Private credit works by connecting a company that needs to borrow with a non-bank investment fund that lends to it directly, under terms the two sides negotiate one-on-one rather than through a public bond market or a traditional bank syndicate. The fund pools money from large institutional investors, uses it to originate loans to middle-market companies, and passes the interest income back to those investors over the life of the fund. The market grew sharply after the 2008 financial crisis, when tighter capital rules pulled banks back from mid-sized corporate lending and specialized funds moved into the gap.
Who Lends and Who Borrows
On the lending side, the market is dominated by asset management firms and private equity groups that run specialized debt funds. Some of those funds are organized as Business Development Companies (BDCs), publicly regulated vehicles aimed at lending to smaller businesses. Others are private funds open only to institutional and accredited investors.
On the borrowing side are mostly middle-market companies with annual revenues roughly between $10 million and $1 billion, though larger companies have increasingly turned to private credit as well.1Board of Governors of the Federal Reserve System. Private Credit: Characteristics and Risks These companies borrow for acquisitions, expansions, or refinancing when traditional bank credit is insufficient or unavailable. Companies owned by private equity sponsors are especially common clients, because their buyout-driven capital structures often need flexibility that banks will not offer.
The defining feature of the arrangement is that it is bilateral. Instead of dozens of investors each buying a slice of a public bond, a single private lender often funds the entire loan. The lender gets deep visibility into the borrower’s finances, and the borrower has one phone number to call when circumstances change.
Where the Money Comes From
Private credit funds raise their capital from large institutional investors looking for steady income over long horizons. Pension funds, insurance companies, sovereign wealth funds, and university endowments are the most common sources. They commit to these funds because private credit yields more than most publicly traded bonds, partly as compensation for holding loans that cannot be easily sold.
The fund itself is organized as a limited partnership. A General Partner (GP) runs the investment strategy, choosing which loans to make, negotiating terms, and monitoring borrowers. Limited Partners (LPs) put up most of the money but play no role in picking individual loans. The Limited Partnership Agreement sets out the GP’s management fee, typically 1.5 to 2 percent of committed or invested capital, along with a performance incentive known as carried interest that pays the GP when fund returns pass a specified benchmark.
Capital Calls
LPs do not hand over their full commitment on day one. The GP issues capital calls as lending opportunities arise, drawing down each investor’s commitment in stages across the fund’s investment period. An LP that misses a capital call faces consequences spelled out in the partnership agreement that can range from penalty interest on the overdue amount to forfeiture of the entire stake. Because the penalties are steep, prospective LPs need enough liquidity to meet calls on short notice, sometimes within 10 to 15 business days.
Lock-Up and Illiquidity
Most private credit funds lock up investor capital for the fund’s full life, often seven to ten years including the investment and harvesting periods. Unlike a mutual fund or a public bond, you generally cannot redeem early. Some funds offer limited liquidity windows or allow investors to sell their interests in the secondary market, but those sales often go at a discount. This illiquidity is one of the main trade-offs for the higher yields the asset class offers.
How the Loans Themselves Are Structured
Each private credit loan is governed by its own negotiated credit agreement. Without a standard prospectus to work from, lender and borrower have wide latitude to shape the terms around the specific deal.
Floating Interest Rates
Nearly all private credit loans carry floating rates tied to a benchmark, most commonly the Secured Overnight Financing Rate (SOFR).1Board of Governors of the Federal Reserve System. Private Credit: Characteristics and Risks On top of the benchmark, the lender adds a spread reflecting the borrower’s credit risk. For middle-market loans, that spread commonly runs 450 to 700 basis points (4.5 to 7 percentage points), though it moves with market conditions. Borrowers benefit when rates fall and feel the pressure when rates climb, a dynamic that has stressed some borrowers through recent rate-hiking cycles.
Covenants and Maturity
Maturities typically run five to seven years. Through that period, borrowers must meet ongoing financial tests called maintenance covenants, usually measured quarterly. A common one is a total leverage ratio capping debt at a specified multiple of EBITDA (earnings before interest, taxes, depreciation, and amortization). If the borrower breaches a covenant, the lender gains the right to demand early repayment, restructure the loan, or impose additional restrictions.
Collateral and Security Interests
Most private credit loans are secured, meaning the lender holds a legal claim called a security interest on the borrower’s assets. Under the Uniform Commercial Code, a security interest becomes enforceable once the borrower signs a security agreement describing the collateral, the lender has provided value, and the borrower has rights in the collateral.2Legal Information Institute. UCC 9-203 – Attachment and Enforceability of Security Interest The lender then files a UCC-1 financing statement with the appropriate state office to establish priority over other creditors. If the borrower defaults, the lender can seize and sell the pledged assets ahead of unsecured creditors.
Payment-in-Kind Interest
Some agreements include a payment-in-kind (PIK) option, which lets the borrower defer cash interest by adding the owed interest to the loan’s principal instead. That preserves cash during growth phases or periods of strain, but it grows the balance owed. Lenders accepting PIK charge a higher rate to compensate for the delayed cash and the risk that the swelling principal may not be repaid in full.
The Main Types of Private Credit
Direct Lending
Direct lending is the largest segment. These are senior secured loans at the top of the borrower’s capital structure, first in line to be repaid in a liquidation. The direct lender usually funds the whole loan rather than syndicating it among multiple banks, which has made this a popular alternative to bank-led credit facilities, especially for private equity acquisitions where speed and certainty of close matter.
Unitranche Financing
Unitranche loans fold what would traditionally be separate senior and subordinated layers into one loan at a single blended rate. The borrower signs one credit agreement with one lender. Behind the scenes the lender may split the loan internally between senior and junior tranches through a separate agreement among lenders, but the borrower sees only one set of terms. Unitranche has become common in mid-market buyouts because it cuts out the complexity of negotiating with multiple creditor classes.
Mezzanine Financing
Mezzanine debt sits between senior loans and equity in the repayment order. Because mezzanine lenders get paid only after senior creditors in a bankruptcy, they charge significantly higher interest rates. Mezzanine loans often include equity warrants, which let the lender buy shares in the borrower at a preset price and share in the upside if the company does well. This lets the borrower raise capital beyond its senior debt capacity without fully diluting existing ownership. Mezzanine lenders sometimes negotiate board observer seats to keep closer watch on their investment.
Asset-Based Lending
Asset-based lending (ABL) ties borrowing capacity directly to the value of the company’s assets rather than its projected cash flows. The lender sets a borrowing base, a formula calculating how much the borrower can draw against eligible collateral such as accounts receivable or inventory.3Office of the Comptroller of the Currency. Comptrollers Handbook: Asset-Based Lending ABL facilities tend to carry fewer financial covenants than cash flow loans, which suits companies with strong collateral but uneven revenue.
Distressed Debt
Distressed debt investing means buying the existing loans or bonds of companies in financial trouble, often at steep discounts to face value. Investors aim to profit by participating in a restructuring, converting debt into equity in a reorganized company, or holding through a recovery. The strategy demands deep expertise in insolvency law, since private credit valuations are harder to pin down than public market prices and fair value may ultimately depend on judicial determinations in bankruptcy.
How Investors Are Taxed
Tax treatment depends on the investor. For taxable investors such as individuals and corporations, interest income flows through the partnership and is taxed as ordinary income at the investor’s applicable rate.
Tax-exempt investors like pension funds and endowments generally owe no tax on interest income. But interest becomes taxable as Unrelated Business Taxable Income (UBTI) if the fund uses borrowed money to make its investments, because income from debt-financed property loses its tax-exempt character.4Internal Revenue Service. Publication 598 – Tax on Unrelated Business Income of Exempt Organizations Many private credit funds use subscription credit lines or other leverage, so tax-exempt investors have to look carefully at each fund’s structure to understand their UBTI exposure. Foreign investors in U.S. funds face separate reporting obligations under the Foreign Account Tax Compliance Act (FATCA), which requires foreign financial institutions (a category that includes investment funds) to register with the IRS and report information about their U.S. accounts.5Internal Revenue Service. FATCA Information for Foreign Financial Institutions and Entities
Who Regulates the Market
The Securities and Exchange Commission oversees private credit fund managers primarily through the Investment Advisers Act of 1940.6U.S. Securities and Exchange Commission. Private Fund Advisers Firms managing private credit funds with $150 million or more in assets must register with the SEC as investment advisers and file Form ADV, a public disclosure of ownership, employees, strategies, fees, and conflicts of interest. Smaller firms generally register with state securities regulators instead. The SEC has also adopted rules specifically for private fund advisers, including requirements around preferential treatment of certain investors and restrictions on specific fund activities.
BDCs operate under a different regime. They elect to be regulated under the Investment Company Act of 1940, which subjects them to restrictions on leverage, diversification, and affiliated transactions that purely private funds do not face.7U.S. Securities and Exchange Commission. Investment Company Registration and Regulation Package A BDC must maintain asset coverage of at least 150 percent, equivalent to a maximum 2-to-1 debt-to-equity ratio, and must follow fair-value accounting rules in reporting its private loan portfolio. BDCs also register their securities under the Securities Exchange Act of 1934, so their financial statements are publicly available.
Insurance companies investing in private credit have their own layer of oversight through the risk-based capital (RBC) requirements set by the National Association of Insurance Commissioners. These rules assign capital charges to different types of private debt based on risk, with proposed charges ranging from 3 percent on collateral loans backed by mortgage assets up to 30 percent on loans backed by joint venture or limited partnership interests.8National Association of Insurance Commissioners. RBC Proposal Form – Life RBC Working Group – Collateral Loan Schedule BA Reporting Changes Those charges shape how much private credit exposure an insurer can hold without straining its regulatory capital, and in turn they shape how much insurance money flows into the market.