Private credit explained: a guide for private clients

Private credit is lending done outside the public bond market and outside the traditional banking system. Instead of a company issuing a bond that trades on an exchange, a fund or group of funds negotiates a loan directly with the borrower and holds it, usually to maturity. For private clients, it has become one of the most talked-about allocations of the past decade — largely because it offers contractual income in a form that does not reprice on a screen every day.

What private credit actually is

The asset class covers any privately negotiated debt instrument. In practice most capital sits in direct lending: senior secured loans to mid-sized companies, typically sponsor-backed, at floating rates. Around that core sit several adjacent strategies — mezzanine and junior debt that sits below the senior lenders in the capital structure, distressed and special situations lending to companies under stress, asset-backed lending secured against receivables, equipment or inventory, real estate and infrastructure debt, and venture debt for growth-stage businesses.

The common thread is bilateral negotiation. Terms, covenants, pricing and security are agreed between two parties rather than set by a syndication desk, and the loan does not trade in a liquid secondary market.

Why the asset class grew

Post-2008 bank regulation raised the capital cost of holding leveraged loans, and banks retreated from mid-market lending. Private funds stepped into that gap. Borrowers accepted a higher coupon in exchange for speed, certainty of execution, confidentiality and a single counterparty they could renegotiate with. Allocators accepted illiquidity in exchange for a spread over syndicated loans. Both sides of that trade are still intact, which is why the market has continued to grow through several rate cycles.

Where the return comes from

A private credit return has four identifiable components, and it is worth separating them because they carry different risks. The base rate is the floating reference rate — most direct loans are priced over a benchmark, so income rises and falls with policy rates. The credit spread compensates for the risk that the borrower fails to pay. The illiquidity premium compensates for the fact that capital is locked up and cannot be sold on demand. Finally, original issue discount and fees add a modest amount of upfront yield.

Two of those four — the base rate and the illiquidity premium — are not credit skill. When headline yields look attractive purely because policy rates are high, the manager has added nothing. The question to ask about any private credit fund is what the spread over the benchmark is, and whether it is being earned by underwriting quality or simply by lending to weaker borrowers.

Structural features that matter

Seniority determines who gets paid first in a restructuring. Senior secured lenders sit at the top of the capital structure with a claim over assets; junior and mezzanine lenders are paid only after them, which is why their coupons are higher. Covenants are the contractual tests — leverage ratios, interest coverage, reporting requirements — that let a lender intervene before a borrower fails. Loans described as covenant-lite have fewer of these tests, which historically means later intervention and lower recoveries.

Floating rates mean the coupon adjusts with the benchmark. That protects the lender's real income when rates rise, but it also raises the borrower's interest burden at exactly the moment the economy is likely slowing — so floating-rate protection for the lender can become credit risk in disguise.

The risks

Illiquidity is the defining risk. Most funds have multi-year lock-ups, and semi-liquid vehicles offering quarterly redemptions typically cap withdrawals at a small percentage of net assets. If many investors want out at once, gates apply. Capital should be treated as committed for the stated term.

Valuation is the second risk. Because loans do not trade, they are marked using models rather than prices. Reported volatility is therefore low, but that smoothness is an artefact of the valuation method rather than evidence of a safer asset. Do not mistake a stable reported NAV for stable underlying credit.

Then come the credit risks themselves: default and recovery, which cluster in downturns rather than arriving evenly; concentration, where a fund's exposure to a single sector or sponsor is larger than the headline diversification suggests; and manager dispersion, which in private markets is wide — the gap between top-quartile and bottom-quartile private credit managers is far larger than in public fixed income. Leverage at the fund level, where the vehicle itself borrows to enhance returns, amplifies every one of these.

How it fits a private portfolio

Most allocators use private credit as a contractual-income sleeve that sits between investment-grade bonds and equity — higher yielding than the former, senior to the latter. It is not a cash substitute and it is not a bond replacement, because it cannot be sold at short notice. A workable approach is to size the allocation so that no part of it is needed for liquidity within the fund's stated lock-up, to diversify across managers and vintage years rather than committing everything in a single period, and to look through to the underlying borrowers rather than relying on the fund's headline diversification statistics.

The diligence questions worth asking are consistently the same: what is the spread over the benchmark and how has it changed; what proportion of the book is senior secured versus junior; how many loans are covenant-lite; what is the default and recovery history across a full cycle, not just recent years; how are assets valued and by whom; what leverage does the fund itself employ; and what are the precise redemption terms, including gates.

What private credit is not

It is not a guaranteed income product. The coupon is contractual, but contracts are only as good as the borrower's ability to pay. It is not low risk simply because reported volatility is low. And it is not a replacement for an emergency reserve or short-term cash needs.

Summary

Private credit is a legitimate, structurally supported asset class that pays investors for taking credit risk and giving up liquidity. Done well, it produces steady contractual income with lower mark-to-market noise than public markets. Done poorly, it concentrates credit risk in illiquid instruments that are difficult to exit and slow to reprice. The difference is almost entirely a function of underwriting discipline, structural seniority and honest valuation — which is why manager selection matters more here than in almost any other part of a portfolio.

This guide is educational and is not investment advice. Private market investments are illiquid and capital is at risk; past performance is not a guide to future returns.