Private debt is capital loaned to companies by non-bank lenders through privately negotiated agreements that are not traded on public exchanges. Instead of a corporate bond that changes hands on a stock exchange, a private debt instrument is a bilateral contract held by the lender until repayment. The global private credit market passed $2 trillion by mid-2024, having grown roughly fivefold since 2009, and it now sits among the fastest-expanding corners of alternative finance.1Board of Governors of the Federal Reserve System. Bank Lending to Private Credit: Size, Characteristics, and Financial Stability Implications
For an investor, private debt promises higher yields than most publicly traded fixed income. It also comes with multi-year lock-ups, no daily market price, and lighter regulatory disclosure than bank loans or public bonds.1Board of Governors of the Federal Reserve System. Bank Lending to Private Credit: Size, Characteristics, and Financial Stability Implications Understanding what you actually own starts with the different shapes private debt takes.
The Main Forms of Private Debt
Private debt is a category, not a single product. Each strategy carries a different level of risk, a different position in the borrower’s repayment order, and a different return profile.
Direct Lending
Direct lending is the largest strategy in the market, accounting for roughly 36% of private credit assets under management. These loans are senior secured debt, which places them at the top of the borrower’s repayment hierarchy. If the borrower is liquidated, direct lenders are paid first, and their claim is backed by specific company assets such as real estate, equipment, or intellectual property.
For borrowers, direct lending replaces a bank syndicate or bond offering with a single lender or small lender group. That means faster execution and fewer parties at the table.
Mezzanine Debt
Mezzanine debt sits between senior loans and equity in the repayment order. Because mezzanine lenders are among the last creditors repaid, they demand more. Total returns typically fall between 12% and 17%, with the coupon itself usually running 10% to 14%. The rest of the return comes from an equity component, often warrants or conversion rights that let the lender take an ownership stake in the borrower.
Mezzanine debt is rarely secured by specific assets, and senior lenders often treat it as closer to equity than to debt. Borrowers use it to bridge the gap between what a senior loan will cover and the equity they can put up themselves, a common structure in leveraged buyouts.
Unitranche Debt
Unitranche financing combines senior and subordinated debt into one loan with a single blended interest rate and one set of terms. The borrower signs a single credit agreement instead of stacking separate senior and mezzanine deals. Terms typically run five to seven years. Behind the scenes, the lenders may still split the loan into first- and second-priority pieces, but the borrower deals with one rate, one repayment schedule, and one set of covenants.
Distressed Debt
Distressed debt investing involves buying the existing loans or bonds of companies in serious financial trouble, usually at steep discounts. The investor’s aim is to influence or profit from a restructuring. In some cases, an investor acquires enough of the debt to convert it into an equity stake and effectively become the new owner. A successful restructuring can produce strong returns; a second failure can wipe them out.
Who Borrows and Who Lends
Middle-market companies are the core borrowers. They have outgrown conventional bank loans but lack the scale or public profile to issue bonds on the open market. Private equity firms are heavy users too, funding acquisitions with private credit because a direct negotiation gives them more speed and certainty than assembling a bank syndicate.
To qualify, a borrower generally needs stable, predictable cash flows. Lenders measure this through EBITDA (earnings before interest, taxes, depreciation, and amortization) and then size the loan against it. In the middle market, total leverage typically runs 4.5 to 5.5 times annual EBITDA. Smaller or less-established borrowers may also have to give a personal guarantee, which makes the owners personally liable if the business cannot repay.
On the other side of the transaction, the lenders come in two main forms.
Business Development Companies
Business Development Companies (BDCs) are specialized investment vehicles created by Congress to channel capital toward private businesses. A BDC cannot acquire new assets unless at least 70% of its total asset value is already invested in qualifying holdings, primarily securities of private companies or thinly traded public firms bought in private transactions.2Office of the Law Revision Counsel. 15 U.S.C. 80a-54 – Acquisition of Assets by Business Development Companies BDCs have driven a meaningful share of the industry’s growth.1Board of Governors of the Federal Reserve System. Bank Lending to Private Credit: Size, Characteristics, and Financial Stability Implications
To keep their favorable tax treatment as regulated investment companies, BDCs must distribute at least 90% of their investment company taxable income to shareholders every year.3GovInfo. 26 U.S.C. 852 – Taxation of Regulated Investment Companies and Their Shareholders The pass-through structure avoids corporate-level tax, but it also means nearly all earnings leave the vehicle as distributions rather than being reinvested.
Private Credit Funds and Other Institutions
Private credit funds are typically limited partnerships that pool capital from institutional investors: pension plans, endowments, sovereign wealth funds, and family offices. Insurance companies and hedge funds also participate, chasing yields above what government bonds and public corporate debt offer. These vehicles operate under different regulatory constraints than banks, which gives them flexibility in loan structuring and, at the same time, less public oversight.
How the Loan Agreements Are Structured
Private debt contracts are individually negotiated, so terms vary. Most agreements share a few common features that shape the investor’s return.
Interest Rates
Most private debt uses floating interest rates that reset periodically against a market benchmark. The Secured Overnight Financing Rate (SOFR) has replaced the now-defunct LIBOR as the dominant U.S. dollar benchmark for pricing these loans.4Federal Reserve Bank of New York. Transition from LIBOR A private loan is typically quoted as SOFR plus a fixed spread, for example SOFR plus 400 to 600 basis points, with the actual spread depending on the borrower’s credit quality, the loan’s seniority, and market conditions.
Financial Covenants
Loan agreements include financial covenants, ongoing tests the borrower must meet to avoid triggering a default. A common one is a maximum debt-to-EBITDA ratio that caps how much total debt the borrower can carry relative to earnings. A breach lets the lender declare a default, accelerate repayment, or renegotiate terms.
Covenant-lite deals, which impose fewer restrictions on borrowers, have become more common. Lighter covenants make private credit more attractive to borrowers and reduce the lender’s ability to intervene early when a borrower’s finances start slipping. Because these agreements are private, their specific terms are not filed with the SEC or disclosed publicly.
Call Protection
Lenders protect their expected returns with call protection, penalties the borrower pays for repaying early. The penalty typically declines over time. One common schedule: 3% of the outstanding balance if prepaid in year one, 2% in year two, 1% in year three, and no penalty afterward. That structure compensates the lender for lost interest income when a borrower refinances into a cheaper loan.
Who Can Actually Invest in Private Debt
Most private credit offerings are not registered with the SEC for public sale. They rely on exemptions under Regulation D, which lets companies raise capital through private placements without full public registration. Issuers must file a Form D notice with the SEC within 15 days after the first sale.5U.S. Securities and Exchange Commission. Exempt Offerings
Under Rule 506(b), the most common exemption, the offering cannot be publicly advertised and sales are limited to no more than 35 non-accredited investors in any 90-day period. Rule 506(c) allows public advertising but restricts sales exclusively to accredited investors and requires the issuer to take reasonable steps to verify each investor’s status.5U.S. Securities and Exchange Commission. Exempt Offerings
To qualify as an accredited investor, an individual needs a net worth over $1 million (excluding a primary residence), either alone or with a spouse or partner. The alternative test is income above $200,000 individually, or $300,000 jointly with a spouse or partner, in each of the prior two years, with a reasonable expectation of the same for the current year.6U.S. Securities and Exchange Commission. Accredited Investors
For Rule 506(c) offerings, checking a box is not enough. Issuers must take objective verification steps, which can include reviewing tax returns and W-2s for income claims, reviewing bank and brokerage statements for net worth claims, or getting written confirmation from a registered broker-dealer, investment adviser, licensed attorney, or CPA.7U.S. Securities and Exchange Commission. Assessing Accredited Investors under Regulation D
Publicly traded BDCs are the exception: their shares trade on stock exchanges and are open to any investor, though the underlying assets carry the same private credit risks as the funds above.
Fees You Pay as an Investor
Private credit funds charge two layers of fees. The first is an annual management fee, paid during the fund’s life regardless of performance. The second is carried interest, sometimes called a performance fee, which the manager earns only when returns exceed a hurdle rate known as the preferred return. The historical benchmark was 2% and 20%, but median terms have compressed. Recent industry data puts the typical structure closer to a 1.5% management fee and 15% carried interest, with preferred returns of 6% to 7%.
Tax Treatment
Private credit investors face tax rules that differ from those covering ordinary stocks and bonds. The fund’s structure determines how the income is reported and taxed.
Schedule K-1 Reporting
Investors in private credit funds structured as partnerships or S corporations receive a Schedule K-1 each year instead of a 1099. The K-1 reports your share of the fund’s income, deductions, and credits. You owe tax on your allocated share of income whether or not the fund actually distributed it to you. If you file on a calendar-year basis but the fund uses a fiscal year, you report the amounts on your return for the year in which the fund’s fiscal year ends.8Internal Revenue Service. Shareholder’s Instructions for Schedule K-1 (Form 1120-S)
BDC Distributions
BDC distributions are generally taxed as ordinary income at your regular rate, which can reach 37% depending on your bracket. Most BDC dividends do not qualify for the lower capital gains rates that apply to qualified dividends from many publicly traded stocks. Because BDCs must distribute nearly all of their income, most of your return arrives as fully taxable distributions.
Retirement Accounts and UBTI
Holding private debt in a self-directed IRA does not automatically shield the income. If the investment produces unrelated business taxable income (UBTI), which can happen when a fund uses debt leverage, and gross UBTI exceeds $1,000, the retirement account must file Form 990-T and pay tax. The filing burden falls on the IRA owner, not the custodian, and any tax owed must be paid from the retirement account rather than personal funds. IRAs are taxed at trust tax rates, which hit the 37% federal bracket much faster than individual rates.
Liquidity: Your Money Is Locked Up
Private debt is fundamentally illiquid. You generally cannot sell your position when you want to, and the specifics depend on the vehicle.
Traditional private credit funds lock up capital for five to ten years. Senior debt funds run shorter, five to eight years; mezzanine and distressed funds can hold capital for eight to ten. During the lock-up, you have limited access to your money beyond the interest the fund distributes.
Interval funds offer a semi-liquid alternative. They allow investors to redeem a limited portion of shares at set intervals, commonly 5% of outstanding shares per quarter. Even in this more flexible structure, fully exiting a position can take years.
A small secondary market exists for private credit fund interests, but trades are infrequent and typically clear at discounts of 5% to 15% below the face value of the holdings. Fewer than 1% of private credit assets under management traded on the secondary market in 2024, so finding any buyer is not guaranteed.
The Key Risks
Private debt yields more than most publicly traded fixed income for reasons that matter.
- Credit risk. Borrowers default. Private credit default rates move with the economy; the rate was 2.46% in the fourth quarter of 2025, up from 1.76% earlier that year. In a concentrated portfolio, a single default can materially affect returns.
- Illiquidity risk. Your capital is committed for years. If your circumstances change, your exit options are limited and expensive.
- Valuation opacity. These loans do not trade on public markets, so there is no independent market price. Fund managers estimate value using internal models, and the reported value may not match what you could actually realize in a sale.
- Limited regulatory protection. Private credit funds operate under lighter regulation than banks or public bond markets, and public disclosures are generally unavailable, which makes assessing a fund’s true risk exposure difficult before you invest.1Board of Governors of the Federal Reserve System. Bank Lending to Private Credit: Size, Characteristics, and Financial Stability Implications
- Interest rate sensitivity. Floating-rate loans protect the lender when rates rise, but the same rate increases push up the borrower’s debt payments and can move a stretched company closer to default.