Private Credit

What Private Credit Is

Private credit refers to debt instruments originated and held by private funds rather than banks or public markets. Where a company might once have borrowed from a commercial bank or issued a publicly traded bond, it may instead borrow from a private credit fund that negotiates the loan directly and holds it to maturity. The borrower gets capital; the fund earns interest; investors in the fund receive that income stream.

The category is wide. Direct lending — senior secured loans made directly to mid-sized companies — is the most common strategy. Adjacent strategies include mezzanine debt (subordinated loans that sit below senior debt in repayment priority but above equity, usually carrying higher interest rates to compensate), asset-backed lending (loans secured by pools of specific assets like receivables or royalties), real estate debt, and specialty finance (lending against niche collateral types). Each sits at a different point on the risk-and-return spectrum, so the label "private credit" covers quite a range.

Why Private Credit Grew

The market expanded meaningfully after the 2008 financial crisis. Regulatory changes that followed the crisis required banks to hold more capital against certain loan types, making it less attractive for banks to originate and hold loans to smaller or more leveraged companies. That pulled back supply of capital precisely where many businesses needed it, and private credit funds stepped into the gap.

Private credit funds also brought a different posture. Because they hold loans in a fund rather than selling them on, they can negotiate covenants — contractual promises the borrower makes, such as keeping debt levels below a certain ratio or maintaining minimum cash flow coverage. Broadly syndicated bank loans had steadily weakened their covenant packages over time; privately negotiated loans often retained tighter protections. Investors and fund managers argue those covenants give lenders earlier warning of borrower stress and more leverage to negotiate before a default occurs.

Floating-Rate Income and the Yield Premium

Most private credit loans carry floating interest rates, meaning the interest payment adjusts periodically based on a reference benchmark rate (historically LIBOR; more recently SOFR or similar indices) plus a fixed spread — the additional percentage the borrower pays above the benchmark to compensate lenders for credit risk. When benchmark rates rise, the income paid to fund investors typically rises as well. This is one of the characteristics that distinguishes private credit from traditional fixed-rate bonds, whose prices fall when rates rise.

The central appeal of private credit is a yield premium above what comparably rated public debt might offer. Practitioners often describe this as the illiquidity premium — extra return earned by investors willing to lock their capital into a fund for several years without a liquid secondary market. Whether that premium adequately compensates for the risks involved is a question each family and its advisers must weigh carefully, because the premium is not guaranteed and the illiquidity is very real.

Understanding Risk: Defaults, Recovery, and Covenants

The primary risk in private credit is borrower default — the borrower fails to make interest or principal payments as agreed. When a default occurs, the outcome for investors depends heavily on where the fund's loan sits in the capital structure (the hierarchy of who gets paid first if assets are liquidated). Senior secured loans have the highest claim on collateral; mezzanine or subordinated debt recovers only after senior lenders are satisfied.

Recovery rates — the fraction of principal that lenders ultimately receive after a default and workout process — vary widely by industry, collateral type, and how quickly the fund acts. In a private setting, the fund manager negotiates directly with the borrower rather than trading out of the position, which can be an advantage (more control) or a disadvantage (time-consuming and resource-intensive). Families evaluating private credit funds should ask how the manager has actually handled past defaults, not just what their default rate appears to be.

Covenants matter here. A fund with tightly negotiated covenants may detect borrower deterioration early, giving the lender time to demand remedies — additional collateral, management changes, accelerated repayment — before a full default occurs. A fund that has relaxed covenants to win deals (a practice sometimes called covenant-lite) may discover problems only after they have become more severe. Reviewing how to evaluate a private fund helps families understand what questions to ask about a manager's underwriting discipline.

Structures and Liquidity Considerations

Private credit is offered through several fund structures, each with different liquidity profiles. Understanding these before committing capital is essential, because the wrong structure for a family's cash flow needs can create real problems.

Drawdown (Closed-End) Funds

The traditional structure is a drawdown fund — investors commit capital, the manager calls it over time as loans are made, and the fund returns capital as loans are repaid, typically over a multi-year life. Investors have no ability to redeem early. This structure aligns well with the nature of private loans, which cannot be sold in a liquid market. Fees, terms, and the mechanics of these funds are covered in detail in the private fund fees and terms article.

Evergreen and Interval Funds

Newer structures attempt to offer limited liquidity. An evergreen fund has no fixed end date; it continuously accepts new capital and reinvests repayments, giving it an ongoing rather than finite life. An interval fund is a registered fund that offers periodic redemption windows — perhaps quarterly — but limits the total amount that can be redeemed in any window. Both structures aim to make private credit accessible without requiring a decade-long lockup.

The tradeoff is that these structures must hold enough liquid assets to meet redemption requests. If many investors want to redeem simultaneously — particularly in a stress environment when the underlying loans are also under pressure — the fund may impose a redemption gate, limiting or suspending withdrawals. The liquidity these structures appear to offer may be more constrained in practice than it looks on paper.

Valuation, Transparency, and "Too Smooth" Returns

Private loans have no daily market price. Fund managers must estimate the value of each loan — a process called mark-to-model or fair value accounting — using financial models and judgment rather than observable market transactions. This means the net asset value of a private credit fund is an estimate, not a market-clearing price.

One consequence is that reported returns in private credit can appear smoother than those of publicly traded equivalents. Public bond funds reprice daily based on market sentiment; a private credit fund may show steady valuations even when the credit quality of its loans is quietly deteriorating. Sophisticated investors and their advisers watch for this and probe underlying loan performance directly rather than relying solely on reported NAV.

A hypothetical family allocating to private credit might notice that a fund's reported quarterly returns show almost no volatility over three years. That apparent smoothness is worth examining: it may reflect genuinely stable loan performance, or it may reflect infrequent and optimistic valuation of loans that have not yet been tested by stress. Asking the manager for loan-level performance data, default history, and audited financial statements is a reasonable first step.

Families are well served by understanding how to read K-1s and complex tax reporting, since private credit funds structured as partnerships generate these forms, often with complexity around interest income characterization and timing.

Costs, Tax Considerations, and Key Questions

Private credit funds typically charge a management fee based on committed or invested capital, plus carried interest — a share of profits above a preferred return threshold. Compared to some private equity strategies, management fees in direct lending are sometimes calibrated to the income-generating nature of the strategy, but the details vary significantly by manager and fund. Reviewing fund fees and terms carefully before committing is important.

Interest income earned by private credit funds is generally characterized as ordinary income — taxed at higher rates than long-term capital gains for most taxpayers. This makes the asset location question — which accounts hold private credit — worth discussing with a CPA. Tax-exempt or tax-deferred accounts may be natural candidates, though unrelated business taxable income (UBTI) rules can complicate placement inside certain tax-exempt structures, and a qualified tax adviser must evaluate any specific situation.

Common questions families and their advisers might raise with a private credit manager include: What is the average loan-to-value or leverage ratio across the portfolio? How many borrowers are there, and how concentrated is the book? What percentage of loans carry covenants, and how tight are they? How has the manager handled past defaults — specifically, what were the recovery timelines and outcomes? How is the portfolio valued, and who performs the independent audit?

Private credit sits within a broader universe of private market options. Families sometimes evaluate it alongside private equity, private real estate funds, and secondaries when considering how illiquid allocations fit within the overall portfolio. How much illiquidity a family can comfortably absorb without impairing other financial goals is a foundational question, explored more fully in discussions of liquidity allocation.