Over the last two decades, private credit has grown exponentially to become one of the most important lending sources, particularly for those that do not meet the lending criteria of traditional banks.

At the same time, private credit as an asset class has captured the attention of institutional investors seeking new avenues for growth and portfolio diversification in debt assets outside of the public credit space. To better understand the distinctions and strategic implications, it’s important to explore the key differences between private credit vs. public credit.

In this guide, we’ll explore the evolution of the private credit market, the key trends shaping its future, the opportunities it presents, and the challenges that participants must navigate as they engage with this rapidly expanding sector.

Private debt market 101: What it is and how it works

Private credit, also called private debt, refers to corporate lending that takes place outside the traditional banking system and public markets.

Unlike public credit instruments like corporate bonds, which are issued and traded on the open market, private debt is negotiated privately between the lender and borrowers. The lenders in this market include private debt funds, asset management firms, and business development companies, while borrowers are primarily SMEs and middle-market firms.

There are several types of public debt, including the following:

Direct lending

This is where lenders provide credit, usually in the form of senior secured loans, directly to borrowers. Direct lending is the most common type of private debt, accounting for about 44% of overall assets under management (AUM).

Mezzanine debt:

This is a form of debt that combines elements of both debt and equity. Specifically, it includes features like warrants or convertible securities, which give lenders the right to convert their debt into equity under certain conditions or circumstances, like in default scenarios. In the capital structure, mezzanine debt sits beneath senior debt and offers higher returns to compensate for the increased risk.

Distressed debt

This is a type of private debt investing that involves purchasing the debt of financially troubled companies at a discount, with the aim of profiting from a restructuring or recovery of the company..

Special situations

This is a broad category that includes tailored debt solutions for unique events, such as restructurings, recapitalizations, or transitional ownership changes.

The primary return for private debt lenders is interest income, which tends to be higher than what would be offered by public credit markets. However, as seen above, depending on the type of debt, lenders may also receive equity-linked instruments, which allow them to participate in and benefit from the future upside of the business. Furthermore, many private debt deals include fees for structuring or managing the loan, which offers an additional layer of return for lenders.

For borrowers, the primary benefit of private debt financing is that it offers an alternative source of capital besides traditional bank financing. Furthermore, private credit offers more flexibility. Borrowers can structure financing in ways that better align with their cash flow cycles, operational timelines, or specific growth objectives.

A brief history of the private debt market’s evolution

While private credit has been around for some time, its significance has grown considerably over the last 15 years, particularly in the wake of the 2007-2008 global financial crisis.

As banks retreated from riskier lending due to new regulations, a financing gap emerged in the market, particularly for middle-market companies that were now finding it increasingly hard to secure debt financing from banks. Concurrently, yield-seeking investors, grappling with historically low interest rates in public markets, began exploring alternative investment strategies.

Private debt emerged as the perfect solution, offering institutional investors the potential for stable cash flows at premium rates while providing middle-market businesses with a much-needed financing alternative to commercial bank loans.

Today, the private debt market has become a big part of the global financial system, with assets under management reaching record levels. The global private debt market is currently valued at $1.8 trillion, a significant jump from just over $300 billion in 2010. Projections suggest it will grow to $2.64. trillion by 2028

Furthermore, the addressable market for private credit in the United States alone is estimated at a staggering $30 trillion, highlighting the immense growth potential within this asset class.

Emerging trends in the private debt market

As the private debt market matures, several key trends are shaping its future. These trends reflect both the evolving needs of borrowers and investors, and broader economic shifts.

Specialization in niche sectors

One of the most prominent trends in the private debt space is a shift toward specialization. Lenders, such as private debt funds, are increasingly targeting niche sectors such as healthcare, technology, infrastructure, and renewable energy.

This specialization allows lenders to cultivate deep expertise, enabling more accurate risk and opportunity assessments compared to generalist investors. This translates to enhanced investment decisions and more effective risk mitigation strategies.

Additionally, niche sectors often present opportunities for higher returns due to market inefficiencies or a lack of competition from traditional lenders. Many niche sectors are underserved by traditional banks, creating opportunities for private debt lenders to fill the financing gap. This can foster strong relationships with borrowers in these sectors and lead to a consistent flow of investment opportunities.

ESG investing in private debt

Environmental, social, and governance (ESG) factors are becoming more prominent in private debt investing. This is driven by increasing demand from investors who want to align their portfolio with sustainable and ethical business practices.

For private lenders, such as private debt funds, this trend presents an opportunity to differentiate themselves by offering specialized funding solutions that prioritize sustainable and socially responsible projects. It provides a chance to potentially unlock new pools of capital from institutional investors with ESG mandates.

For borrowers, the new trend presents new opportunities to access flexible, mission-aligned financing. Borrowers with strong ESG credentials may benefit from better lending terms or faster access to capital, especially when they can demonstrate measurable impact and outcomes.

Technology integration in private credit lending

Advancements in technology are reshaping how private debt is sourced, underwritten, and managed. For example, artificial intelligence (AI), machine learning, and data analytics are enabling more efficient and precise credit risk assessment and streamlining everyday fund operations. This is lowering the operational costs of lenders, which can enhance returns for investors.

Banks entering the private credit space

Another emerging trend within the private debt market is the growing involvement of traditional banks.  Recognizing the immense potential of private debt, many banks are either starting their own private credit divisions or forming collaborative partnerships with alternative lenders to both gain access to this growing market, and better serve their customers by offering more flexible financing solutions.

Key opportunities in the private market

The current economic landscape presents several compelling opportunities that private debt lenders can take advantage of to create value for their stakeholders. 

Providing junior and hybrid capital solutions

In the current high-interest environment, many fundamentally sound businesses now face constrained senior debt capacity due to increased debt servicing requirements. This creates an opportunity for private debt investors to provide junior or hybrid capital (like mezzanine debt or unitranche loans), which can help companies meet their debt obligations while giving them the flexibility to pursue growth initiatives.

In turn, private lenders get to enjoy higher yields due to the subordinated nature of the debt.

Financing growth quality companies

As equity and public market investors have shifted focus from growth-at-all-costs to profitability, a significant funding gap has emerged for scaling businesses with strong fundamentals.

Private credit providers are well-positioned to fill this void by offering tailored growth capital solutions. This allows highly promising companies to fund expansion without excessive equity dilution, while providing lenders with the possibility of enhanced returns through equity participation features, such as warrants.

Capitalizing on rescue financing opportunities

As the possibility of a recession looms, businesses may find themselves in need of rescue financing. This could be particularly relevant if companies face a liquidity crisis, but their underlying fundamentals remain strong.

For private debt investors, these situations represent an opportunity to step in with tailored financing solutions that can stabilize businesses. Providing capital to distressed companies can yield substantial returns, particularly when coupled with effective restructuring and turnaround strategies.

Challenges faced by private debt market participants

While private credit offers numerous advantages and attractive opportunities for participants, it also presents numerous risks that can affect the profitability and sustainability of investments.

 Let’s dissect the three most pressing challenges that private debt market participants must consider.

Regulatory risks

One of the most significant challenges facing private debt market participants is an evolving regulatory landscape. Private debt markets are generally less regulated than public debt markets, but as the sector continues to grow, regulators are increasingly turning their attention to the space.

Introduction of new regulations or changes to existing ones could impact the terms and conditions of private credit transactions. For example, stricter capital requirements or limitations on the types of loans that can be issued could reduce the availability of certain private debt investments, potentially leading to lower returns or fewer investment opportunities. Moreover, increased scrutiny from regulators can cause higher compliance costs for lenders such as private debt funds, which may be passed on to investors.

The lack of uniform regulations across different regions and jurisdictions adds another layer of complexity. What is permissible in one market may not be in another, making it difficult for private debt funds to operate smoothly on a global scale. This regulatory uncertainty can be a source of concern for both investors and borrowers, as it introduces an element of unpredictability into the market.

Illiquidity risks

Unlike publicly traded bonds or stocks, private debt investments are often illiquid, meaning they cannot be easily bought or sold on secondary markets. Once an investor commits capital to a private debt fund, for example, the investment is typically locked in for several years. This illiquidity can be a challenge for investors who need access to capital before the loan matures or the fund exits its investments.

In addition, the illiquid nature of private debt investments means that investors may have fewer opportunities to adjust their portfolios should market conditions or their investment objectives change.

Credit risk and market volatility

Another major challenge facing private debt market participants is credit risk and market volatility. Credit risk refers to the likelihood that a borrower may default on its debt obligations. This risk is particularly relevant in private debt, as many of the borrowers are smaller or less established companies with higher risk profiles.

Market volatility can exacerbate the default risk, as economic fluctuations, changing interest rates, or sector-specific downturns can negatively impact a borrower’s ability to repay its debt. For example, during an economic recession, companies may experience lower revenues or higher operational costs, which can strain their ability to meet loan obligations. In these scenarios, private debt investors may face higher default rates, reduced returns, or even the loss of their principal investment.

To mitigate these risks, private debt investors should conduct thorough due diligence, include relevant covenant protections in their lending agreements, and practice diversification across borrowers, debt instruments, and geographies.

Final thoughts: Private debt market trends, opportunities, and challenges

The private debt market has seen exceptional growth in recent years, with institutional investors increasingly turning to it as a way to diversify their portfolios and achieve steady, attractive returns. For borrowers, this market offers a valuable, flexible alternative to traditional financing options.

However, while the benefits and opportunities are abundant, investors must be mindful of the risks involved and implement relevant mitigation strategies to minimize potential downsides.

At Alter Domus, we specialize in supporting fund and asset managers in the private debt space. With our expertise and advanced private debt solutions, we empower you to make more informed decisions, manage risks effectively, and optimize your investment operations.

Reach out to our team today to learn how our private debt solutions can help you unlock the full potential of this highly promising market and stay ahead of the curve.

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Corporate lending was once the exclusive domain of commercial banks. However, over the last one and a half decades, a combination of economic shifts, market disruptions, regulatory reforms, and a growing hunger among investors for higher yields have catalyzed the rise of an alternative form of corporate funding known as private debt, or private credit.

Today, private debt is one of the most important components of the global business financing space.

This article looks at the growing influence of private debt financing and how it stacks up against traditional bank lending. We’ll look at why businesses are increasingly turning to it, the benefit it offers to both borrowers and lenders, and the strategies that banks are employing to stay competitive as private debt increasingly challenges their market dominance.

What is private debt financing?

Private debt financing refers to loans or credit extended to businesses by lenders who operate outside the traditional banking system. These are collectively known as non-bank lenders, and include private debt funds, asset management firms, and business development companies.

The returns for these non-bank lenders and their investors come primarily from interest payments on the loans they issue. These loans typically carry higher interest rates than traditional bank loans or publicly traded bonds. The higher rate reflects the added risks lenders take on, including the fact that private loans are typically illiquid (they can’t be easily sold or traded), and that borrowers are often small to mid-sized companies that may have less predictable cash flow or weaker credit profiles

The rise of private debt financing: A short history

Although private debt has existed in various forms for decades, its role in the financial ecosystem significantly expanded following the 2008 financial crisis.

As banks grappled with heightened regulatory scrutiny and capital constraints in the aftermath of the crisis, many scaled back their corporate lending activities. This created a vacuum in the market, particularly for middle-market companies, which were now deemed too risky for banks to lend to.

Recognizing this void, non-bank lenders quickly moved in to fill the gap, offering more flexible, accessible financing solutions to businesses that would have otherwise struggled to secure funding. 

Since then, private debt as an asset class has grown a lot. Currently, the global private debt market is valued at over $1.8 trillion (from just over $300 billion in 2010), with Preqin estimating it will reach $2.64 trillion by 2029.

The continued appetite and demand for private credit is driven by its appeal to businesses looking for financing alternatives to bank loans, and hunger among investors for yields that outpace traditional fixed-income investments.

Comparing private debt financing and bank lending

Let’s look at the primary differences between private debt.

Source of capital

As mentioned, lenders such as private debt funds and asset management firms that operate outside the traditional banking system issue private debt. These entities typically raise capital from institutional investors (such as pension funds, insurance companies, endowments, family offices, and high-net-worth individuals) with the specific mandate to grow it through investments like private debt. Since private lenders are not deposit-taking institutions, they are not subject to the same regulatory requirements as banks.

Traditional bank financing, by contrast, comes from regulated financial institutions, such as commercial banks and credit unions. These lenders use funds from customer deposits to issue loans and, as such, are subject to strict financial regulations that greatly shape how they assess credit risk and limit the types of loans they can issue.

Loan structure and flexibility

Private debt offers greater flexibility in structuring loans. Terms such as repayment schedules, covenants, interest types, and amortization are negotiated directly between the borrower and lender and thus can be tailored to their specific needs, circumstances, and preferences.

In contrast, traditional bank loans follow more standardized terms. Because banks must follow regulatory requirements and internal risk guidelines, the loan products they offer tend to be more rigid. Borrowers must meet predefined credit criteria, and there is usually less room for customization of the loan terms and structure.

Type of borrowers served

Private credit tends to serve riskier borrowers, or those who have more complex or unique financial needs, such as mid-market companies, private equity-backed firms, or those in high-growth sectors. These borrowers often struggle to meet the stringent requirements of traditional banks, particularly when it comes to having an established credit history or meeting certain size, cashflow or profitability thresholds.

In contrast, traditional banks generally serve larger, well-established companies with strong credit ratings, consistent financials, and a stable operating history.

Price of capital

The price of capital for private debt is generally higher than traditional bank financing. Private lenders charge higher interest rates and fees to offset the increased risk they are taking on, as mentioned earlier.

The price of capital from traditional banks is typically lower due to their lower risk exposure and regulated status.

Benefits of private debt financing

For borrowers

• Access to capital: Private debt provides an alternative for businesses that may not qualify for traditional bank loans. And for those who can still qualify for commercial bank loans, it allows them to diversify their sources of capital and reduce reliance on banks.
• Flexibility in terms: Private debt allows for customized loan structures, as we have seen, including repayment schedules, interest rates, and covenants. This flexibility helps businesses better align financing with their unique needs and cash flow situations.
• Speed and efficiency: Private debt deals can be processed faster than traditional bank financing (due to fewer regulations). This can give companies faster access to capital when time is critical.

For lenders

• Attractive returns: Private debt typically offers higher yields than other traditional fixed-income investments like public market bonds, making it an attractive option for lenders seeking superior returns on capital.
• Diversification and low correlation to public markets: Private debt allows funds and asset managers to diversify their portfolios beyond just traditional equity or public credit. Since private debt is not publicly traded, its performance is typically less correlated to public market fluctuations. Therefore, it can provide stability during periods of market downturns.
• Control and customization: The flexibility of private credit enables lenders to structure deals that better align with their desired outcomes and risk tolerance.

How banks are competing with private debt lenders

As private debt financing continues to gain traction, traditional banks are stepping up their game. Rather than ceding ground to non-bank lenders, banks are evolving their strategies to remain competitive and better serve the shifting needs of borrowers.

Prioritizing efficiency and speed

To match the agility of private debt firms, banks are focusing on improving the efficiency and speed of their lending processes. While regulatory frameworks limit how much banks can alter their lending models, they are finding ways to accelerate deal timelines and enhance borrower experiences. Many are streamlining approval processes, offering faster credit decisions, and creating more responsive loan servicing models.

A key driver behind these improvements is technology. For example, banks are increasingly leveraging AI and machine learning to assess credit risk more accurately and automate key parts of the underwriting workflow, resulting in quicker and more efficient loan approvals.

Developing in-house private credit capabilities

Recognizing the strong demand for private credit, major banks are building their own private lending operations. Big banks like Goldman Sachs, Morgan Stanley, and JPMorgan Chase all offer a private debt practice. These internal platforms allow banks to directly participate in the high-growth private debt space, while leveraging their existing client relationships and financial infrastructure.

Partnering with private debt firms

Rather than going head-to-head with private credit lenders, some banks are choosing to partner or collaborate with them. By forming co-lending partnerships with private debt lenders, banks can pool resources and expertise to offer larger, more flexible financing solutions. These partnerships enable banks to maintain a foothold in the private debt market without needing to create their own private credit offerings from scratch. 

Final thoughts: Private debt financing vs bank lenders

The corporate lending landscape has evolved significantly since the 2008 financial crisis, with private debt becoming a key alternative to traditional bank loans. Offering flexibility, speed, and tailored solutions – including asset based loans – this form of debt funding has become increasingly attractive, particularly to businesses with unique financing needs or that don’t meet the criteria of traditional banks.

Meanwhile, for fund and asset managers, private credit offers an opportunity to deliver significantly higher yields than what is possible with other fixed-income instruments. For a broader perspective on how this asset class compares to its public market counterpart, explore our article on private credit vs. public credit.

As a leading provider of private debt solutions, Alter Domus offers the operational infrastructure and support fund and asset managers need to execute and manage private debt strategies with efficiency and ease.

Visit our Private Debt Solutions page to learn more about how Alter Domus can help you better capitalize on the growth of private debt financing and achieve your goals.

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Private credit and public credit represent two distinct segments of the global credit market. While both serve the same fundamental purpose, which is to provide capital to borrowers while generating consistent returns for investors, they differ significantly in structure, accessibility, and their risk and return profile.

In this private credit vs public credit comparison guide, we’ll break down how the two asset classes stack up against one another so investors and borrowers alike can decide which is the better option for their needs and circumstances.

Understanding private and public credit

What is private credit?

Private credit refers to corporate lending that takes place outside the traditional banking system and public markets. It occurs between private investors and companies that prefer not to issue debt publicly. Non-bank lenders such as private debt funds, asset management firms, and business development companies (BDCs) often provide this type of credit.

Private credit is most commonly used by SMEs or middle-market firms that may have problems securing commercial bank loans due to their size, credit profile, or complex business models. Transactions are typically negotiated privately and often feature customized terms tailored to the specific needs of both the lender and the borrower.

As an asset class, private credit has gained popularity in recent years, particularly among middle-market companies looking for customized financing solutions and investors seeking higher yields than what’s currently being offered by bank loans and public debt, fueling the rapid expansion of the private debt market.

What is public credit?

Public credit refers to debt instruments, such as corporate bonds, that are issued and traded on public markets.

Larger, more established companies seeking capital from a wide pool of investors generally offer these instruments. Public credit is subject to extensive regulatory oversight, and details such as interest rates and maturity dates are publicly disclosed and accessible through open markets.

Private credit vs public credit: Key differences

Let’s look at some key differences between private and public credit.

Investor access

Public credit is available to both institutional and retail investors through platforms like bond markets or mutual funds. In contrast, private credit is generally limited to institutional investors such as private debt funds, mainly due to high minimum investment thresholds and the fact that there’s no open market for this asset class..

Standardization vs customization

Public debt instruments are typically standardized. This standardization allows for efficient trading and widespread accessibility. However, it also limits the ability to tailor loan terms to the specific needs of individual borrowers.

Private credit, on the other hand, offers greater customization. Loans can be structured to meet borrowers’ unique requirements, including flexible repayment schedules. For instance, a growing company seeking financing for a specific project might require a loan with a unique repayment structure that aligns with its projected cash flows. Private credit lenders can accommodate such needs.

Transparency and regulation

Public credit is highly regulated. Issuers are required to disclose financials, credit ratings, and material updates on a regular basis, which translates to high transparency for investors. 

Private credit operates in a more opaque environment. Detailed financial information may not be publicly accessible, and valuation may rely on third-party assessments. This lack of transparency increases the complexity of analyzing and monitoring private credit investments.

Liquidity

Public credit boasts high liquidity, meaning it’s relatively easy for investors to exit their investments. Private credit, on the other hand, is highly illiquid. There’s limited secondary market activity for the latter, and investors must be ready to commit their capital for multiple years (typically 5-10 years).

Risk and return profile

Private credit tends to carry higher risks than its public counterpart. This is primarily due to lower liquidity in private credit instruments. Additionally, private credit deals often involve smaller, less-established companies, which can increase the potential for default. To compensate for these increased risks, private credit typically offers higher yields.

Conversely, the yields of public credit are lower due to its higher liquidity and the fact that it generally involves lending to larger, more established firms, which have a lower risk of default.

Benefits of private credit

Private credit offers several benefits for both investors and borrowers.

Investors

For investors, the biggest benefit of private credit is the potential for enhanced returns. As mentioned, this asset class offers higher yields to compensate for its illiquidity and the overall higher risk of investments. For example, while investment-grade corporate bonds may yield 3–6%, private credit strategies (such as direct lending or mezzanine financing) often deliver 8–12% or more in annual returns. The Cliffwater Direct Lending Index (CDLI), for example, returned 12.13% in 2023 and has delivered a 9.55% annualized total return since its inception in 2004.

The other benefit is diversification. Private credit allows investors and managers to diversify their portfolios beyond just traditional equity or public debt. It has low correlation to public markets and can therefore act as a hedge against market volatility.

Finally, private credit allows investors to negotiate and tailor debt arrangements to align with their specific risk and return objectives.

Borrowers

Private credit provides a crucial source of capital for borrowers who may face challenges securing financing from traditional sources like banks. In particular, private debt financing enables businesses to structure deals quickly and confidentially, often on terms that align more closely with their unique operational and financial needs.

Private debt deals can also be completed faster, which is especially valuable in time-sensitive situations. Furthermore, unlike public debt, which requires detailed disclosures, private debt transactions are typically confidential. This allows borrowers to avoid disclosing sensitive information, which could impact their competitive position or market perception.

Benefits of public credit

Just like private credit, private credit also has its benefits for both investors and creditors.

Investors

Since public credit instruments, like corporate and government bonds, can be traded easily in secondary markets, this allows for quicker investor portfolio adjustments in response to changing market conditions or investment objectives.

Additionally, public disclosure requirements associated with public credit instruments make it easier to assess the relative value and potential worthiness of an investment.

Borrowers

For borrowers, public credit markets enable businesses to raise large amounts of capital efficiently from a broad investor base. Additionally, successfully issuing and managing public credit can enhance a borrower’s credibility, visibility, and creditworthiness in the eyes of stakeholders. The transparency and oversight involved can signal to the market that the company is financially sound and can meet its obligations.

Finally, for investment-grade issuers, the cost of capital in public markets is typically lower than private debt due to the lower perceived risk from public scrutiny and the liquidity offered to investors.

Final thoughts: Choosing between private credit and public credit

Private and public credit play important roles in the debt financing ecosystem. But as seen, they offer quite different value propositions for both investors and borrowers. Private credit stands out for its flexibility and potential for higher returns. It appeals to long-term investors willing to accept illiquidity and higher risk for the chance of greater rewards.

On the other hand, public credit offers greater liquidity, accessibility and a lower-risk profile. It is a better fit for investors who prioritize ease of entry and exit, transparency, and standardized terms.

Ultimately, choosing between private and public credit comes down to your investment objectives, risk appetite, and time horizon. By understanding what each option brings to the table, you can make more informed decisions and build a well-balanced credit strategy. Many sophisticated investors choose to incorporate both into their portfolios to balance risk and maximize returns.

For fund or asset managers looking to unlock the full potential of private credit, Alter Domus offers specialized solutions that support every stage of the private credit lifecycle, from fund structuring and loan administration to data analytics and investor reporting.

Get in touch with Alter Domus to learn how our private debt solutions and services can support your investment goals and help you create more value for your investors.

Private debt has become one of the fastest-growing segments of the alternative investment landscape. Once considered a very niche strategy, it has slowly gained mainstream acceptance, particularly among institutional and other sophisticated investors seeking higher yields and greater control over risk compared to traditional debt markets and other alternative asset classes, like private equity or venture capital.

The increased appetite and acceptance has led to a spike in private debt finds launched.

In this guide, we’ll tell you everything you need to know about private debt funds including how they operate, how they are structured, and some of the key strategies they employ to manage risk and generate value for investors.

What is a private debt fund?

Private debt, also known as private credit, refers to the provision of debt financing to borrowers through channels other than traditional banking institutions or public markets. So rather than securing loans from banks or issuing publicly-traded bonds, businesses borrow the funds needed to support growth, refinance existing debt or fund acquisitions and current operations from private lenders. Understanding the differences between private credit vs. public credit is essential to grasp how this asset class fits into a diversified investment strategy.

One of the primary sources of this type of lending is private debt funds. These are pooled investment vehicles that gather capital from a range of investors, including institutional investors (such as pension funds, insurance companies, and endowments) and high-net-worth individuals. The fund then strategically deploys this pooled capital to provide diverse forms of debt financing to companies.

Unlike public credit investment vehicles, which are traded on open markets, private debt is privately negotiated between the lender (the private debt fund) and the borrower (the company). This allows the lender and borrower to tailor the terms of the loan or debt facility to the specific needs of both parties.

Returns for investors in private debt funds primarily come from interest payments on the fund’s portfolio of loans. The rates charged depend on factors such as the borrower’s creditworthiness, the type of debt issued, and the prevailing market conditions.

But generally, the illiquid nature of private debt and the fact that they are typically extended to borrowers with more complex financing needs, such as middle-market companies or those lacking access to conventional financing, means they typically command higher rates to compensate for the higher risk and/or custom terms.

What’s more, most private debt also comes with a floating rate that’s pegged to a base rate, such as the Secured Overnight Financing Rate (SOFR), which offers investors potential protection against rising interest rates.

Why have private debt funds become popular?

Private debt funds rose to prominence following the 2008 global financial crisis. As banks came under tighter regulatory scrutiny and adopted more conservative lending practices, a financing gap emerged, particularly for middle-market firms and other businesses with riskier credit profiles.

Private debt funds stepped in to fill this void, positioning themselves as a vital alternative to traditional lending.

In the years following the financial crisis, persistently low interest rates (that meant low yields on traditional bonds and savings products) further pushed investors towards private debt as an alternative.

The end result has been exponential growth in this sector. Private debt assets under management have surged from just over $300 billion in 2010 to over $1.8 trillion currently. According to Preqin, this figure is projected to reach $2.64 trillion by 2029.

Benefits of private debt

Let’s look at some of the primary benefits of private debt for investors.

• Potential for enhanced returns: Private debt often offers the potential for higher risk-adjusted returns compared to traditional fixed-income investments. This is largely due to what’s known as the illiquidity premium, which is the additional return investors demand and receive for holding assets that cannot be easily sold or traded in the short term. Since private debt investments are typically long-term and not publicly traded, investors are compensated with higher yields.
• Diversification benefits: Private debt offers portfolio diversification by providing access to an asset class that tends to behave differently from publicly traded investments. They can act as a stabilizing force against market volatility in a broader investment portfolio.
• Customization and risk control: Managers of private debt funds possess greater control over the terms of the loans they originate. This enhanced control allows them to better manage credit risk and tailor each investment to specifically meet the fund’s desired risk-return profile.

Types of private debt funds

Private debt funds come in various forms. Let’s look at the most common types.

Direct lending funds

Direct lending is the most common form of private debt, accounting for about 44% of overall assets under management (AUM).  It involves providing loans directly to middle-market companies. These loans usually take the form of senior secured debt, meaning they are backed by the borrower’s assets and have priority in repayment if default occurs. However, they can also take other forms, such as unitranche loans (combining senior and subordinated debt). 

Distressed debt funds

These funds invest in the debts of companies facing financial difficulties. The objective here is to purchase debt at a discount, with the potential to realize significant gains if the company’s fortunes improve or through restructuring initiatives.

Mezzanine debt funds

Mezzanine debt is a hybrid form of financing that offers both debt and equity-like features (e.g., equity warrants or conversion rights). In the capital structure, it sits between senior debt and equity and therefore carries higher risk. Accordingly, mezzanine debt offers higher returns to compensate for this increased risk.

This type of debt is commonly used in leveraged buyouts and other acquisition financing. For corporate borrowers, mezzanine debt is attractive because it provides growth capital without diluting ownership significantly or imposing the restrictive covenants of senior loans.

Special situations

Special situations investing involves deploying debt capital in companies undergoing unusual or complex events that create opportunities for value realization. These events might include restructurings, asset sales, spin-offs, regulatory changes, or shareholder activism. Unlike distressed debt, which deals with troubled companies, special situations may involve fundamentally sound businesses facing temporary disruptions or strategic shifts.

The goal is to capitalize on the inefficiencies caused by these unique circumstances and profit when things settle down. The approach is highly opportunistic and requires deep due diligence and a hands-on style. However, the returns for special situations debt funds can be high due to limited competition and borrower urgency.

How private debt funds are structured and managed

Private debt funds are often set up as limited partnerships comprising two main stakeholders.

Limited Partners (LPs)

These are investors committing capital to the fund. As mentioned, they include institutional investors, like pension funds, insurance companies, and endowments, and high-net-worth individuals. LPs have limited liability, meaning their potential losses are typically capped at their investment amount.

General Partner (GP)

They are the fund managers. They are responsible for setting the fund’s strategic direction and overseeing its day-to-day operations, including sourcing deals, conducting due diligence, managing the portfolio, and ultimately exiting investments. The GPs have unlimited liability.

The relationship between LPs and the GPs is governed by a detailed Limited Partnership Agreement (LPA), which defines the investment strategy of the firm, the fee structure, and other important terms.

Besides the GPs and the LPs, there are several other players in a private debt fund who also play an important role. These include analysts and specialists who provide crucial support to the fund managers in evaluating and managing investments.

How private debt funds work

The investment process of a private debt fund involves the following steps.

Identifying investment opportunities

The first step in a private debt fund’s operation is sourcing deals, i.e., seeking potential entities needing private debt financing. This typically involves leveraging established relationships and networks with intermediaries such as investment banks, private equity funds, financial advisers, and business owners. In some cases, corporate borrowers may bring potential debt financing opportunities directly to the private debt fund.

Initial deal screening

Once a deal is identified, it undergoes initial screening to determine whether it fits the fund’s strategy and risk profile. At this stage, the investment team assesses the loan amount, purpose, borrower type, and broad financial metrics. Deals that don’t meet the basic criteria are quickly filtered out to focus resources on stronger candidates.

Creditworthiness assessment (risk & return evaluation)

This is one of the most critical steps in the process. The fund conducts a detailed evaluation of the borrower’s financial health, business model, and industry position. Key metrics such as cash flow stability, leverage, and collateral coverage are analyzed to understand the risk of default and the potential return.

This phase may also include scenario testing to assess how the borrower would perform under various stress conditions. The overarching goal here is to evaluate the risk-return tradeoff and determine whether the loan offers sufficient return relative to the risks involved.

Due diligence

If the borrower clears the credit assessment, the fund moves into due diligence. This involves validating the borrower’s financials, reviewing legal documentation, and evaluating any operational risks. The team may conduct site visits, consult external advisors, and review contracts or litigation history to ensure there are no hidden red flags.

Deal structuring

Once due diligence is complete, the next step is structuring the deal. This includes setting the interest rate, repayment schedule, financial covenants, and collateral requirements.

Investment committee approval

The proposed deal is then presented to the investment committee for final approval. The committee reviews the investment thesis, risk profile, and return expectations. If approved, the fund proceeds to legal execution and funding.

Execution and funding

Legal documents are finalized, and the capital is disbursed according to the agreed terms. The fund ensures the borrower complies with initial conditions and that all security interests are properly registered.

Ongoing monitoring

Post-investment, the fund closely monitors the borrower’s financial health and compliance with loan terms. This includes tracking timely interest payments, reviewing financial statements, and checking adherence to covenants. Missed or delayed interest payments can be an early signal of distress, prompting the fund to intervene or renegotiate terms. Active monitoring helps safeguard returns and ensures the portfolio remains on track.

These loan monitoring and administrative tasks are often referred to as middle office operations, and tend to be time-consuming, involved workflows that require in-depth knowledge of bespoke credit vehicles. Due to this, many private debt managers choose to outsource some or all of their middle office credit operations . Alter Domus offers services for any loan or fund operations task from such as loan agency or loan administration.

Key investment strategies for private debt funds

Private debt funds use several investment strategies to achieve their core objectives of generating consistent income, preserving capital, and delivering strong risk-adjusted returns for investors. Let’s break down the most notable strategies.

Sector-focused investing

Many private debt funds are increasingly adopting a sector-focused approach. Some sectors that are popular with private debt funds include real estate, technology, infrastructure, healthcare, and industrials. Focusing on specific sectors allows fund managers to build deep industry knowledge, build valuable networks, and better assess the risks and opportunities associated with potential borrowers.

Covenants and protections

Private debt funds often incorporate specific covenants in loan agreements. These covenants are designed to protect the lender’s investment and provide early warning signs if the borrower’s financial health begins to deteriorate. The two main types of covenants are:

• Financial covenants: These, for example, may require borrowers to maintain certain leverage ratios or liquidity levels.
• Operational covenants: These may include restrictions on asset sales, additional debt, or other business activities that could increase risk.

Diversification

Diversification is another key strategy that many funds use to achieve their objectives. Rather than concentrating capital in a few large positions, fund managers typically spread investments across multiple borrowers, industries, and geographies.

This approach limits the fund’s exposure to any single point of failure, be it a borrower default or regional economic shock.

Importantly, sector focus, which we looked at earlier, and diversification are not mutually exclusive. A fund may specialize in a few core sectors while still diversifying across different borrowers, deal sizes, geographies, and loan types. For example, a fund focused on infrastructure might diversify by investing in different sub-sectors (e.g., energy, transportation, and utilities) or by combining senior debt, subordinated debt, and unitranche structures.

The result of diversification is a more resilient portfolio; that is, one that’s better equipped to withstand cyclical shifts while delivering consistent, risk-adjusted returns over time.

Common questions about private debt funds

How liquid are private debt funds?

Unlike publicly traded stocks or bonds that can be bought and sold relatively easily on exchanges, private debt investments are generally considered illiquid. This means that it can be challenging for investors to sell their fund interests or the underlying debt holdings quickly and at a fair market price. In fact, most private debt funds are structured as closed-end funds with multi-year lock-up periods, typically ranging from five to ten years.

The illiquid nature of private debt is not inherently negative, however, as we’ve already seen. It’s often compensated by higher yields. But it does mean investors should carefully consider their own liquidity needs and investment horizon before committing capital.

Generally, private debt funds may be more suitable for investors with a long-term perspective, i.e., who do not require immediate access to their capital and are comfortable with it being committed for an extended period.

What are the fees and costs associated with private debt funds?

Like many other actively managed investment vehicles, private debt funds charge management and performance fees.

A typical structure includes a management fee of around 1% to 2% of committed capital, which covers operational and administrative costs. In addition, fund managers may earn a performance fee (or “carried interest”), of around 10% to 20% of profits, once a hurdle return is met, often in the range of 6% to 8%.

If there are any other fees or charges, they will be outlined in the fund’s LPA.

Final thoughts: Understanding private debt funds

Private debt funds have become a key part of the alternative investment space.  Their appeal to investors stems from the potential for strong risk-adjusted returns, greater control over deal terms, and a low correlation to public market movements. 

However, understanding the structure, operations, and strategies behind private debt funds is crucial for making informed investment decisions.

Overall, private debt can be a compelling option and a valuable addition to an investor’s portfolio, provided they are comfortable with longer investment horizons and limited liquidity.

For fund managers, success in the private debt market depends on not just being able to source quality deals but also having a strong operational backbone. Alter Domuscan help with the latter. We provide custom private debt solutions that streamline fund management, optimize operational efficiency, and support fund managers in navigating the complexities of the private credit markets.

Reach out today to learn more about how Alter Domus can support your private debt strategy.

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