Canadian institutional investors are taking on more private credit, both as a replacement for equity, as well as a tool to enhance their fixed income allocations, said Janet Rabovsky, partner at Ellement Consulting Group in a webinar presented by the Canadian Investment Review on Tuesday.

For pension plans in particular, the equity-like return that private credit can yield, accompanied by significantly lower volatility than equities, has major appeal, she said.

But what is private credit?

“Private credit is exactly as the word states, credit that’s not publicly traded,” said Rabovsky.

Read: Hydro Québec pension plan cautious about credit

There’s no strict definition for the asset class, she added, noting it’s a catch-all term that encompasses a range of solutions, the most popular of which is direct lending. Debt tied to infrastructure and real estate also fall into this category.

As with any asset class, there are pros and cons to investing, and the choice to take on private credit should be determined by both financial and non-financial factors, said Rabovsky.

Liquidity is one factor to consider. “As with other private asset classes, one hopes to access an illiquidity premium. Some might argue that this is diminishing given the popularity of this asset class. But it still remains, especially outside of core holdings.”

Private credit’s lower volatility and tendency to be floating rate, meaning returns will go up as interest rates do, are also attractive aspects of the asset class, added Rabovsky.

Picking the right manager when first entering the asset class is extremely important, she noted. “Disciplined and skilled managers who have experience in negotiating covenants and asset security have an advantage, as do those who have invested through the global financial crisis.”

Read: Are investors becoming cautious around private debt?

It’s also important for investors to understand what they’re getting into. The asset class is more complicated than traditional fixed income, using vehicles investors may not be familiar with, while higher fees and different tax considerations are also in play, said Rabovsky.

“As with any asset class, investors should not invest in something they don’t understand and don’t have the time to monitor.”

As with all debt-based investment, default risk goes hand-in-hand with private credit, she said. “It’s fair to say there will be defaults. These are higher risk loans, but many don’t experience any permanent capital loss or very little capital loss ratios, with ratios which are well below those of high-yield debt.”

When specifically considering direct lending, the most popular form of private credit, there are several sub-categories and distinctions, noted Rabovsky.

“Loans can be sponsored or non-sponsored,” she said. “A sponsored deal is where money is lent to a private equity sponsor who will usually purchase the company with 50 per cent equity and 50 per cent debt. This means that when there are issues with the company, there are equities backing the company which can be drawn on and the sponsor may be asked to provide more capital.”

Read: Private credit demystified: It’s not just about corporate lending

Non-sponsored lending, on the other hand, is lending directly to the business owner. This method is less popular because it often requires more hand-holding from the lender, though returns are generally higher, congruent with the added effort, said Rabovsky.

Within real estate debt, a borrower is leveraging a real asset — in this case, physical property. “It includes both commercial mortgage and senior-secured and mezzanine debt. Real estate debt funds have become popular as they can close on a deal much more quickly than a bank and offer the borrower more flexibility.”

One increasingly popular form of real estate debt is commercial mortgages, especially in the current low interest rate environment, noted Rabovsky.

Infrastructure debt is also secured against physical assets. As with real estate debt, infrastructure tends to be purchased through a combination of debt and equity, she said, noting a social infrastructure asset, like a hospital, is likely to be closer to 90 per cent debt, since it probably includes a guaranteed government payment to the investor.

Read: Why are institutional investors embracing private credit?

A port, on the other hand, is an example of economic infrastructure, and would be with about 50 per cent debt and 50 per cent equity, said Rabovsky.

When investors are considering a private credit investment, they should ask themselves two key questions, she added. “What are you hoping to achieve? And where in the portfolio are you going to be placing this? Is this an equity replacement or is this a fixed income enhancer? And that may determine whether you’re looking at the more public or private forms of credit.”