Private credit works by pairing a borrower directly with a non-bank lender, usually a specialized investment fund, that negotiates and holds the loan itself instead of routing it through a bank syndicate or a public bond market. Each loan is bilateral: one lender, one borrower, one credit agreement written for that specific deal. The lender earns interest, the borrower gets capital tailored to its situation, and the fund’s investors get a yield-oriented return in exchange for locking their money up for years.
To see how the pieces fit, it helps to look at the loan first, then the fund that holds it, then the rules that sit over both.
Who Sits on Each Side of the Loan
On the lender side are asset managers and private equity firms that run dedicated debt funds. Some of these are Business Development Companies, publicly regulated vehicles built to lend to smaller businesses. Others are private funds open only to institutional and accredited investors.
On the borrower side are mostly middle-market companies, generally those with annual revenues between roughly $10 million and $1 billion, though larger companies increasingly borrow this way too.1Board of Governors of the Federal Reserve System. Private Credit: Characteristics and Risks They come looking for money to fund acquisitions, expansions, or refinancings when a traditional bank line isn’t big enough, fast enough, or flexible enough. Companies owned by private equity sponsors are especially common borrowers because buyout capital structures often need terms banks won’t write.
Because the relationship is one-to-one, the lender gets deep visibility into the borrower’s finances and the borrower gets a single counterparty to call when conditions change. That direct line is one of the reasons private credit exists at all.
How the Loans Are Structured
There is no standard prospectus. Each credit agreement is negotiated, and the details can move a long way from deal to deal. A few features show up in nearly every one.
Floating Rates
Almost all private credit loans carry floating interest rates tied to a benchmark, most commonly the Secured Overnight Financing Rate.1Board of Governors of the Federal Reserve System. Private Credit: Characteristics and Risks The lender adds a spread on top for credit risk, commonly 450 to 700 basis points on middle-market loans, though the number moves with market conditions. When rates fall, borrowers pay less; when rates rise, payments climb, which has strained some borrowers during recent hiking cycles.
Covenants and Maturity
Maturities usually run five to seven years. During that time the borrower has to pass ongoing financial tests called maintenance covenants, typically checked quarterly. A common one is a total leverage ratio that caps debt at a set multiple of EBITDA. Break a covenant and the lender can demand early repayment, force a restructuring, or impose new restrictions.
Collateral
Most of these loans are secured. The lender takes a security interest in the borrower’s assets, which under the Uniform Commercial Code becomes enforceable once the borrower signs a security agreement describing the collateral, the lender has given value, and the borrower has rights in that collateral.2Legal Information Institute. UCC 9-203 – Attachment and Enforceability of Security Interest The lender then files a UCC-1 financing statement with the state to establish priority. If the borrower defaults, secured lenders can seize and sell the pledged assets ahead of unsecured creditors.
Payment-in-Kind Interest
Some agreements let the borrower pay interest in kind, meaning the interest owed is added to the principal balance instead of paid in cash. It preserves the borrower’s cash during growth or stress but grows the balance owed. Lenders charge a higher rate for PIK to make up for the deferred cash and the risk that the larger principal won’t be repaid in full.
The Main Forms Private Credit Takes
Direct Lending
Direct lending is the largest segment. These are senior secured loans at the top of the borrower’s capital structure, first in line for repayment in a liquidation. A single lender typically writes the whole loan rather than syndicating it. That has made direct lending a common alternative to bank-led facilities, particularly for private equity acquisitions where speed and certainty matter.
Unitranche
Unitranche loans collapse what would traditionally be separate senior and subordinated layers into one loan with a blended rate. The borrower sees one lender, one agreement, one set of terms, which speeds up closing. Unitranche has become common in mid-market buyouts because it removes the friction of negotiating with multiple creditor classes.
Mezzanine
Mezzanine debt sits between senior loans and equity. Because mezzanine lenders are paid only after senior creditors in a bankruptcy, they charge markedly higher rates. They also often take equity warrants, giving them a share of the upside if the company performs. This lets borrowers raise capital beyond their senior debt capacity without fully diluting existing owners.
Asset-Based Lending
Asset-based lending sizes the loan to the value of the borrower’s assets rather than to projected cash flow. The lender sets a borrowing base against eligible collateral. Advance rates commonly run 70 to 85 percent on eligible accounts receivable, and up to 65 percent of book value or 80 percent of net orderly liquidation value on inventory.3Office of the Comptroller of the Currency. Comptrollers Handbook: Asset-Based Lending ABL facilities usually carry fewer financial covenants than cash-flow loans, which suits companies with strong collateral and uneven revenue.
Distressed Debt
Distressed investors buy the existing loans or bonds of troubled companies at steep discounts to face value, aiming to profit from a restructuring, a debt-for-equity conversion, or a recovery. Valuations are harder here than in public markets because there are no trading prices; fair value can end up depending on judicial determinations in bankruptcy proceedings.
How the Fund Behind the Loans Works
Almost every private credit loan is held by a fund, and how that fund is put together shapes the whole strategy.
The money comes from large institutional investors that want steady income over long time horizons: pension funds, insurance companies, sovereign wealth funds, and university endowments. They accept the illiquidity of private loans in exchange for yields higher than most publicly traded bonds.
The fund itself is a limited partnership. A General Partner runs the investment strategy, picking loans, negotiating terms, and monitoring borrowers. Limited Partners provide most of the capital but don’t choose individual investments. The Limited Partnership Agreement sets the GP’s management fee, typically 1.5 to 2 percent of committed or invested capital, plus carried interest that pays the GP when returns clear a specified benchmark.
Capital Calls
LPs don’t wire in their full commitment on day one. The GP issues capital calls as lending opportunities appear, drawing down each investor’s commitment in stages across the fund’s investment period. Missing a call can be costly: partnership agreements can impose penalty interest on the overdue amount or, at the extreme, forfeiture of the LP’s entire stake. Investors have to keep enough liquidity to meet calls on short notice, sometimes within 10 to 15 business days.
Lock-Ups
Most private credit funds lock capital up for the life of the fund, often seven to ten years across the investment and harvesting periods. Early redemptions generally aren’t available. Some funds offer limited liquidity windows or let investors sell their interests on the secondary market, but those sales tend to price at a discount. That illiquidity is a core trade-off for the yield.
What Investors Owe in Tax
Tax treatment depends on who the investor is. For taxable investors, interest income flows through the partnership and is taxed as ordinary income at the investor’s rate.
Tax-Exempt Investors and UBTI
Pension funds, endowments, and other tax-exempt investors generally don’t owe tax on interest. But interest becomes taxable as Unrelated Business Taxable Income when the fund uses borrowed money to make its investments, because income from debt-financed property loses its tax-exempt character.4Internal Revenue Service. Publication 598 – Tax on Unrelated Business Income of Exempt Organizations Since many private credit funds use subscription credit lines or other leverage, tax-exempt investors have to look closely at each fund’s structure for UBTI exposure.
Foreign Investors and FATCA
Foreign investors in U.S. private credit funds run into the Foreign Account Tax Compliance Act. Foreign financial institutions, which includes investment funds, must register with the IRS and agree to report information about their U.S. accounts. Those that don’t register and comply face a 30 percent withholding tax on certain U.S.-source payments.5Internal Revenue Service. FATCA Information for Foreign Financial Institutions and Entities
Who Regulates the Market
Fund Managers
The SEC oversees private credit fund managers primarily through the Investment Advisers Act of 1940.6U.S. Securities and Exchange Commission. Private Fund Advisers Firms managing $150 million or more in private fund assets register with the SEC as investment advisers and file Form ADV, a public document covering ownership, employees, strategies, fees, and conflicts. Smaller firms usually register with state securities regulators. The SEC has also adopted rules aimed specifically at private fund advisers, including limits on preferential treatment of certain investors and restrictions on some fund activities.
Business Development Companies
BDCs elect regulation under the Investment Company Act of 1940, which imposes restrictions on leverage, diversification, and affiliated transactions that don’t apply to purely private funds.7U.S. Securities and Exchange Commission. Investment Company Registration and Regulation Package They must maintain asset coverage of at least 150 percent, equivalent to a maximum 2-to-1 debt-to-equity ratio. They also follow fair-value accounting for their private loan portfolios and register their securities under the Securities Exchange Act of 1934, which makes their financials public.
Insurance Company Investors
Insurance companies that invest in private credit face risk-based capital requirements set by the National Association of Insurance Commissioners. The rules assign capital charges by risk profile. Collateral loans backed by mortgage assets carry a proposed 3 percent RBC charge, for instance, while loans backed by joint venture or limited partnership interests carry a 30 percent charge.8National Association of Insurance Commissioners. RBC Proposal Form – Life RBC Working Group – Collateral Loan Schedule BA Reporting Changes Those charges shape how much private credit exposure an insurer can carry, and by extension how much insurance capital flows into the market.