Private Credit: A Complete Guide

Private credit—also called private debt or direct lending—refers to loans and debt instruments provided by non-bank lenders to companies, real estate projects, or other borrowers. Unlike bonds traded on public markets, these are privately negotiated agreements between lenders and borrowers.

The private credit market has experienced explosive growth, reaching $3.5 trillion in assets under management globally by 2025—more than doubling since 2020. This expansion followed the 2008 financial crisis, when regulatory changes (Basel III, Dodd-Frank) forced banks to reduce lending, creating a structural opportunity for alternative lenders. The trend has only accelerated as banks continue to retreat from middle-market lending.

For investors, private credit offers potentially higher yields than traditional fixed income—typically 9–12% annually—with different risk characteristics than public bonds. The asset class has become a core component of institutional portfolios and is increasingly accessible to individual investors through new platforms and fund structures.

The Lending Process

Private credit involves direct negotiations between lenders and borrowers, bypassing traditional bank intermediation:

Origination: Lenders source opportunities through private equity sponsor relationships, direct outreach, or intermediaries Underwriting: Comprehensive due diligence on borrower financials, business quality, collateral, and repayment capacity Structuring: Negotiating terms including interest rate, covenants, security package, and amortisation schedule Documentation: Detailed legal agreements governing the loan, including protective covenants Monitoring: Ongoing surveillance of borrower performance, covenant compliance, and early warning indicators

Fund Structures

Most private credit exposure comes through pooled funds:

Closed-End Funds: Fixed terms (typically 5–7 years), drawing capital as loans are made and returning proceeds as loans mature or are repaid. Similar to private equity fund mechanics.

Open-End / Evergreen Funds: Continuous offerings with periodic liquidity, allowing ongoing investment and quarterly or monthly redemptions. Increasingly popular for retail access.

BDCs (Business Development Companies): US publicly traded vehicles providing retail access to private lending with daily liquidity.

Income Generation

Private credit generates returns primarily through:

Interest Income: Regular coupon payments, typically floating rate (base rate + credit spread) Origination Fees: Upfront fees of 1–3% for arranging loans Prepayment Penalties: Fees charged if borrowers repay early, protecting lender economics PIK Interest: "Payment-in-kind" interest added to principal rather than paid in cash—increasing total return but deferring actual cash receipt

Private credit encompasses diverse strategies across the risk-return spectrum:

Direct Lending The largest and most established segment—providing senior secured loans to mid-market companies, often backing private equity transactions. Direct lending represents over half of the total private credit market. Typical spreads of 500–650 basis points over the base rate, with first-lien security on all borrower assets.

Mezzanine Debt Subordinated loans ranking below senior debt but above equity in the capital structure. Higher yields (12–18%) compensate for the increased risk of being further back in the repayment queue. Often includes equity warrants or conversion rights, giving lenders upside participation.

Distressed Debt Purchasing debt of troubled companies at significant discounts to face value, seeking profit through restructuring, recovery, or operational turnaround. High risk but potentially exceptional returns for managers with specialist workout expertise.

Special Situations Opportunistic lending for complex, time-sensitive scenarios: rescue financing for companies in distress, bridge loans to cover gaps between transactions, and debtor-in-possession financing in bankruptcy proceedings.

Asset-Based Lending Loans secured by specific tangible assets: receivables, inventory, equipment, or real estate. The asset coverage provides meaningful downside protection, making this one of the lower-risk private credit strategies.

Venture Debt Lending to venture-backed companies, typically alongside or between equity funding rounds. Often includes equity warrants as additional compensation. Bridges funding needs without equity dilution for founders and existing shareholders.

Real Estate Debt Loans secured by property assets: construction financing, bridge loans for value-add projects, and mezzanine debt on commercial real estate. Returns and risks vary significantly by position in the capital stack and property type.

Each strategy offers different yield, risk, and liquidity characteristics. Most investors access private credit through diversified funds spanning multiple strategies.

Return Expectations

Private credit has delivered compelling risk-adjusted returns:

Historical Performance: 10-year annualised returns of approximately 12.1% for senior direct lending strategies Current Yields: Senior loans typically offer 9–12%; mezzanine strategies 13–17% depending on market conditions and base rates Income Focus: Unlike equity investments, most returns come from predictable, contractual interest income rather than speculative capital appreciation

The income-oriented nature of private credit makes it particularly attractive for investors seeking regular cash flow—a characteristic that distinguishes it clearly from private equity or venture capital.

Risk Factors

Credit Risk: Borrower default remains the primary concern. Historical default rates for sponsored middle-market loans have averaged 2–4% annually, with recovery rates of 60–70% on senior secured positions.

Illiquidity Risk: Loans cannot be easily sold on secondary markets. Investors must generally hold positions until maturity or fund wind-down, though secondary market activity is growing.

Interest Rate Risk: Most private credit is floating rate, which protects lenders against rising rates. However, higher rates create borrower stress that can increase default risk—a dynamic that played out during the 2022–2023 rate hiking cycle.

Selection Risk: Manager skill significantly impacts outcomes. Poor underwriting leads to elevated defaults and lower recoveries. The dispersion between top and bottom quartile managers is meaningful.

Economic Sensitivity: Recessions increase default rates and reduce recovery values. Private credit has performed relatively well through recent downturns, but it is not immune to economic stress.

Volatility Characteristics

Private credit exhibits lower mark-to-market volatility than public bonds—valuations update quarterly based on credit assessments rather than daily market prices. This can obscure underlying risk while providing reported portfolio stability. Investors should understand that low volatility in private credit is partly a feature of infrequent pricing, not necessarily lower fundamental risk.

To understand private credit risk, you need to understand where different debt instruments sit in a company's capital structure—the hierarchy that determines who gets paid first if things go wrong.

The Capital Stack (Top = Safest)

Senior Secured Debt (First Lien) - First claim on all company assets - Lowest risk within the capital structure - Typical yields: base rate + 500–650 bps - Historical recovery rates: 60–80%

Second Lien / Unitranche Debt - Subordinate to first lien or blended senior/sub structure - Higher yield compensates for lower priority - Typical yields: base rate + 700–900 bps

Mezzanine Debt - Unsecured or subordinated to all senior debt - Often includes equity warrants or PIK interest - Typical yields: 12–18% - Recovery rates: 20–40%

Preferred Equity - Sits between debt and common equity - Fixed dividend but no guaranteed repayment - Higher risk, higher return potential

Common Equity - Last in line for repayment - Highest risk but unlimited upside - This is what private equity invests in

Why Position Matters

In a default scenario, senior secured lenders are repaid first from asset liquidation. If a company's assets are worth less than its total debt, losses flow upward through the capital stack—junior creditors absorb losses before senior creditors. This is why senior direct lending has historically delivered low loss rates (sub-1% annually for quality managers) despite operating in higher-risk mid-market segments.

Allocation Considerations

Institutional investors typically allocate 5–15% of portfolios to private credit, seeking:

Yield Enhancement: Meaningfully higher income than investment-grade bonds or savings accounts Diversification: Low correlation with public equities and bonds Downside Protection: Senior secured positions with contractual asset coverage Inflation Hedge: Floating rates adjust automatically with interest rate changes

Complementary Role

Private credit occupies a distinctive middle ground in the alternatives landscape: - Higher yield than investment-grade bonds - Lower volatility than public high yield - Less upside than private equity but more predictable income - More liquidity than private equity but less than public bonds - Income starts immediately rather than requiring a multi-year J-curve

Suitable Investors

Private credit suits investors who: - Can commit capital for 3–7+ years (depending on fund structure) - Prioritise regular income over capital appreciation - Accept illiquidity in exchange for higher yields - Have portfolios large enough for a meaningful allocation - Want private market exposure with lower risk than equity strategies

Institutional Funds Traditional private credit funds require £1–5 million minimums but offer access to top-tier managers and diversified strategies. These are the primary vehicles for pension funds and endowments.

Feeder Funds and Platforms Platforms like iCapital, CAIS, and Moonfare aggregate smaller investors, offering access with £50,000–100,000 minimums. These platforms handle due diligence, operational complexity, and reporting. Fees layer on top of underlying fund costs.

Business Development Companies (BDCs) Publicly traded BDCs provide instant liquidity and low minimums: - **Ares Capital (ARCC)**: Largest BDC, diversified direct lending - **Main Street Capital (MAIN)**: Lower middle-market focus with internal management - **Blue Owl Capital (OBDC)**: Institutional-quality direct lending at scale

BDC dividends often yield 8–11%, though share prices can be volatile and may trade at premiums or discounts to net asset value.

Interval Funds and Evergreen Structures A growing category of semi-liquid vehicles: - Lower minimums than traditional PE-style structures - Quarterly or monthly liquidity windows (with limitations) - Simpler tax reporting than partnership structures - Suited to individual investors seeking private credit exposure

UK-Specific Options - **Investment trusts**: Listed vehicles with private credit exposure (e.g., Ares Capital Europe) - **Specialist wealth platforms**: Curated access through advisers and wealth managers - **P2P lending platforms**: Direct lending at smaller scale (Funding Circle, Assetz Capital, LendInvest)—though these carry different risk profiles

Due Diligence Priorities

When selecting a private credit manager, evaluate: - Track record through full credit cycles (not just bull markets) - Default and recovery experience, including workout capabilities - Sourcing and origination network - Portfolio construction: diversification across sectors, borrowers, and geographies - Fee structures and alignment with LP interests - Transparency of reporting and valuations

Market Maturity Risks

The private credit market's rapid growth brings its own risks:

Competition and Spread Compression: With over 100 direct lending funds competing for deals, credit spreads have tightened and documentation has become more borrower-friendly. This means lower returns and weaker protections for lenders.

Covenant Erosion: As competition intensifies, lenders accept weaker covenants—reducing early warning signals when borrowers face trouble. "Covenant-lite" terms are increasingly common even in private credit.

Adverse Selection: In a competitive market, the most disciplined managers may lose deals to those willing to accept lower standards. Quality of new lending may deteriorate.

Structural Risks

Leverage on Leverage: Many private credit funds use fund-level borrowing (subscription lines, NAV facilities) to enhance returns. This adds a layer of leverage on top of already-leveraged portfolio companies.

Valuation Subjectivity: Private credit valuations rely on manager estimates. In stress scenarios, reported NAVs may not reflect realisable values, potentially masking losses until they crystallise.

Refinancing Risk: As loans mature, borrowers must refinance—potentially at higher rates or on less favourable terms. A wave of maturities in a difficult market can stress the entire ecosystem.

Key Takeaways

Private credit has earned its place as a core alternative asset class, offering attractive income, diversification, and downside protection through the capital structure. However, the market's rapid growth and increased competition mean that manager selection has never been more important. Choose experienced managers with proven credit cycle track records, disciplined underwriting, and genuine alignment with investor interests.