What private credit is and how it works

What is private credit? It is lending by investors other than banks, usually through private funds, to companies or projects that raise debt outside the public bond market. The numbers that matter are the loan amount, the borrower’s leverage, the interest rate spread over a benchmark rate, the value of collateral, and the protections in the loan contract.

Private credit has become a larger part of corporate finance because it can deliver capital quickly and confidentially, often to borrowers that are too small, too leveraged or too specialised for public bond markets. For investors, it offers contractual interest payments and a claim on borrower assets, while also bringing risks that are harder to price because the loans do not trade on open exchanges.

What is private credit in plain English?

Private credit is debt arranged privately between a borrower and one or more non-bank lenders. The lender is often an asset manager, pension fund, insurance company, sovereign wealth fund or private credit fund. The borrower may be a middle-market company, a private equity-owned business, a property developer, an infrastructure project or a company seeking a tailored loan.

The word “credit” means lending. The word “private” means the loan is negotiated directly rather than sold broadly to the public in the form of listed bonds. A public bond can be bought and sold in capital markets by many investors. A private credit loan is usually held by the lender or a small group of lenders until repayment, refinancing or sale in a private transaction.

Many private credit loans are “senior secured” loans. “Senior” means they rank ahead of junior debt and equity if the borrower fails. “Secured” means the lender has a claim on specified assets, such as accounts receivable, inventory, equipment, property or shares in operating subsidiaries. Some loans are unsecured, subordinated or structured as preferred equity, but the classic private credit product is a negotiated loan with a defined maturity, interest rate and covenant package.

A simple example shows the mechanics. A 50-person software company may want $25 million to acquire a smaller rival. A bank may decline because the business has limited tangible assets or because the loan would sit outside the bank’s risk limits. A private credit fund may agree to lend $25 million for five years, charge a floating interest rate equal to a reference rate plus a fixed spread, require quarterly reporting and set limits on additional borrowing. The company receives capital. The fund seeks interest income and repayment of principal.

How does private credit work?

The process starts with origination, which means finding borrowers. Deals may come from private equity sponsors, corporate advisers, banks, brokers or direct relationships between lenders and companies. A private equity sponsor is an investment firm that buys companies using a mix of equity and debt. In sponsor-backed lending, the private credit lender provides debt to a company owned by that sponsor.

The lender then conducts due diligence, meaning financial, legal and commercial review. It examines revenue quality, cash flow, customer concentration, margins, debt levels, management, collateral and the borrower’s ability to service interest. “Debt service” means the cash needed to pay interest and scheduled principal. For a cash-flow loan, the lender focuses on earnings and recurring cash generation. For an asset-based loan, it focuses more on the value and liquidity of collateral.

If the lender proceeds, it proposes a term sheet. A term sheet is a document that summarises key terms: loan size, maturity, interest rate, fees, collateral, ranking, covenants and events of default. “Covenants” are promises in the loan agreement. They may require the borrower to maintain a minimum level of earnings relative to interest, keep total debt below a set multiple of earnings, provide financial statements or restrict dividends and acquisitions. An “event of default” is a specified breach, such as missed payment or insolvency, that can let lenders demand repayment or enforce collateral rights.

Private credit loans are often floating-rate loans. A floating rate resets periodically by reference to a benchmark rate plus a credit spread. If the benchmark is 4 percent and the spread is 6 percentage points, the borrower pays about 10 percent before fees, subject to the exact contract. Floating rates can protect lenders when policy rates rise, but they can increase pressure on borrowers because interest expense rises too.

After closing, the lender monitors the borrower. Monitoring can include monthly accounts, budgets, compliance certificates, board observation rights and conversations with management. If performance weakens, the lender may amend terms, charge fees, require extra equity from owners, restrict spending or negotiate a restructuring. A restructuring is a change to debt terms when the borrower cannot meet the original obligations.

Who uses private credit, and why?

Borrowers use private credit for several reasons. Speed is one. A private lender can commit capital through a direct negotiation, which may be faster than arranging a syndicated bank loan or issuing a public bond. A syndicated loan is a loan provided by a group of banks or institutional lenders. A public bond issue requires disclosure documents, ratings work in many cases and investor marketing.

Certainty is another reason. A private lender may agree to hold the whole loan, or a large portion of it, reducing the risk that market conditions change before financing is completed. That can matter in acquisitions, where a buyer must show it has committed funding.

Flexibility also draws borrowers. A private credit loan can be designed around a company’s cash-flow pattern, acquisition plan, collateral base or regulatory constraints. A borrower may accept a higher interest rate in exchange for fewer lenders, a more tailored amortisation schedule, delayed-draw capacity or more confidentiality. A delayed-draw facility lets the borrower take funds later, subject to agreed conditions, rather than borrowing the full amount at closing.

Private credit is common in middle-market corporate lending. Middle-market companies are businesses that are larger than small firms but smaller than public-market issuers. Definitions vary, but they often have tens of millions to a few hundred million dollars of annual revenue. These companies may need capital that is too large for a local bank relationship and too small for a liquid bond market transaction.

Private credit also appears in real estate debt, infrastructure debt, asset finance, trade finance and distressed lending. Distressed lending involves lending to, or buying debt of, companies under financial strain. Each area has different collateral and legal rules, so the same label covers loans with different risk profiles.

How is private credit different from bank loans and bonds?

A bank loan sits on a bank’s balance sheet, although banks may sell or syndicate parts of it. Banks fund themselves with deposits, wholesale borrowing and equity, and they operate under banking regulation and capital rules. Private credit funds raise money from investors and lend that capital according to fund documents. They do not take ordinary deposits and do not provide the payment services associated with commercial banks.

A public bond is a security issued into capital markets. Bondholders usually receive a fixed or floating coupon and can trade the bond through dealers. Public bonds typically have broader disclosure and a larger investor base than private credit loans. They can be more liquid, meaning easier to sell, although liquidity varies by issuer and market conditions.

Private credit is usually less liquid. A fund investor may commit capital for several years and have limited rights to redeem. The loans themselves may be hard to value because comparable transactions are limited and trading is infrequent. Fund managers use valuation policies, third-party inputs and internal models, but a marked value can differ from the price available in a stressed sale.

Pricing differs as well. Private credit borrowers often pay a higher spread than stronger public-market borrowers because the loans may be smaller, more complex, more leveraged or less liquid. The higher spread compensates lenders for credit risk, illiquidity, monitoring costs and complexity. It does not remove the possibility of loss.

What are the main risks in private credit?

The main risk is credit risk: the borrower may fail to pay interest or repay principal. If a company’s earnings fall, interest rates rise or costs increase, its cash flow may no longer cover debt service. Secured lenders may recover money through collateral, but recovery depends on asset values, legal process, seniority and the company’s condition at default.

Illiquidity risk is also central. Investors in private credit funds may not be able to withdraw money on demand. A closed-end fund, which has a fixed life, may lock up capital for several years. An open-end fund, which allows periodic subscriptions and redemptions, may still impose notice periods, gates or suspension rights. A gate limits withdrawals when many investors seek cash at once.

Valuation risk follows from illiquidity. Public stocks and bonds have visible market prices. Private loans rely more on models and manager judgment between financing events. Reported stability in valuations can reflect the absence of trading as well as actual credit performance.

Concentration risk can arise if a fund has large exposure to a sector, sponsor, geography or borrower type. Legal and documentation risk matters because lender protections depend on the exact contract and local insolvency law. Operational risk also matters: private credit requires underwriting, documentation, monitoring and workout skills.

For borrowers, the risk is cost and control. Private credit can be expensive relative to bank loans for stronger credits. Covenants can restrict business decisions. If performance weakens, lenders may gain significant influence over cash use, asset sales, acquisitions or ownership outcomes.

How do investors access private credit?

Large institutions often invest through private credit funds, separately managed accounts or direct lending partnerships. A separately managed account is a customised portfolio run for one investor. Some insurers and pension plans also make loans directly or co-invest beside fund managers.

Individual investors may see private credit through interval funds, listed credit vehicles, business development companies in some jurisdictions, or diversified wealth products. Access, disclosure, liquidity and investor protections vary by country and product type. A listed vehicle can offer daily market pricing for its shares, while the underlying loans may remain illiquid. That difference can create a gap between the traded share price and the estimated value of the loan portfolio.

Fees also shape returns. Private credit funds may charge management fees on committed or invested capital and performance fees above a hurdle rate. A hurdle rate is a minimum return that must be earned before performance fees apply. Investors usually assess net returns, meaning returns after fees and expenses, and compare them with the risks of leverage, default and lock-up.

Some funds use leverage, meaning they borrow money to increase the amount they can lend. Leverage can raise returns when loans perform and magnify losses when defaults rise or financing costs increase. Fund documents, credit facilities and regulatory rules determine how much leverage may be used.

Practical takeaway

Private credit is private-market lending by non-bank investors. It can give borrowers flexible capital and give investors exposure to contractual interest income, often through senior secured loans. The trade-off is that the loans are less transparent and less liquid than public securities, and outcomes depend on underwriting quality, borrower cash flow, legal protections and the economic cycle. For any borrower or investor, the relevant questions are who gets paid first, what cash flow supports the debt, what happens if performance deteriorates and how quickly capital can be recovered.