Private debt funds: An in-depth guide

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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