Private Credit
What It Is
Private credit refers to debt financing provided by non-bank lenders directly to companies, projects, or real assets. Unlike public bonds, private credit instruments are not traded on exchanges — they are negotiated directly between lender and borrower. This creates an illiquidity premium but also significantly limits the ability to exit early.
Sub-Strategies
Direct Lending: Senior secured loans provided to mid-market and larger companies, typically at floating rates. This is the largest and most common private credit sub-strategy. Loans are senior in the capital structure (first to be repaid in a default), often secured against company assets.
Mezzanine Finance: Subordinated debt sitting between senior debt and equity in the capital structure. Mezzanine lenders take more risk than senior lenders (they are repaid after senior debt in a default) and earn higher returns to compensate. Mezzanine instruments often include equity warrants or conversion rights.
Distressed Debt: Purchasing the debt of financially troubled companies at a significant discount to face value, with the expectation of recovering value through restructuring, operational improvement, or bankruptcy proceedings. Returns depend on recovery value, not contractual interest.
Opportunistic Credit: Bespoke financing for situations that don’t fit standard lending categories — NAV lending (lending against a PE fund’s portfolio value), litigation finance, preferred equity, or rescue financing. Higher complexity, higher potential return.
Asset-Backed Lending: Loans secured directly against physical or financial assets (e.g., real estate, equipment, receivables, royalties). The lender has a direct claim on the underlying asset if the borrower defaults. Common in real estate debt, aviation finance, and trade finance.
Floating-Rate Loans and Interest Rate Sensitivity
Most direct lending and senior private credit instruments pay floating-rate interest: a base rate (historically LIBOR; now commonly SOFR in USD or SONIA in GBP) plus a fixed credit spread. When interest rates rise, the coupon increases — benefiting lenders. When rates fall, the coupon decreases.
This is a significant structural difference from fixed-rate public bonds: private credit lenders are generally less exposed to interest rate risk in a rising rate environment, but borrowers face higher cash debt service costs, which can increase default risk.
Caveat: Not all private credit instruments are floating-rate. Mezzanine and fixed-rate tranches exist. Always confirm the rate structure of a specific instrument before drawing conclusions about interest rate sensitivity.
Covenants, Collateral, Seniority, and Recovery
Seniority determines the order of repayment if a borrower defaults. Senior secured lenders are first; mezzanine lenders are second; equity holders receive any residual. In a distressed scenario, seniority is the primary determinant of recovery value.
Collateral is the asset or assets the lender can seize and sell if the borrower defaults. Senior secured loans are backed by specific collateral (e.g., company assets, receivables, property). Unsecured loans and some mezzanine instruments have no specific collateral claim.
Covenants are contractual restrictions in the loan agreement that the borrower must comply with. Financial covenants require the borrower to maintain minimum financial ratios (e.g., interest coverage ratio, leverage ratio). Maintenance covenants are tested regularly; incurrence covenants are triggered only by specific actions. “Covenant-lite” loans (common in leveraged finance) omit financial maintenance covenants, giving lenders weaker early-warning mechanisms.
Default and workout: When a borrower fails to meet a covenant or misses an interest payment, a default is triggered. Lenders then enter a workout process — negotiations to restructure the debt, extend terms, take additional security, or enforce on collateral. Distressed workouts can take months to years and may involve legal proceedings.
Recovery: In a default, the percentage of loan principal ultimately recovered by the lender depends on seniority, collateral quality, and the borrower’s residual asset value. Recovery rates vary widely; there is no guaranteed recovery even for senior secured lenders.
PIK Interest: Inflated Income Before Cash is Received
PIK (Payment in Kind) interest is a form of non-cash interest: instead of paying cash coupon, the borrower adds the accrued interest to the loan principal. The lender’s loan balance grows, but no cash is received until the loan is repaid or refinanced.
PIK is common in mezzanine finance and stressed situations. For the lender’s fund accounting and NAV:
- PIK interest is accrued as income each period, increasing NAV and reported returns
- But no cash has been received — the income is entirely unrealised until the loan matures
- If the borrower later defaults, the entire accumulated PIK interest may be at risk
Caveat: PIK income accrual can inflate reported fund NAV and income yield before any cash is in hand. Investors should distinguish between funds reporting cash yields and those reporting yields that include significant PIK components. In performance reporting, accrued PIK contributes to RVPI (unrealised value) not DPI (cash received).
Income Return vs Total Return
Private credit returns come from two sources:
- Income return – Regular cash payments (interest, fees) received from borrowers during the loan term. This is the “yield” component, similar to bond coupon income.
- Total return – Income plus capital appreciation or loss. In private credit, capital gains or losses arise when loans are repaid above or below face value, or when distressed debt purchased at a discount recovers to par.
For direct lending funds with performing portfolios, most of the return is income. For distressed strategies, capital appreciation (or loss) may dominate. The distinction matters for LP planning: income return generates regular distributions (typically quarterly or semi-annually); capital return only flows at loan maturity or exit.
Illiquid Credit Valuation
Private credit loans are not market-traded. Their value must be estimated using models — typically discounted cash flow analysis or comparable credit spreads from active markets. This is a Level 2 or Level 3 valuation (see Valuation Risk).
When a borrower’s credit quality deteriorates, the loan must be written down — but determining the right write-down level requires significant judgement. Lenders may be reluctant to mark down loans aggressively, particularly while a workout is ongoing and recovery value is uncertain. This creates a tension between conservative accounting and preserving LP confidence.
Key Metrics
| Metric | Use |
|---|---|
| Yield / Spread | Current income return vs a benchmark rate |
| NAV | Fund value including accrued income and mark-to-model prices |
| DPI | Actual cash distributions to investors |
| Loss rate / Default rate | Proportion of loans impaired or in default |
| Interest coverage ratio | Borrower’s ability to service debt from operating income |
Related Concepts
Source Anchors
- AIMA Due Diligence Questionnaires — AIMA’s Private Credit DDQ covers origination, credit process, covenant monitoring, valuation, and operational controls for private credit managers
- IPEV Valuation Guidelines — fair value framework for measuring illiquid credit instruments at each reporting date
Manual Review Notes
- Recovery rates for private credit vary significantly by seniority, collateral type, industry, and economic cycle. No recovery rate range should be cited without specific qualification as historical, jurisdiction-specific, and asset-class-specific data.
- PIK mechanics are described at a conceptual level. The accounting treatment of PIK interest (including whether it is accrued daily, monthly, or at a fixed point) varies by fund and accounting standard. Operations teams should verify the treatment per each fund’s accounting policy.
- “Covenant-lite” as a structural trend in leveraged finance is well-documented but cycles. The description should be framed as a risk observation, not a permanent feature of all private credit.
- Asset-backed lending encompasses very different risk profiles depending on the underlying asset (real estate vs royalties vs aviation). A single “asset-backed lending” label masks significant variation.