How Private Credit Deals Actually Work - Behind the Curtain of Real Returns

Private credit is a $2 trillion market offering businesses tailored loans and investors higher returns compared to public markets. Here's what you need to know:

• What is Private Credit? Privately negotiated loans with flexible terms and floating interest rates, offering higher yields due to illiquidity and complexity premiums.
• Why It Grew: Post-2008 regulations limited bank lending, creating opportunities for private lenders.
• Key Players: Corporate borrowers, private credit firms, private equity, pension funds, and hedge funds.
• Structures: Includes senior secured loans (lower risk, ~9% annual returns), mezzanine debt (higher risk, 10%-20% returns), and distressed strategies.
• Returns: Historically, private credit outperforms public bonds, with direct lending yielding ~11.6% annually.
• Risks: Illiquidity, default risk, and limited transparency require robust due diligence and risk management.

Quick Comparison:

Feature	Public Credit	Private Credit
Liquidity	High	Low
Yields	Market-driven, lower	Higher, illiquidity premium
Interest Rate	Fixed	Floating
Customization	Standardized terms	Flexible terms
Regulation	Heavily regulated	Less regulated

Private credit offers strong returns but requires careful evaluation of risks, borrower credit quality, and fee structures. For those with a long-term outlook, it can be a powerful addition to an investment portfolio.

Private Credit Basics

What is Private Credit?

Private credit refers to loans that are privately negotiated between lenders and borrowers, offering customized terms that standard bonds or bank loans typically can't provide. These loans often come with floating interest rates tied to benchmarks like SOFR, meaning payments adjust as interest rates fluctuate.

What sets private credit apart is its higher yields compared to traditional bonds. This is due to an "illiquidity and complexity premium", which compensates investors for the challenges of valuation and limited exit opportunities. However, these investments are less liquid and carry a risk of default. On the positive side, the floating-rate structure helps offset interest rate risks that tend to impact fixed-rate instruments.

Public Credit	Private Credit
Definition	Debt securities traded in public markets	Privately negotiated loans
Liquidity	High liquidity, publicly traded	Lower liquidity
Yields	Market-driven pricing	Higher yields due to illiquidity
Structure	Standardized terms	Flexible and customizable
Interest Rate	Typically fixed	Typically floating
Regulation	Heavily regulated	Less regulated, more flexible

This framework lays the groundwork for understanding the roles of the various participants in the private credit landscape.

Key Players in Private Credit Deals

The private credit market involves several participants, each playing a unique role in structuring and executing these deals.

At the center are corporate borrowers, including middle-market companies, startups, distressed firms, and leveraged buyout targets. These businesses often turn to private credit for tailored financing solutions.

Private credit firms act as the main lenders, handling everything from underwriting to managing these specialized loans. Private equity firms also frequently interact with private credit, especially when they need additional financing for acquisitions or leveraged buyouts.

Other major contributors include insurance companies and pension funds, which provide the long-term capital required to support these loans. Family offices often participate as limited partners in private credit funds or act as direct lenders. Meanwhile, hedge funds and alternative asset managers are becoming increasingly active players in this space.

Understanding the structure of private credit deals helps clarify how these loans balance risk and return.

Private Credit Structures

Private credit strategies cater to different borrower profiles and segments of the capital structure, offering a variety of risk and return profiles. This allows investors to align their investments with their specific goals and risk tolerance.

• Senior Secured Loans: These loans sit at the top of the capital structure, providing stability and lower risk since they are backed by specific company assets. Over the past decade, senior lending has achieved an annualized return of nearly 9%, outperforming public loans and even global equities.
• Mezzanine Debt: Positioned between senior debt and equity, mezzanine loans are unsecured and subordinated, offering higher returns (typically 10% to 20%) to account for the additional credit risk.
• Distressed and Opportunistic Strategies: These focus on companies facing significant challenges. While these deals often lack regular yields, they can offer substantial upside during successful turnarounds.

"Different loans carry different types and levels of risk - and can generate a range of returns commensurate to that risk." – Goldman Sachs Asset Management

The flexibility of private credit structures allows lenders to design loan agreements that meet specific business needs, even though liquidity is reduced. For instance, lenders can include customized payment plans and covenants that encourage transparency and accountability.

Performance data highlights the appeal of private credit. Direct lending has historically delivered average returns of 11.6%, far exceeding the 5% from leveraged loans and the 6.8% from high-yield bonds during periods of rising interest rates. Over the past decade, private credit has consistently provided yields that are 3–6% higher than those from public high-yield and broadly syndicated loans.

Private credit in focus: A deep dive into direct lending​

How Private Credit Deals Work: Step-by-Step Process

Understanding the journey of private credit deals - from the initial application to final funding - offers a clear picture of how these investments can deliver strong returns while providing lenders with the flexibility to manage risks and customize terms.

Deal Origination and Underwriting

The process begins when a borrower applies for a private credit loan. Borrowers typically choose lenders based on factors like the purpose of the loan, the required amount, and the specific industry involved. Once a potential deal is identified, lenders dive into a comprehensive due diligence process. This involves scrutinizing financial records, verifying identities, and gaining a detailed understanding of the borrower’s business structure, model, and future plans.

The underwriting phase follows, where lenders evaluate key aspects such as the borrower’s financial health, credit history, collateral, and other relevant details. This thorough assessment helps determine the risk level and whether the loan is a good fit for approval. Once the underwriting is complete, the focus shifts to structuring interest rates and payment terms that align with the deal's unique characteristics.

Interest Structures and Payment Terms

Private credit loans are known for their flexible interest rates and payment options. Typically, these loans are tied to benchmark rates like the Secured Overnight Financing Rate (SOFR) or Treasury yields. Lenders then add a credit spread, calculated in basis points, to account for the risk of the loan. This structure often results in returns ranging from 7% to 9%, significantly higher than the approximate 3% yield of standard investment-grade corporate bonds.

Borrowers can also benefit from adaptable payment structures. Options include regular cash interest payments or payment-in-kind (PIK) interest, where accrued interest is added to the loan balance instead of being paid immediately. Many agreements also feature a base rate floor, ensuring that the effective interest rate doesn’t drop below a certain threshold, even if benchmark rates decline. Additionally, prepayment penalties, often called call protection, are common and safeguard lenders’ expected returns. Borrowers are encouraged to compare term sheets from multiple lenders to secure the most favorable terms. With payment and interest terms in place, lenders turn their attention to managing the risks associated with these loans.

Risk Assessment and Mitigation Methods

Risk management is a critical component of private credit. By early 2024, the private credit market had grown to $1.5 trillion, with projections estimating it could reach $2.8 trillion by 2028. This rapid growth underscores the importance of robust risk assessment strategies. However, the market faces challenges, such as limited transparency - only about 20% of private credit issuers are rated - and less regulatory oversight compared to public markets.

To navigate these challenges, private credit managers rely on specialized tools, including advanced data analytics and customized workflows, to evaluate and monitor their portfolios. Active portfolio management and covenant monitoring play significant roles in reducing risks. Covenants set specific conditions borrowers must meet, while proactive monitoring helps identify and address potential breaches early. Increasingly, lenders are turning to AI and machine learning to uncover complex risk factors that traditional methods might miss [14].

Other strategies include using credit scoring models, diversifying portfolios, and implementing risk-based pricing. Lenders also continuously monitor borrowers’ financial profiles, maintain loan loss reserves, and conduct regular stress tests to prepare for economic downturns. Unlike bank loans, which depend on volatile deposits, private credit markets tend to rely on more stable, long-term funding. This stability proved advantageous during the March 2023 deposit runs that impacted several banks.

What Drives Real Returns in Private Credit

Private credit returns are influenced by several key factors, including interest income, the credit quality of borrowers, and the fee structures that ultimately shape the net results for investors.

Main Drivers of Real Returns

Private credit returns rest on three primary elements: interest income, borrower credit quality, and loan seniority. These investments aim to provide income, total return, and reduced volatility compared to traditional equity investments.

Higher interest rates play a significant role in boosting yields for both fixed- and floating-rate loans. Recently, rising rates and wider spreads have pushed private credit returns to around 12%. Additional returns can come from purchasing new issuances at a discount and applying moderate leverage.

Borrower creditworthiness is another critical component. A borrower's financial health and their position within the capital stack directly influence returns. Private credit spreads, reflecting both the added risk and the illiquidity premium, typically range from 200 to 600 basis points above those in public markets.

Senior lending, which occupies the top position in the capital structure, highlights the potential for lower-risk returns. Investors are also compensated for the illiquidity of their capital through a yield premium. However, this comes with trade-offs, such as limited opportunities for active management and challenges in rebalancing portfolios. Over the last decade, this yield premium has averaged 4.2% compared to public credit offerings. Beyond these core factors, fee structures also play a pivotal role in shaping net returns.

Fee Structures and Their Impact

Fee structures can significantly affect the returns investors take home. The traditional "2 and 20" model has shifted, with the median now closer to a 1.5% management fee and a 15% performance fee.

Management fees vary depending on the strategy. For instance, direct lending often incurs lower fees due to its larger capital base, while strategies like opportunistic, distressed, multi-strategy, and asset-based lending tend to have higher fees. In the post-investment phase, direct lending and niche managers have reported median management fees around 1.00%.

Performance fees also play a role. Some managers have eliminated performance fees for evergreen funds to attract fee-sensitive investors, though this can reduce their incentives. Investors are increasingly negotiating lower management fees for early, large, or long-term commitments. Performance fees are often tied to a preferred return threshold, and in today’s rising interest rate environment, limited partners are pushing for higher thresholds.

The average size of private debt funds has grown from around $600 million in 2019 to over $1 billion in 2024, enabling economies of scale that reduce management costs per dollar invested. A practical example can be seen in Steadfast Equity’s approach to private credit.

Example: Steadfast Equity's Investment Approach

Steadfast Equity demonstrates a structured and transparent approach to private credit investing, offering consistent returns through ethical bond offerings. The firm emphasizes long-term value creation while providing clear, fixed-return options.

Steadfast Equity offers a range of bond terms, such as a 1-Year Monthly plan with a 10.0% APY or a 1-Year Compounded option yielding 12.5% APY. These options allow investors to explore the market while securing competitive returns. For longer-term commitments, the firm becomes even more compelling. Its 5-Year Compounded plan delivers an 18.5% APY, outperforming the market average of approximately 12%, while the 12-Year Compounded plan offers 16.5% APY, providing fixed returns over an extended period.

What sets Steadfast Equity apart is its strategic allocation of capital across growth-stage companies in sectors like technology, SaaS, AI, biotechnology, real estate, and alternative investments. This diversification helps manage sector-specific risks while tapping into growth opportunities. Additionally, the firm’s selective partnership model, built on shared values, underscores its commitment to thorough due diligence and relationship-focused lending.

"We believe returns in private credit are approaching levels typically seen by buyout investors, while lenders are also enjoying increased protections and improving deal terms. In combination, these forces may create a compelling era for the private credit asset class."– Jeff Diehl, Managing Partner and Head of Investments, Adams Street Partners

The gross internal rate of return (IRR) of 14% to 15% achieved by many private credit managers compares favorably with the 18% mean net return for buyout funds between 2008 and 2018. However, private credit offers lower volatility, making it an attractive option for institutional investors seeking steady income and a solid risk-adjusted return profile.

How to Evaluate Private Credit Opportunities

Choosing the right private credit investment demands a structured approach to due diligence and a solid grasp of the trade-offs involved. With private credit growing to around $1.5 trillion by early 2024 and projected to hit $2.6 trillion by 2029, the landscape is brimming with opportunities - but it's also more intricate than ever. Building on earlier discussions about deal structuring and risk mitigation, a systematic evaluation process is crucial for making informed decisions.

Conducting Due Diligence

Investing in private credit successfully hinges on thorough due diligence. A key part of this process is selecting managers with proven expertise, especially those who have navigated multiple credit cycles. Unlike public markets, where information is readily available, private credit requires a closer look at both the manager's skills and the deals they structure.

Evaluating the Manager's Track Record

Start by assessing a manager's approach to underwriting, deal sourcing, and their financial backing. Pay attention to how they adapt to changing economic conditions. The past decade's favorable economic environment, which allowed many managers to avoid significant losses, has shifted to a period of higher interest rates and slower revenue growth. This new climate demands managers with a strong track record in credit selection and risk management.

Assessing Financial Health and Collateral

Quantitative factors, like a borrower's ability to meet debt obligations, are just as important as reviewing a manager's expertise. Analyze metrics such as EBITDA compared to current interest expenses for portfolio companies. Identify the SOFR threshold at which interest coverage falls below 1x. Also, review the loan-to-value (LTV) ratio to gauge the equity buffer for each loan. Consider how LTV has changed since the loan's inception and examine the type of collateral pledged - whether it's a primary or secondary claim - as this impacts recovery prospects in case of default.

Lender Protections

Strong lender protections can significantly reduce default risks and enhance returns. Look for maintenance-based covenants that provide early warning signs of financial distress. Ensure senior lenders have agreements in place with junior lenders to safeguard their rights during defaults. For asset-based lending, verify that facilities operate with conservative leverage or maintain sufficient liquidity buffers.

Investment Discipline

Review the manager's investment pacing to ensure they deploy capital selectively and maintain high standards. Managers who stick to disciplined deal flow often achieve better results than those who compromise quality to hit deployment targets.

"In private markets, careful selection may drive results. Investors considering private markets may want to focus their manager selection on those with experience investing through multiple credit cycles. For managers, credit selection is critical when seeking to achieve attractive outcomes and mitigating downside risk." - BlackRock

Stress Testing Investments

Regularly stress-test potential investments against scenarios like interest rate hikes, economic downturns, or sector-specific challenges. Understanding how investments perform under adverse conditions is critical for assessing downside protection.

Leveraging Technology and Data

Incorporating technology and data analytics into due diligence is becoming more common. Evaluate whether managers effectively use these tools for credit assessments and ongoing portfolio monitoring. Strong systems for oversight can make a significant difference in managing risks.

By following these steps, you'll establish a strong foundation for evaluating the benefits and challenges of private credit investments.

Pros and Cons of Private Credit

Once due diligence is complete, it's essential to weigh the benefits and challenges of private credit.

Advantages	Disadvantages
Higher Yields: Offers a yield premium averaging 4.2% over public credit over the last decade	Illiquidity Risk: Investments are locked up for long periods with limited secondary market options
Floating Rate Structure: Loans tied to variable rates provide protection against rising interest rates	Credit Risk: Exposure to borrowers who may struggle to secure better financing terms
Stronger Lender Protections: Includes covenants and maintenance requirements, unlike broadly syndicated loans where 90% lack strict covenants	Complexity: Requires more extensive due diligence and ongoing monitoring than public markets
Direct Borrower Engagement: Smaller lender groups (2-5 managers) allow for better alignment and flexibility	Valuation Challenges: Infrequent valuations can lead to potential biases during stress periods
Diversification: Low correlation with traditional fixed income and equity markets	Fee Impact: Management and performance fees can reduce net returns significantly
Downside Protection: Senior positions in the capital structure and collateral backing	Market Timing Risk: Illiquidity can complicate tactical allocation adjustments

The current market environment presents both opportunities and risks. As David Miller, Head of Global Private Credit & Equity at Morgan Stanley, explains:

"Amid the current economic environment, we continue to take a proactive approach, which includes closely analyzing companies' earnings and free cash-flow generation."

Key Considerations in Today's Market

Private credit has become an attractive asset class, but it's not without challenges. Investors must stay cautious about increased exposure to lower-quality loans and relaxed underwriting standards, which have raised concerns in private debt portfolios.

Ultimately, private credit investments should align with your portfolio's liquidity needs, risk tolerance, and return goals. While the asset class offers appealing yields and diversification, its illiquid nature requires a long-term perspective and careful integration into your overall strategy. Success in private credit isn't just about spotting good opportunities - it's also about knowing when to walk away from deals that fall short of your risk and return criteria.

Conclusion: Making Smart Private Credit Investment Decisions

Private credit investing hinges on understanding deal structures, maintaining disciplined risk management, and adopting a long-term outlook. With the industry expected to grow from $1.6 trillion in 2024 to $2.7 trillion by 2029, it presents both exciting opportunities and significant complexities.

To succeed, investors must prioritize rigorous security selection and credit underwriting. As markets shift, those who can sidestep weaker credits through careful structuring and thorough due diligence will have a clear advantage. Strong underwriting practices form the foundation, but effective risk management is equally crucial.

Given the relative lack of transparency and regulatory oversight compared to public markets, investors need robust internal processes to evaluate opportunities. Although default rates are currently favorable at 2.71%, this shouldn’t lead to complacency. Instead, it highlights the need for proactive risk management to prepare for potential market changes.

The regulatory environment is also evolving. Global regulators are increasingly focusing on private credit markets. The International Monetary Fund, for instance, has called for enhanced oversight. Financial regulators may soon require greater transparency regarding banks' exposure to private credit, which could reshape how deals are structured and reported. These shifts underscore the importance of due diligence and adaptability.

For investors, aligning goals with risk tolerance and liquidity needs is key. Private credit offers yield premiums averaging 4.2% over public credit, but patience and strategic manager selection are essential. Partnering with experienced managers who uphold disciplined underwriting - even under pressure to deploy capital - can lead to more stable, attractive returns over time.

Success in this space demands a clear grasp of deal mechanics, realistic liquidity expectations, and resilient portfolio construction. By focusing on quality investments and adhering to rigorous due diligence, investors can better position themselves to capture the steady, long-term returns that make private credit so appealing.

As the boundaries between public and private markets continue to blur, those ready to adapt to this shifting landscape will find new opportunities to explore.

FAQs

What are the key risks of private credit investments, and how can investors reduce them?

Private credit investments carry a variety of risks, such as credit risk (the chance a borrower might default), illiquidity (difficulty in selling these investments on secondary markets), and economic sensitivity (borrowers facing challenges during economic downturns or recessions). These risks can directly affect both returns and the preservation of capital.

To address these challenges, investors should prioritize thorough due diligence. This includes assessing the borrower's creditworthiness, understanding industry trends, and evaluating the strength of the management team. Structuring deals with protective measures, like covenants, can offer an added layer of security. Diversifying investments across multiple borrowers, industries, and loan types is another effective way to limit the impact of individual defaults or sector-specific issues. A disciplined approach to risk management is critical for successfully navigating this specialized market.

How do fees in private credit investments affect the returns investors actually receive?

Fees have a big impact on the investors see from private credit investments. These typically include management fees - often around 1% of assets under management - and performance fees, which generally range from 10% to 20% of profits. While these fees are meant to reward fund managers for their expertise and hard work, they also cut into the returns investors ultimately receive.

For example, even if a private credit deal delivers strong gross returns, the combination of management and performance fees can significantly shrink the profits that make it to the investor. Because of this, it's crucial for investors to take a close look at the fee structure of any private credit opportunity to ensure the potential returns align with their financial objectives.

What role do private equity firms and hedge funds play in shaping the private credit market?

Private equity firms and hedge funds play a big role in shaping the private credit market, driving its expansion and pushing new ideas forward. With banks stepping back from leveraged lending, these firms have stepped up, making direct lending a cornerstone of their strategies.

What sets these players apart is the combination of deep capital reserves and specialized expertise they bring to the table. This enables them to craft financing solutions that are tailored to the unique needs of borrowers. Their presence has also intensified competition, prompting traditional asset managers - and even some banks - to increase their activity in this space. For investors, this evolving landscape offers both hurdles to overcome and promising opportunities to explore.

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• How Private Credit Became a Trillion Dollar Market
• What the Hell Is Private Credit - and Why You’ve Never Heard of It Until Now
• How Private Credit Outpaces Public Markets - While Being Secured
• You Think 5% Is Good? Try 20-40% - The Real High End of Private Credit Returns