Private Credit & Direct Lending

What is Private Credit?

Definition:

• Private credit = loans made by non-bank lenders that are not traded on public markets
• Also called "private debt," "alternative lending," or "shadow banking"
• Lenders are typically specialized investment funds, not traditional banks

The Basic Concept:

• Company needs capital → approaches private credit fund (not a bank)
• Fund negotiates terms directly with the borrower
• Loan is held by the fund until maturity (not syndicated or traded)

Private Credit vs. Traditional Lending

What is Direct Lending?

Definition:

• Direct lending = the largest segment of private credit
• A single lender (or small club) provides the entire loan directly to a borrower
• No bank intermediary, no syndication, no public market

What is Direct Lending?

How It Works:

• Borrower approaches direct lender (or vice versa through PE sponsor)
• Lender conducts due diligence and structures the loan
• Terms are negotiated bilaterally (one-on-one)
• Lender holds the loan on their books until repayment

The Private Credit Universe

Major Strategies Within Private Credit:

• Direct lending: Senior secured loans to middle-market companies (~60% of market)
• Mezzanine: Subordinated debt, often with equity kickers
• Distressed debt: Buying debt of troubled companies at a discount
• Special situations: Complex or time-sensitive financing needs
• Venture debt: Loans to early-stage, VC-backed companies
• Real estate debt: Private loans secured by property

Why Did Private Credit Emerge?

Post-2008 Regulatory Changes:

• Basel III capital requirements: Banks must hold more capital against risky loans
• Leveraged lending guidelines: Regulators discouraged banks from lending to highly leveraged borrowers
• Volcker Rule: Limited banks' proprietary trading and fund investments

Why Did Private Credit Emerge?

Result:

• Banks retreated from middle-market lending
• Created a $500B+ gap in available financing
• Private credit funds stepped in to fill this void

Why Borrowers Choose Private Credit

Speed and Certainty:

• Faster execution: Weeks instead of months — no syndication process
• Certainty of close: One decision-maker, not a committee or market
• No "market flex": Terms won't change based on market conditions

Why Borrowers Choose Private Credit

Flexibility:

• Customized structures: Tailored to specific business needs
• Confidentiality: No public disclosure required
• Relationship-based: Easier to negotiate amendments later

Why Borrowers Choose Private Credit

Access:

• Too small for public markets: Bond markets often require $300M+ issuance
• Banks won't lend: Regulatory constraints or risk appetite
• Complex situations: Turnarounds, acquisitions, or growth capital

Why Borrowers Choose Private Credit

The Trade-off:

• Private credit is more expensive than bank debt or public bonds
• Borrowers pay a premium for speed, certainty, and flexibility
• Typical spread premium: 100-300 bps over comparable syndicated loans

Key Market Participants

Who Are the Direct Lenders?

Types of Direct Lending Funds:

• Business Development Companies (BDCs): Publicly traded, provide retail investor access
• Private credit funds: Closed-end funds raised from institutional LPs
• Insurance company affiliates: Seeking yield and duration matching
• Bank-affiliated funds: Banks' off-balance-sheet lending arms

Who Are the Direct Lenders?

Major Players (by AUM):

• Ares Management, Apollo, Blackstone, Blue Owl, Golub Capital, HPS
• Top 10 managers control ~40% of the market
• But market is becoming more fragmented with new entrants

Who Borrows from Private Credit?

Typical Borrower Profile:

• Size: $10M - $100M EBITDA (the "middle market")
• Ownership: Often private equity-backed (~80% of deals)
• Credit quality: Typically below investment grade (B/B+ equivalent)
• Industries: Software, healthcare, business services, manufacturing

Use of Proceeds:

• LBO financing: PE firm acquiring a company
• Add-on acquisitions: Bolt-on M&A for existing portfolio companies
• Refinancing: Replacing existing debt at better terms
• Growth capital: Expansion, capex, working capital

The PE-Private Credit Relationship

Why PE Loves Private Credit:

• Repeat relationships: Same lenders across multiple deals
• Speed: Can close acquisitions faster than competitors
• Flexibility: Negotiate covenant terms that work for the business
• Partner mentality: Lenders understand the PE value creation model

The Dynamic:

• PE sponsors are the de facto "customers" of direct lenders
• Lenders compete for sponsor relationships
• Creates tension: borrower-friendly terms vs. lender protections

Anatomy of a Direct Lending Deal

Typical Deal Structure:

• Loan type: First lien, senior secured term loan
• Size: $50M - $500M (unitranche or senior stretch)
• Tenor: 5-7 years (typically 6-year average)
• Rate: Floating rate, tied to SOFR + spread
• Amortization: Minimal (1% annual) with bullet maturity

Unitranche vs. Traditional Structure

How Private Credit Deals Are Priced

Components of the All-in Cost:

• Base rate: SOFR (Secured Overnight Financing Rate)
• Credit spread: 450-700 bps depending on risk
• SOFR floor: Minimum base rate (often 0.75-1.00%)
• OID (Original Issue Discount): Upfront fee, typically 1-3%
• Commitment fee: On undrawn revolver (typically 50% of spread)

Private Credit Pricing Example

Calculating the Yield:

• Cash coupon: 4.50% + 5.75% = 10.25%
• OID amortized: 2.00% ÷ 4 years (assumed avg life) = 0.50%
• All-in yield to lender: ~10.75%

Private Credit Pricing Example

Covenants in Private Credit

Maintenance Covenants (Tested Quarterly):

• Leverage covenant: Max Net Debt / EBITDA (e.g., ≤6.0x)
• Interest coverage: Min EBITDA / Interest (e.g., ≥2.0x)
• Fixed charge coverage: Cash flow relative to fixed obligations

Incurrence Covenants (Tested at Events):

• Debt incurrence: Limits on additional borrowing
• Restricted payments: Limits on dividends, share buybacks
• Asset sales: Restrictions on selling material assets

Call Protection

What is Call Protection?

• Premiums borrower must pay to repay the loan early
• Protects lender's expected return on the investment
• Compensates for reinvestment risk

Typical Structure:

• Year 1: Non-call (cannot be repaid) or 3% premium
• Year 2: 2% premium
• Year 3: 1% premium
• Year 4+: Callable at par (no premium)

Credit Analysis in Private Credit

The 5 Cs of Credit (Still Relevant):

• Character: Management quality, track record, PE sponsor reputation
• Capacity: Cash flow to service debt (EBITDA, FCF)
• Capital: Equity cushion, debt/equity mix
• Collateral: Asset coverage, recovery prospects
• Conditions: Industry dynamics, macro environment

Key Credit Metrics

Leverage Metrics:

• Total Debt / EBITDA: Primary measure of leverage (typical: 4-6x)
• Net Debt / EBITDA: Adjusts for cash on balance sheet
• Senior Debt / EBITDA: Leverage at priority debt level

Coverage Metrics:

• EBITDA / Interest: Interest coverage ratio (typical: 2-3x)
• EBITDA - Capex / Debt Service: Cash flow coverage
• Fixed Charge Coverage: Broader measure including rent, mandatory amort

EBITDA Quality and Add-backs

The EBITDA Add-back Problem:

• Borrowers present "Adjusted EBITDA" with numerous add-backs
• Common add-backs: one-time costs, synergies, pro forma adjustments
• Can inflate EBITDA by 20-50% vs. "real" cash flow

Lender Due Diligence:

• Quality of earnings (QoE) analysis: Third-party verification
• Normalize for one-time items: True recurring earnings power
• Stress test add-backs: What if synergies don't materialize?

Industry Considerations

Preferred Industries for Direct Lending:

• Software/SaaS: Recurring revenue, high margins, asset-light
• Healthcare services: Stable demand, often recession-resistant
• Business services: Predictable cash flows, low capex
• Insurance brokers: Fee-based, sticky customer relationships

Industries to Approach Carefully:

• Retail: E-commerce disruption, inventory risk
• Energy: Commodity price volatility
• Hospitality: Cyclical, COVID showed vulnerability
• Highly cyclical manufacturing: Earnings volatility

The Direct Lending Process

Typical Timeline:

• Competitive deal: 4-8 weeks from CIM to close
• Proprietary deal: Can be faster (2-4 weeks)
• Complex situations: 8-12 weeks

Deal Origination

How Deals Come to Market:

• Sponsor relationships: PE firms bring deals to preferred lenders
• Investment bank-led processes: Competitive "bake-offs"
• Direct company outreach: Companies approach lenders directly
• Refinancing opportunities: Existing debt coming due

The Role of Relationships:

• Repeat sponsor relationships are gold
• Lenders invest heavily in sponsor coverage teams
• Best deals often go to "relationship" lenders first

Due Diligence in Direct Lending

Key Due Diligence Workstreams:

• Financial DD: Quality of earnings, cash flow analysis, projections
• Commercial DD: Market position, competitive dynamics, growth drivers
• Legal DD: Material contracts, litigation, regulatory compliance
• Management DD: Leadership assessment, track record
• ESG DD: Environmental, social, governance factors

Third-Party Reports:

• Lenders often receive or commission QoE, market studies, legal reviews
• Cost typically borne by borrower or split

Investment Committee Approval

The Credit Memo:

• Executive summary: Deal thesis and key terms
• Company overview: Business model, market position
• Financial analysis: Historical performance, projections, sensitivities
• Risk assessment: Key risks and mitigants
• Recommendation: Proposed terms and conditions

IC Decision Factors:

• Risk-adjusted return expectations
• Portfolio concentration and diversification
• Sponsor relationship considerations
• Competitive dynamics in the deal

Private Credit Return Profile

Target Returns (Net to LPs):

• Senior direct lending: 8-12% net IRR
• Unitranche: 9-13% net IRR
• Mezzanine: 12-16% net IRR
• Opportunistic/distressed: 15-20%+ net IRR

Return Composition:

• Current income: ~80-90% of return (cash coupon)
• Fees: OID, commitment fees, amendment fees
• Capital gains/losses: Typically minimal in performing credit

Key Risk Factors

Credit Risk:

• Default risk: Borrower fails to make interest or principal payments
• Loss given default: How much is recovered post-default
• Migration risk: Credit quality deterioration over time

Other Risks:

• Illiquidity risk: Cannot sell loans easily if needed
• Interest rate risk: Floating rates help, but floors limit benefit
• Concentration risk: Single borrower or industry exposure
• Covenant erosion: Competitive pressure weakening protections

Default and Recovery

Historical Default Rates:

• Middle-market loans: 2-4% annual default rate (long-term average)
• Stress periods: Can spike to 8-10% (e.g., 2008-09, 2020)
• Default rates vary significantly by vintage and underwriting standards

Default and Recovery

Recovery Expectations:

• First lien senior secured: 60-80% recovery
• Unitranche: 50-70% recovery
• Second lien: 20-40% recovery
• Unsecured/mezz: 10-30% recovery

The Illiquidity Premium

Why Private Credit Earns More:

• Illiquidity premium: 150-300 bps for holding loans to maturity
• Complexity premium: Custom structures require expertise
• Origination premium: Work to source and diligence deals
• Size premium: Smaller deals have higher per-dollar costs

Is It Worth It?

• For long-term investors (pensions, endowments): often yes
• For those needing liquidity: may not be appropriate
• Risk/return must be evaluated vs. liquid alternatives

Private Credit Market Size

Market Growth:

• 2010: ~$300 billion AUM
• 2020: ~$850 billion AUM
• 2024: ~$1.7 trillion AUM
• Projected 2028: $2.5+ trillion

Drivers of Growth:

• Bank retrenchment from middle-market lending
• PE deal volume requiring financing
• Institutional investor demand for yield
• Expanding addressable market (larger deals)

Competitive Dynamics

Impact of Capital Influx:

• Spread compression: More capital chasing deals → lower returns
• Leverage creep: Lenders accepting higher leverage to win deals
• Covenant erosion: Weaker protections to be competitive
• Moving up-market: Private credit competing in larger deals

Lender Response:

• Focus on relationship-driven proprietary deals
• Expand into new asset classes (real estate, infrastructure)
• Provide more comprehensive financing solutions

Private Credit vs. Syndicated Loans

When Does Private Credit Win?

• Deal size: $50M-$500M (too small for efficient syndication)
• Speed: Time-sensitive M&A or opportunistic situations
• Complexity: Non-standard structures or industries
• Confidentiality: Borrower prefers no public disclosure
• Flexibility: Potential future amendments anticipated

When Does the Syndicated Market Win?

• Large deals: $500M+ where pricing advantage emerges
• Rate-sensitive borrowers: Willing to trade flexibility for lower cost
• Established credits: Well-known issuers with public track record

Current Market Challenges

Concerns in the Market:

• Valuation transparency: Loans marked by lenders, not market
• Hidden stress: PIK (payment-in-kind) masking cash flow issues
• Covenant-lite creep: Protections weakening in competitive deals
• Concentration risk: Large funds with correlated exposures
• Rising rates impact: Higher debt service burden on borrowers

Regulatory Scrutiny:

• SEC and Fed increasing oversight of private credit
• Concerns about systemic risk and interconnectedness
• Focus on leverage, valuation practices, and liquidity

Skills for Success in Private Credit

Technical Skills:

• Financial modeling: LBO models, debt capacity analysis
• Credit analysis: Cash flow analysis, downside scenarios
• Accounting: Understanding financial statements, GAAP vs. cash
• Legal documents: Reading credit agreements, indentures

Soft Skills:

• Relationship building: Sponsors, borrowers, lawyers, bankers
• Negotiation: Term sheets, amendments, workouts
• Written communication: Credit memos, IC presentations
• Judgment: Knowing when risks are acceptable vs. deal-breakers

Private Credit: Key Takeaways

What You Should Remember:

• Private credit = non-bank lending outside public markets
• Direct lending is the largest segment (~60% of market)
• Emerged post-2008 as banks retreated from middle-market lending
• Borrowers pay a premium for speed, certainty, and flexibility
• Typical borrowers: PE-backed middle-market companies ($25M-$100M EBITDA)

Private Credit: Key Takeaways

Understanding the Product:

• Unitranche: Single loan combining senior + subordinated debt
• Pricing: SOFR + 450-650 bps, plus OID and fees
• Covenants: Typically tighter than syndicated loans
• Target returns: 8-13% net IRR depending on risk

Private Credit: Key Takeaways

Market Dynamics:

• Market has grown from $300B (2010) to $1.7T+ (2024)
• Competition is compressing spreads and weakening terms
• PE sponsors are the primary "customers" of direct lenders
• Increasing regulatory scrutiny as market grows

Career Consideration:

• Growing field with strong demand for talent
• Combines credit skills with relationship management
• More predictable lifestyle than PE/IB

Further Learning

Resources to Explore:

• Industry reports: Preqin, PitchBook, KBRA DLD
• Publications: Private Debt Investor, Creditflux
• Regulatory filings: BDC 10-Ks show real portfolios and performance
• Credit agreements: Publicly filed docs on SEC EDGAR
• Rating agency methodologies: Moody's, S&P guides to leveraged finance

Further Learning

Practice:

• Build LBO and debt capacity models
• Read credit memos and investment committee materials
• Analyze BDC portfolio companies' financials