Private Credit vs. Private Equity: What's the Difference?

Private Credit vs. Private Equity: An Overview

Securities traded on the public markets, like stocks and bonds, may be the backbone of most everyday investors’ portfolios. But there are also plenty of alternative investments that aren’t publicly available, like private credit and private equity.

These assets can be quite profitable, but because they’re also risky and tend to tie up capital for a long time, trading generally takes place among institutional investors and accredited investors.

In the private credit market, investors make loans to businesses and sometimes individuals who may have trouble accessing credit from banks or the public market. Because there is often a heightened risk that the borrower may be unable to repay the loan, private credit investors can collect higher interest rates than they would earn on bonds or other debt investments.

Private equity investing, meanwhile, involves taking an ownership share in a company that isn’t currently traded on the public markets. Unlike a stock, which can be easily bought and sold on a public exchange, private equity investments require investors to make a longer-term commitment with their capital. In exchange for this lack of liquidity, private equity investors also look for elevated returns.

The chance for outsized gains might make private credit and private equity attractive to investors who have access to these private markets.

Private Credit

When you invest in private credit, you lend out your money—mainly to companies, but occasionally to individuals—and then generate returns by collecting interest payments.

Private credit plays an important role in the financial system by making loans available to businesses that may not be able to secure them through banks or the public debt markets.

The borrowers seeking these private, non-bank loans often have credit ratings that are below investment grade, suggesting a heightened risk that they may not be able to pay their debts. To compensate for the greater risk of default, they generally have to pay higher interest rates. This means the potential for higher profits for investors willing and able to stomach the risk.

As investors in private credit are making loans, rather than acquiring an ownership stake, they are more likely to be repaid if the borrower faces bankruptcy. In addition, there is a chance for diversification, with the flexibility to invest in different types of loans with distinct risk/return profiles. Private loans often have floating interest rates, which can benefit investors when rates increase.

However, given the risks involved, private credit firms often require investors to meet strict accreditation standards and start with a high minimum investment. Private credit firms also make loans for extended terms, requiring investors to commit their capital over long time frames.

Large institutional investors are central players in the private credit industry because they have the scope and expertise to manage these potential drawbacks.

Private Equity

Rather than making a loan, investors in private equity are acquiring an ownership stake in a company. Private equity firms typically pool together assets from institutional investors and accredited investors into large investment funds.

Then they use this money to acquire companies. This may include purchasing businesses that are already privately owned or taking control of public companies in their entirety. Firms often form consortiums with other investors to complete these buyouts.

Once a private equity firm has taken control of a target company, it will carry out a strategy to increase the value of its investment. That could include significant restructuring or cost cutting. The goal is to add value and then exit the investment, which could be done through a sale to another owner or by taking the company public through an initial public offering (IPO).

A successful private equity transaction can be very profitable for investors. However, because these exit strategies take time to develop, private equity investors also tend to have their investments tied up for extended periods.

In addition, along with the chance for stellar gains from private equity comes the risk of painful losses. As shareholders, private equity investors would be among the last to be compensated in the event of bankruptcy, meaning they could lose 100% of their investment.

Given the lack of liquidity and heightened risk levels, private equity firms also limit participation to institutions and individuals with significant wealth and financial sophistication. However, these high barriers to entry haven’t restricted the growth of the private equity market.

Key Differences

Private credit and private equity share some key similarities. They both represent alternative investments available only on a private basis. In addition, they typically have strict accreditation standards and require lofty minimum investments, leading to a concentration of institutional investors in both areas.

Management fees also tend to be high for these private investments, but investors are rewarded with the potential for outsized returns. This helps explain why both asset classes have experienced tremendous growth in recent decades.

There are also some important differences to keep in mind. For one thing, private equity involves taking an ownership stake, while private credit represents a loan. This makes the two types of investment quite different in terms of their risk-reward profile.

Private equity investors could earn huge profits if and when the company they invested in is sold or brought public. Conversely, they could lose their investment entirely if the company is unsuccessful. Meanwhile, returns for private credit investors are more predictable—established by the terms of the loan and relatively stable (provided the borrower doesn’t default).

The Bottom Line

Investing in private credit involves making loans to companies or individuals and collecting interest payments, while private equity investors acquire an ownership stake in a company whose shares don’t currently trade on the public markets.

Both of these investment classes may offer higher potential returns than their publicly traded counterparts, but they also tend to be highly expensive, less liquid, and less transparent, making them more suitable for institutional investors and accredited investors.