Private credit

Private credit is a rapidly growing segment of the private markets that functions as an alternative to traditional bank loans or public debt markets. Compared to these other debt financing options, private credit can provide borrowers a higher degree of financial flexibility, including more customizable loan terms and repayment schedules. 

In the 2010s and early 2020s, privately held companies have increasingly turned to private credit as a way to fuel their growth. Today, experts place the size of the global private credit market at more than $1 trillion, with plenty of room for expansion on the horizon.

What is private credit? 

Private credit is a type of corporate financing in which companies raise loans from non-bank lenders such as specialized private credit firms, asset managers, private equity firms, or hedge funds. While many types of companies can and do raise private credit, this type of lending is often associated with the private markets, particularly private equity-backed companies. Private credit has become a common source of the loans that many PE firms use as a key component in leveraged buyouts. 

The capital that these non-bank lenders provide to companies typically comes from investment funds that the lenders raise from limited partners (LPs), who invest in the fund for the purpose of generating financial returns. This structure—investing through a fund—gives private credit managers an established pool of capital that they can deploy quickly and flexibly at their own discretion. These factors help differentiate private credit from traditional bank loans, which are typically financed and syndicated on a deal-by-deal basis that can involve many complicated negotiations among stakeholders.

Because a private credit loan does not typically involve broad syndication, the lender and borrower can negotiate terms directly to meet their specific needs, rather than structuring the loan so it will attract other investors. Some of the key points of negotiation can include interest rates, repayment schedules, covenants, and collateral requirements. 

Many investment firms deploy capital primarily or exclusively in the private credit market. Increasingly, large private equity firms and other established investors are also branching into the private credit space. 

Private credit vs. other financing types

To better understand how private credit works and its place within the economy, consider some of the other ways in which companies can raise new financing:

• Public equity financing is when a publicly traded company issues and sells new shares for trading on a stock exchange, such as the NYSE or Nasdaq. Anyone with access to a brokerage account can invest in public equity. 

• Private equity financing is when a company issues and sells new stock through a privately arranged transaction, such as a venture capital round. The two main segments of private equity are the venture capital market and the buyout market, which is also commonly referred to on its own as “private equity.” Most investments in this space come from funds that are raised specifically for the purpose of investing in private companies, such as venture capital funds and buyout funds. 

• Public debt financing is when a company issues bonds or other debt instruments that are may or may not trade on a public exchange such as the NYSE Arca or via the over-the-counter market. Capital for public debt comes from public investors, and the trading price of public debt products varies to reflect investor confidence in the borrower’s future ability to maintain payment and market interest rate expectations, among other factors. 

• Bank lending is when a company raises debt through a bank. For borrowers, this has historically been the primary alternative to public debt. Most commonly, a bank first agrees to make a private term loan or revolver to a company, then, if the commitment requirement is substantial, raises the capital by syndicating the loan among other lenders. These loans are historically raised, negotiated, and syndicated on a deal-by-deal basis. Private credit has gained significant traction relative to traditional bank debt since the 2008 financial crisis, driven largely by regulatory changes that constrained bank lending and made it more costly—this caused many banks to scale back their lending to middle-market companies, particularly those with higher leverage or unconventional financial profiles, and increased demand for the flexible financing offered by  private lenders. 

Private credit has fewer disclosure requirements than public credit, which can make private loans simpler for in-house finance teams to organize and execute. Private credit also tends to be a less liquid market than public credit, in the same way that private equity is less liquid than public equity markets. 

Private credit investment strategies

Within the widening world of private credit, there are several types of opportunities that investors might pursue—investments in different types of debt, issued by different types of companies, that come with different profiles of risk and reward. Some funds are solely dedicated to one of these strategies, while others pursue a more varied approach.  

In addition to private credit investors, all of these loan types are also issued by banks and other traditional lenders. 

Senior debt

Senior debt is a loan that takes priority over other debt issued by a company in the event of a bankruptcy or liquidation. If a company goes out of business and has limited assets to pay back its lenders, any holders of senior debt will be made whole first, before holders of more junior debt receive any return. Because of this prioritization, senior debt is seen as the least risky place to invest in a company’s capital stack. Lenders may negotiate for senior debt status based on the amount of capital they’re providing, the quality of the collateral backing the loan, or their bargaining position in the transaction.

Mezzanine debt

Mezzanine debt is a type of issuance that combines debt but without the priority of senior debt. It is subordinate to senior debt in the capital stack, which means that if a company liquidates, senior debt holders are paid back before mezzanine debt holders. This often makes mezzanine debt a riskier investment than senior debt. To compensate for this risk, mezzanine debt also frequently has higher yields than more senior debt products.

Mezzanine debt often includes some mechanism by which the loan might convert to equity or the lender might otherwise acquire equity in the company. Private equity investors frequently use mezzanine debt to help finance leveraged buyouts. 

Distressed debt 

Distressed debt refers to debt issued by a company that is either in default or experiencing some other form of financial difficulty. Distressed debt is typically rated below investment grade, and because of this, they often offer higher yields. Compared to other forms of debt, there’s a higher-than-normal chance that an investment in distressed debt will zero out, and because of this increased risk, distressed debt also typically brings the potential for higher-than-normal returns.

Unlike senior debt or mezzanine debt, distressed debt is not a particular type of debt that a company chooses to issue. Almost any type of debt product that’s issued might eventually become distressed debt if the issuer fails to live up to its financial expectations.

If a loan becomes distressed, the lender may begin to charge penalty interest, which typically increases the loan rate (and thus the yield). A lender might also increase the rate of a distressed loan through a restructuring. In some cases, a lender might choose to sell a distressed loan through the secondary debt markets. If a new investor buys a distressed loan at a discount, then by definition, the effective interest rate on the loan will also increase, again increasing the potential yield. 

Venture debt

Venture debt refers to a loan that’s issued to a startup company that’s backed by venture capital. In most cases, companies that raise venture debt have already raised prior rounds of equity funding from VCs and are looking for additional capital to fuel medium- or late-stage growth without incurring further equity dilution. Venture debt is typically seen as a complement to traditional venture capital funding, rather than a replacement.

Special situations lending

Special situations lending involves issuing loans to companies in need of financing to support rare or one-off events, such as a company restructuring or an M&A deal. Some special situations loans might also qualify as distressed debt, and like distressed debt, special situations loans tend to be higher-yielding than some other types of private credit. The situations that prompt these types of loans are often complicated and unique, sometimes requiring significant expertise and oversight from lenders. 

Asset-based lending

Asset-based lending involves loans that are secured by specific assets, rather than by the general credit of the borrower. These types of loans can be an attractive alternative to traditional term loans for  borrowers with limited cash flows or with valuable portfolios of other assets, which can include accounts receivable, inventory, equipment, or real estate. Because  the value of these sorts of assets can be difficult to assess when compared to cash, issuing asset-based loans can require additional expertise and diligence on behalf of lenders. 

Secured loans and unsecured loans

Many loans in the private credit market are secured. In order to obtain a secured loan, a company puts up some assets as collateral. These assets might be  hard assets, such as in asset-based loans, which are a type of secured loan.  If a company fails to repay a secured loan as scheduled, it may enter default, and the lender could liquidate or seize some or all of the collateralized assets as compensation.  These secured loans may be satisfied with the security assets before payments are made to general creditors, including senior debt holders.  

Other private loans are unsecured, where the borrower does not put up collateral. Because unsecured loans present increased risk to the lender, they also typically feature higher interest rates, making them more expensive to the borrower. Other terms of unsecured loans can also be less friendly to borrowers. Unsecured loans are more likely to be found in higher risk areas of the market, such as mezzanine credit and distressed credit. 

Why private credit appeals to investors

In most cases, the capital that private lenders supply to companies originates with limited partners, who invest in private credit funds because they expect to generate an attractive return. The recent boom in private credit thus reflects a growing interest in the sector among LPs. Some of the primary reasons that investors are drawn to private credit include: 

Higher yields

Private credit usually offers higher interest rates to investors than public credit, which converts to higher yields. This is mainly to compensate investors for the fact that private credit tends to be less liquid. Since capital may be tied up for longer in a private loan than in a public one, investors often receive more favorable interest rates, a trade-off for the reduced degree of flexibility.

Most private loans are based on some benchmark lending rate, such as the Secured Overnight Financing Rate or Treasury yields. On top of this benchmark, most lenders add a credit spread, which can be thought of as a premium  that the borrower agrees to pay on top of the benchmark rate in order to compensate the lender for the risk of issuing the loan. Spread is often measured in basis points, or bps. Loans with a higher risk of default tend to have higher spreads. 

Diversification

Private credit can also be an attractive way for investors to diversify their portfolios and invest in assets that are less correlated with public markets. Many of the companies that raise private debt funding are privately owned, including many smaller companies in narrow industries that tend to be less represented on public exchanges.  

Regular cash flows

Most private credit investments provide predictable cash flows in the form of regularly scheduled payments. This is very different from private equity, where returns to investors tend to be infrequent. Private credit can be an attractive option for investors seeking exposure to private companies without sacrificing stable cash flows. 

Customization

The various investment strategies that exist within the private credit space allow investors to customize their approaches. Investors can choose between senior debt, mezzanine debt, distressed debt, or other deal types, and they can also choose between various repayment structures, covenants, and other loan terms. 

Potentially reduced downside 

Some areas of private credit are seen as relatively safe investments where allocators can lock in stable returns with little danger of losing capital. This is particularly true of secured loans, where the borrower puts up collateral in exchange for financing. These loans also typically offer lower yields than some other asset classes, but the trade-off can be attractive for investors focused on risk-adjusted returns.  

Why private credit appeals to companies

Just as there are several reasons investors might deploy capital into private credit funds rather than other asset classes, there are also several reasons companies might turn to private credit rather than other financing options: 

Flexible terms

Private lenders are more likely to offer customizable loan structures that can meet a borrower’s specific needs, including flexible repayment timelines and covenants. Bank lenders are more likely to structure their loans on standard underwriting or banking models. 

Easier access to capital

The process of raising private credit is typically faster and more streamlined than raising a bank loan, with fewer approvals required before closing a deal. This can be appealing to companies operating on a specific timeline. Private lenders may also be more willing than banks to issue private loans to companies with seasonal revenue swings or other non-standard financial models. 

Higher leverage

Depending on the company and the situation, private lenders might also be more likely than banks to issue loans that will leave the borrower highly levered—that is, with a high level of debt relative to the company’s assets and income. This access to leverage can be particularly appealing for companies that are in distress or navigating other special situations. 

Disclosures and oversight

Private loans typically require fewer regulatory disclosures and less regulatory oversight than publicly traded loans. This can allow companies to raise financing more discreetly and confidentially. 

How private credit works

The full process ranging from when a firm raises private credit financing and issues debt to when the debt is fully repaid  can take many years and cover many twists and turns. Some private loans look very different from others, with varying timelines, deal terms, and covenants between borrower and lender. In general, however, the timeline of raising private credit often follows a similar outline: 

Capital sourcing

Traditionally, private loan providers source capital from LPs who are looking to generate some long-term return on their investment. In most cases, private lenders raise this capital through specialized funds with lifespans of several years. This process of raising fund capital and maintaining LP relationships is historically a key business need for private lenders. 

Increasingly, however, some of the largest private lenders in the industry are maintaining pools of perpetual capital instead of raising discrete, closed-end credit funds. In some cases, the capital that underlies these evergreen funds is sourced from insurance providers or other businesses with long-term needs for steady capital accumulation. 

On the company side, relationships also play a major role in sourcing capital from lenders: Companies raising private credit financing often have existing ties with investors, investment banks, or other financial advisors who may have their own connections with private credit providers—or, in some cases, may be private credit providers in their own right. In addition to leveraging existing networks, a company might also seek other potential lenders who specialize in the size or type of loan that the company hopes to raise. 

Identifying borrowers

Many different types of companies can and do raise private credit financing. However, there are a few particular company archetypes that are most closely associated with the private credit industry: 

Middle-market businesses

Many borrowers in the private credit industry fall within the middle market, typically defined as having annual revenue between $10 million and $1 billion. In addition to the other attractions of private credit, these types of companies may be drawn by a lack of alternatives: Many of the companies in this bracket don’t have enough market interest to successfully issue public bonds or raise syndicated loans through traditional banks.

LBO targets

A company that’s being acquired by a private equity firm via an LBO typically adds new debt to its balance sheets to help finance the transaction. In many cases, some or all of this debt is from private lenders. In some LBOs, the debt portion consists only of senior debt, which can come through term loans, revolving credit facilities, or other loan forms. Other LBOs use a combination of senior and mezzanine debt. 

Startups and high-growth companies

Companies that have recently raised venture capital backing may turn to private credit as a way to fuel growth without further diluting their cap tables. In some cases, a startup might raise private credit as a last bit of bridge financing before an eventual IPO. These companies are often drawn by the private nature and customizability of private loans. Like middle-market companies, some startups might also otherwise struggle to raise public debt or syndicated loans.

Companies in financial distress

Due to an increased risk of default, companies in financial distress may struggle to raise debt financing from traditional sources, making private credit an attractive option. The flexibility of private credit is also beneficial for lending to distressed companies, as their situations are often unique and may benefit from creative loan structuring. 

Real estate projects

Most real estate projects require a significant initial outlay of capital many months or even years before they start to generate revenue. In many cases, the source of that capital is some form of loan. As a lender, lending to a real estate project may require different expertise and different knowledge than lending to a company. 

Loan structuring and negotiation

One of the main advantages of the private credit industry is that loans in the space tend to be more flexible and negotiable than public loans or syndicated loans. Some of the key aspects of a private loan that the borrower and lender must negotiate include: 

Loan size

The size of a private loan is typically dictated in large part by the purpose of the loan and the financial profile of the borrower. Most private loans are raised for some specific goal, and the nature of that goal will inform how much capital the borrower hopes to raise. Whether the company is able to obtain a loan of its desired size may depend on how potential lenders assess a range of financial factors, including the company’s revenue, its cash flows, its current leverage levels, and the lender’s broader appetite for risk. 

Interest rate

The interest rate on a loan can be seen as the cost the borrower pays for accessing capital. The higher the interest rate, the more expensive the loan, from the perspective of the borrower. If a lender believes a loan is riskier than others, they may require the borrower to pay a higher interest rate. Other variables around the interest rate are also typically open to negotiation, such as whether the rate is fixed or floating and whether the loan amortizes. 

Servicing interest

Private lenders can offer borrowers the option of servicing their loans through cash interest payments or through payment-in-kind interest (commonly called PIK interest). In cash interest payments, the borrower covers interest on the loan through regularly scheduled cash payments. In PIK interest, instead of paying cash, the borrower continuously adds any new interest that has accrued onto the existing balance of the loan, increasing the total owed.

As such, PIK interest is a way for borrowers to reduce their cash outlay on interest payments in the short term at the expense of increasing their debt load in the future. PIK interest is more commonly seen in riskier debt instruments, such as mezzanine debt, while cash interest is more common in senior debt. 

Maturity

The maturity date on a loan is the time at which full repayment is due the lender. A company and a private lender may negotiate for either longer or shorter maturities depending on the purpose of the loan, the company’s long-term financial outlook, and other variables. 

Repayment schedule

Borrowers in the private credit market typically make regular payments to the lender over the life of a loan, often on a quarterly or monthly basis. The structure of these payments can take many different forms and is often a key aspect of a loan’s terms. 

In some loans, for instance, the borrower might make payments only on the interest throughout the term of the loan, followed by a balloon payment on the principal at the time of maturity. Other loans might be fully amortized, with the borrower making proportional payments on both the principal and the interest over time. Depending on a company’s cash flows and other financial variables, different borrowers might prefer different structures and schedules.

Security and collateral

The borrower and the lender must decide whether a loan will be secured or unsecured, and if it is secured, they must also decide which assets will serve as collateral. Most private loans in the private credit market are secured, which helps mitigate risk for the lender, but there are plenty of exceptions. Mezzanine debt, for instance, is less likely to be secured. Common types of collateral that borrowers might use to secure a private loan include accounts receivable, cash flow, inventory, equipment, and real estate.  

Covenants

A loan covenant is an agreement between a borrower and lender that must be upheld for the borrower to remain in good standing. In private credit, these covenants can take many forms: A loan agreement might include a covenant that the borrower will maintain a certain minimum revenue threshold, or that it won’t take on any more debt. 

Depending on how many of these guardrails are included, a loan might be described as either covenant-heavy or covenant-lite. A distressed or otherwise risky loan is more likely to be covenant-heavy, in order to give the lender warning of any financial trouble or potential default. 

Equity kickers 

An equity kicker is a term in a loan that provides the lender an option to eventually acquire some of the borrower’s equity, giving the lender access to additional financial upside beyond the loan’s repayment. Warrants, convertible debt, and profit-sharing arrangements can all be forms of equity kickers. These types of structures can provide an additional financial incentive to lenders beyond the loan’s interest.

Due diligence and risk assessment

As with any investment in the private markets, a private credit provider typically performs significant due diligence on a potential borrower before it agrees to issue a loan. A major portion of this diligence is determining the creditworthiness of a borrower and weighing how much risk the lender might take on by issuing a loan. 

Compared with investment firms performing diligence for a private equity or venture capital investment, a private lender may be less concerned with a company’s financial upside and more concerned with potential downsides—i.e., the risk it defaults on a loan because the return on most debt is capped.

Funding and deployment

Once the lender conducts due diligence and approves a loan, the process of getting capital into the hands of the borrower tends to be much quicker in a private loan than in a bank loan. Instead of raising capital from other lenders through syndication, which can be a time-consuming process, a private lender can simply wire funding from its own accounts to the borrower’s accounts, potentially calling capital from LPs as needed. 

In some cases, the borrower receives the full amount of the loan up front in a lump-sum disbursement. In others, capital may be drawn at different times throughout the loan term, such as in a revolving credit facility. 

Monitoring and compliance

Private lenders typically require borrowers to provide regular financial statements in order to track the company’s performance and ensure the company maintains any loan covenants. Lenders might also schedule regular meetings or check-ins with company management, and they might employ third-party auditors as an additional level of oversight. 

Repayment and exit strategies

Unlike with a private equity or venture capital investment, a private credit investment has a predetermined timeline, in the form of the repayment schedule. Since a private credit investor makes their money through interest payments, rather than from reselling the company’s equity, there’s no need to determine and execute an exit strategy. Assuming the borrower remains in good standing and makes all payments on time, the formal relationship between the lender and borrower comes to an end once the loan fully matures.  

Participants in the private credit market

As the private credit market has grown in recent years, the number of players actively borrowing and lending in the market has grown, too. Some of the entities that most commonly appear in private credit activity include: 

Corporate borrowers

As covered above, many different types of companies obtain loans through the private credit market. Some of the most common profiles of borrowers in the market include middle-market companies, LBO targets, startups and other high-growth companies, and companies in financial distress. 

Private credit firms

Some investment firms are in the sole business of issuing private loans to corporate borrowers. These firms might specialize in one particular type of private credit, such as mezzanine debt, or they might deploy capital across the asset class. 

Private equity firms

Over the past decade or two, many firms that traditionally focused on making equity investments in private companies have branched into private credit, too. There are clear synergies between the two asset classes, as private credit providers frequently issue loans to companies that are backed by private equity firms.  

Hedge funds and alternative asset managers

Private credit is part of the playbook for many hedge funds and other asset managers that invest across both the public and private markets. This wasn’t always the case: Many years ago, private credit was a niche area populated primarily by lending specialists. Today, it’s a much larger segment of the market populated by some of the largest and most diversified investment firms in the world. Many of the traditional lines between private credit, private equity, and other alternative assets have blurred.

Family offices

Family offices can play multiple roles in the private credit ecosystem, acting at various times as both LPs in private credit funds managed by other lenders and as direct lenders themselves. A family office might also serve as a co-investor providing a portion of the capital alongside another private lender in a larger deal. While cases of family offices issuing loans directly have grown more frequent, it’s traditionally much more common for family offices to invest in private credit as LPs.

Insurance companies and pension funds

As sources of long-term capital, insurance companies and pension funds are some of the most important players in the modern private credit market. These industries are well positioned as capital providers for private credit for multiple reasons, including their long time horizons and requirements for consistent financial growth in a large base of capital. 

In some cases, insurance companies and pension funds act as standard LPs in traditional private credit funds. In other cases, they serve as capital sources for large pools of perpetual capital managed by private credit providers. Apollo Global Management has been a pioneer in this regard with its ownership of Athene Holding, a retirement services provider that now contributes hundreds of billions of dollars to Apollo’s asset base.  

Risks of private credit

These various types of investors are all drawn to the private credit industry by the prospect of generating relatively high returns at relatively low risk. However, there are still plenty of potential risk factors that can derail investments in private credit:

Default

The primary risk in issuing a private loan is default. If the borrower goes bankrupt or becomes unable to make payments for other reasons, the lender might lose some or all of their investment, depending on whether (and to what extent) the loan is secured and any recovery in reorganization or dissolution. 

Refinancing

If a borrower is in danger of default or in other distress, or interest rates have decreased, it may seek to refinance an existing private loan on more attractive terms. If the alternative is default or prepayment, agreeing to a refinancing that might decrease the lender’s potential profit might be the lesser of two evils. 

Illiquidity

Private credit is largely an illiquid asset class, where an investor’s capital might be locked up for several years at a time. Investors may want to consider their liquidity needs before tying up significant capital in private credit. 

Interest rates

The relative performance of investments in private credit can be closely tied to interest rates in the rest of the economy, particularly for private loans with fixed rates. If the interest rate on a private loan is substantially higher than interest rates in the broader economy at the time of issuance, the loan might be in line to produce a better-than-average return. If the rates were to spike, however, the performance of that same loan might start to be outpaced by yields in other asset classes or loans with floating rates. 

Market economics

As the above connection with interest rates shows, the private credit industry is closely intertwined with the broader financial system. In many cases, investing in private credit is also a bet on the underlying success of the companies that act as borrowers in the market. While the tangle of cause and effect is often complex, major shifts in the economy can also have significant knock-on impacts in private credit. 

Legal and regulatory changes

The private credit industry may be affected by future legal and regulatory changes. Such changes may be related to private credit itself, or they may be related to one or more of the many other industries in which private lenders deploy capital. The size and centrality of the private credit market today means it can be impacted by a wide range of potential shifts. 

Regulation in private credit

At present, investing in many private credit funds is restricted to accredited investors. Many lenders and asset managers, however, are exploring ways to give retail investors exposure to the asset class, whether or not that means being able to invest directly in funds. 

Regulators in the U.S. are currently aiming to better their understanding of how and where the private credit industry operates, with potential implications for future regulation. The Federal Deposit Insurance Corp. recently asked some of the country’s biggest banks to report on their year-end exposure to the private credit industry, but not every major lender agreed to comply. 

Future trends and industry outlook

The private credit industry has grown considerably over the past two decades, and many players in the industry expect that growth to continue in the years to come, with estimates that the size of the industry could be between $2 trillion and $3 trillion by the end of the decade.

One reason for this positive outlook is that the private markets continue to grow. As startups stay private for longer and the number of publicly traded companies declines, a larger percentage of economic growth takes place in the private sector, and private lenders are well positioned to capitalize.