanding supply of money available to lend exerts downward pressure on the interest rates on the loans and, hence, the yields earned by investors. In addition, private investments are, by their nature, more difficult to evaluate, raising the risks of unpleasant surprises.

Publicly traded funds of private investments have plunged and soared more dramatically than funds tracking publicly traded stocks or bonds in recent years. The average publicly traded fund invested in private credit had a maximum drop of 34.4% in the past three years, compared with a 24% maximum drop in the S&P 500 index and a 7.4% maximum drop in the overall bond market.

Take a long-term view of private-credit investments

Those combinations of risks and rewards make private-credit investments appropriate for income-seeking investors who can afford to leave money untouched for several years, says Dole, who has put some of his own money into the category. For some investors, that might mean only 1% to 2% of their portfolio assets; for others, it might mean allocations in the low- double-digit percentages, he says.

Finding the right investment vehicle to tap the private-credit market takes a little work. The largest market for private credit involves loans to healthy private businesses. But investors can also seek out riskier options, such as financing lawsuits, purchasing music copyrights and buying life insurance settlements.

The vast majority of private-credit funds are not publicly traded, have long lockup periods and are offered only to wealthy investors, such as those who can meet the SEC’s threshold for an accredited investors by proving a net worth of at least $1 million, not counting their home.

Regular investors who want more-liquid investments and prefer to stick with funds operating under stricter SEC regulations can explore publicly traded business development corporations, typically referred to as BDCs, and standard exchange- traded funds that may hold stakes in BDCs.

You may also be hearing more about “interval funds,” which a growing number of fund sponsors are using to offer private investments to the public. More than 20 new interval funds have been launched so far this year, according to research firm Morningstar. And large alternative asset managers, including a partnership between KKR and the Capital Group, have proposed forming more interval funds in 2025.

Both BDCs and interval funds have special rules that enable them to pool many untraded private loans and equity stakes in private companies into investment vehicles that can be purchased daily from brokerages. But while interval funds allow investors to purchase shares at any time, they accept only a limited number of sales at certain intervals, generally quarterly. Many major brokerages require purchases to go through advisers to ensure that investors are warned about liquidity limitations.

Because they can be bought and sold like stocks or ETFs, BDCs are generally considered to be more familiar and attractive to individual investors. These funds typically make loans to or equity investments in small and midsize private firms. Such loans and investments generally aren’t expected to pay off for years, which means BDCs can’t easily get cash to redeem shares if their own investors want out. So BDCs trade as closed-end funds with a fixed number of shares, the price of which can trade at a premium or discount to the value of the BDC’s underlying holdings.

BDCs are similar to real estate investment trusts in that they are required to distribute 90% of their profits to their investors annually. BDC fund managers are also allowed to use leverage, using borrowed funds to acquire portfolio assets — in this case, borrowing at low short-term rates to lend out at higher, longer-term rates. That increases risks, but also holds out the potential for raising returns.

Morningstar lists 58 publicly traded BDCs, six of which were launched this year. BDCs come with high fees, including operating and interest expenses, as well as performance-based management fees — and these fees may be broken out separately, together or a combination of the two. Some ETFs that hold shares in many BDCs report expense ratios in excess of 12%. For context, consider that mutual funds consisting of publicly traded bonds — funds that face intense competition and don’t collect performance compensation — charge an average expense ratio of 0.37%, according to the Investment Company Institute.

How to invest in private debt

Because many private-investment funds are comparatively small, or focused on particular niches, analysts say the safest way to dip your toes in the private market is to look for large and broadly diversified BDCs that opt for the most secure types of investments — typically business loans, sometimes referred to as direct lending.

One standout is Ares Capital Corp. (ARCC). As the nation’s largest BDC, it has lent money to or invested in 535 private companies. One-fourth of the BDC’s approximately $26 billion in assets are invested in software or technology services firms; another fourth of the portfolio is allocated to health care and commercial services companies.

Ares Capital uses leverage to enhance its yield, but more than half of the loans in the portfolio are classified as “senior,” meaning that they get paid off first in the event of a bankruptcy. Ares has notched a total return of 21.4% over the past year and 10.6% over the past five years. The fund’s dividend yield was 8.7% as of November 30. Twelve of the 14 analysts who follow the fund are bullish and say the portfolio boasts a good balance of safety and returns.

For more diversification, investors can opt for one of several ETFs that hold shares of many BDCs. Virtus Private Credit (VPC) holds 35 BDCs, including Ares Capital, and other major players such as Golub Capital BDC (GBDC). Golub holds about $8 billion worth of floating-rate loans to businesses and yields 10.2%.

Because Virtus invests in BDCs with high expense ratios, the ETF itself has an expense ratio of 9.7%. But even after those fees, it yields 11.7%. Its one-year total return of 16.4% puts it in the top percentile for its category, as does its five-year annualized return of 8.2%.

Another, more diversified option is Invesco Global Listed Private Equity (PSP), with 58 holdings, including some BDCs but also the stocks of some asset managers that are big players in the private debt market. The fund’s yield is comparatively low by BDC standards, at 2.5%. But its 36.9% total return for the past year places it in the top 5% of its category. The fund ranked at least seventh in its category in three of the past five years.

Among Invesco’s standout holdings is Blackstone (BX), a member of the Kiplinger Dividend 15, the list of our favorite dividend payers. Blackstone yields 1.8%. With $1.1 trillion worth of real estate loans, business loans and equity holdings in private companies, Blackstone is the largest alternative asset manager in the world. Interest rate cuts and a continuing strong economy helped lift the stock to a 72% return over the past 12 months.

Note: This item first appeared in Kiplinger Personal Finance Magazine, a monthly, trustworthy source of advice and guidance. Subscribe to help you make more money and keep more of the money you make here.

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