Private credit is a type of lending by financial institutions that are not banks, such as alternative asset managers and private equity firms. Private credit is also known as private debt, direct lending, or private lending.

Private credit funds raise capital from investors, then make loans to businesses, rather than buying equity in them. The loans are typically due for repayment after three to seven years and have a floating (variable) interest rate.

Private credit in a nutshell

Businesses that typically find it hard to borrow in more traditional ways, like from banks or in the corporate bond markets, perhaps because they don’t meet strict lending criteria, often turn to private credit lending.

Private credit has exploded since the global financial crisis in 2008-9 – when banks cut back on their lending and investors were searching for yield in a zero-interest rate environment –. The worldwide market has grown from around $230bn in assets under management in 2008 to more than $1.6tn by March 2023. It is estimated to grow to $2.8tn by 2028.

Around 40 percent of private credit funds invest in the U.S. The other big market is Europe.

The attractions of private credit for a portfolio

Pension funds, family offices, insurance companies, high-net-worth individuals, and sovereign wealth funds are among the biggest investors – known as limited partners – in private credit funds.

Private credit is an attractive asset class to these institutional investors for its low correlation to public markets, relatively high returns, and, crucially, portfolio diversification, especially as the range of private credit assets available has rapidly grown in recent years.

For example, while private credit was typically extended to mid-market firms with annual revenues between $10 million and $1 billion, this has now changed to include larger companies, spreading the credit risk among a wider range of businesses.

Private credit also lends to a wide range of different sectors – from private corporate debt to infrastructure debt, venture debt, and commercial real estate debt – again spreading risk and creating a diversification of returns in a portfolio.

Investing in such diverse sectors across various company sizes means private debt funds can create portfolios that provide investors with lower volatility and so more stable returns that are uncorrelated with public markets and, in some cases, macroeconomics.

Risk management is a key part of private credit funds’ investing strategy. Before lending to a business the private credit fund’s manager will carry out thorough due diligence on it and analyze how credit-worthy it is.

A deal will only go ahead if the company seeking to borrow money agrees to strict repayment criteria and ongoing monitoring, and the private credit manager is confident they will get their money back plus interest for investors, even if economic circumstances change.

Smart ways to use private credit

Private credit, as well as being a portfolio diversifier, also provides debt financing to support various aspects of private equity transactions. Two particular uses are in recapitalization and secondary buyouts.

Using private credit for secondary buyouts

When a company owned by a private equity fund is sold to another private equity firm this is known as a secondary buyout, or sponsor-to-sponsor deal. Private credit can be used to fund these transactions.

Banks have historically underwritten most of the debt for big buyouts using syndicated loans. However private credit has become a popular alternative. This is because private credit firms can potentially offer more efficiency, certainty of execution, and flexibility.

In the case of secondary buyouts, private equity firms often prefer to work with other private equity firms as individual lenders, rather than with many bank lenders. Likewise, private credit firms may be more familiar with companies previously owned by other private equity firms and so more comfortable lending to them, possibly at higher levels of leverage.