Private Credit Investing Essentials

What is Private Credit?

Private credit is a form of lending where sponsors or borrowers work directly with private lenders. Private Credit lenders are non-bank institutions that provide loans to businesses without using a bank. The predominant form of Private Credit is senior secured direct lending , although other private credit forms include: distressed debt, mezzanine debt, asset-based lending, structured credit, and venture debt, among others.

What is Direct Lending?

• Direct lending is a form of financing where a borrower directly negotiates a loan with a lender (typically an asset manager). These loans are usually arranged on a bi-lateral basis between the borrower and the asset manager.
• Borrowers rely on direct lending for quicker, flexible, and more specifically tailored solutions that may not be available through the traditional bank lending market.
• Within the direct lending universe, a borrower is typically a privately held company that may or may not be supported by a private equity sponsor or other institutional capital.

LOAN TYPES AND COVENANTS

The majority of direct lending facilities are put in place to support leveraged buyouts (LBOs) .¹ Additional potential uses of proceeds include acquisitions, growth capital, and refinancings. Direct lending facilities are generally floating rate debt instruments, meaning base rates for loans change in line with those set by central banks. Therefore, there is very little or no interest rate risk associated with most direct lending loans.²

In the core mid-market, direct lending transactions generally include covenant protections for lenders. Covenants generally take the form of financial covenants, which ensure that a borrower maintains an agreed upon level of operating performance. Negative covenants prevent or limit the company from incurring debt, selling assets, transferring collateral, taking dividends etc. A third type of covenant, known as affirmative covenants, cover reporting, maintenance of insurance, and general compliance with prevailing laws and regulations.

Upper mid-market transactions are usually covenant-lite, without financial covenants, and generally have much looser creditor protections.

Because direct lending deals are generally the product of bi-lateral negotiations, transactions typically have tight documentation terms (e.g. covenants, EBITDA definitions), strong equity cushions, and attractive spreads, particularly relative to alternative credit oriented financing solutions.

Growing Demand

PRIVATE CREDIT MARKET GROWTH

Since the Great Financial Crisis in 2008, tightening capital requirements and regulations on leveraged lending have made it more difficult for banks to directly hold the loans of core middle market companies and has resulted in many traditional banks withdrawing from, or limiting their exposure to, that portion of the market. This vacuum was largely filled by direct lenders.

In addition to supportive regulatory tailwinds, there is a substantial amount of capital that private equity managers possess but have not yet invested.³ This capital is referred to as dry powder, and when combined with the existing maturities of middle market leveraged loans, has resulted in debt financing demand that significantly exceeds the current supply of private credit.⁴ This supply/demand imbalance, that has been favoring direct lenders since the Great Financial Crisis, has enabled direct lending loans to generate premium yields that compare favorably to most credit alternatives available to investors including broadly syndicated loans and high yield bonds.⁵

EXPANDING CAPABILITIES

Early private credit funds and direct lenders lent to relatively small companies. Today, they can serve as a one-stop solution to fund entire debt capital structures for companies with $500 million or more in EBITDA. Direct lenders who operate in the upper middle market compete with broadly syndicated loan solutions, which is an alternative available to borrowers of this size. As a result, private credit loans in this segment usually resemble broadly syndicated loans which usually contain lower pricing, more aggressive capital structures and looser creditor protections.

Credit Alternatives Yield Comparison

US Prospective Financing Demand¹⁰

Key Features

SIMPLER PROCESS

Direct lending reduces the number of parties involved in a transaction and can streamline the due diligence and negotiation process. Direct lending typically reduces execution risk because lenders are usually buy-and-hold investors.

Companies are drawn to the more flexible nature of private credit and the often simpler and quicker negotiation process. This gives more certainty on pricing and speed of execution, along with terms that can be custom tailored to a specific borrower’s needs.

A traditional loan syndication involves a bank underwriting a loan and selling the facility to investors such as CLOs and mutual funds. The process is time intensive and can take many months to complete. A credit agency also has to rate the instrument. This can be onerous for a borrower, especially if they are involved in a time-sensitive, competitive auction process, and can expose them to unfavorable changes in market conditions. Syndication structures generally allow the bank to raise prices and fees if market conditions change, which can introduce uncertainty for issuers. A private credit loan has much fewer, if any, of these disadvantages.

RISK MANAGEMENT

With effective underwriting, direct lenders have demonstrated the potential to generate higher returns compared to other debt financing options, with lower default rates and better recovery rates.¹³ From a risk/return standpoint, these attributes can make private credit an appealing choice for investors looking to generate premium returns with relatively lower risk investment.²

As of the start of 2025, yields on direct lending loans are currently higher than they have been for more than a decade. This has helped to lower debt multiples and increase equity commitments in leveraged buyout transactions.¹⁴

Public Syndication vs. Direct Lending Overview¹⁵

Benefits of Sponsor-Backed Private Credit

Sponsor financing refers to third-party debt that a private equity firm uses in combination with its own equity capital to acquire a business. As such, the private equity firm serves as a partner to the debt manager, and provides financial support, industry expertise, and an additional layer of due diligence, among other benefits.

In addition to supporting leveraged buyouts, debt managers can partner with private equity firms to support portfolio company acquisitions, growth initiatives (e.g. capital to purchase new equipment), and refinancings. Debt financing providers benefit from working with high quality sponsors.

Non-sponsored financings, on the other hand, often involve closely held businesses which are supported by the company’s individual owners. These individuals generally are more capital constrained than institutional private equity firms. As such, during crises, non-sponsored deals may face challenges due to the financial constraints of its financial backers. As a result of the added risk, non-sponsored deals often come with higher spreads, although non-sponsored deals may experience greater volatility, higher loss potential, and lower ultimate returns.

Extensive Due Diligence
Private equity sponsors conduct extensive due diligence, which can provide lenders with additional information when underwriting a loan. The private equity firm’s key due diligence usually includes third-party consultant studies, quality of earnings (QoE) analyses conducted by an accounting firm, and valuable input from notable industry operators. These reports and findings are directly shared with the debt manager investing in the deal. The quality of financial information available in non-sponsored deals is generally less robust.

Hands-on Support
Private equity sponsors often provide operational support to companies, which improves efficiency and enhances overall value.

Equity Injection
A private equity sponsor can help mitigate risk by providing a cash injection in the form of equity into a business, should it come under financial pressure.

Collaboration
Private equity sponsors and lenders can collaborate to provide ample capital and guidance to strengthen the operations of a business and to support growth initiatives, which can enhance the overall value of a company.

Transaction Overview of a Sponsor-Backed Company Financing¹⁵

Capital Structure

The capital structure is important for private credit investors because it determines the order that a debt provider may be paid back in the event of a sale or liquidation of a company.

Generally, first lien senior loan providers sit at the top of the capital structure. They therefore assume the lowest risk and are paid first in the event of a default. Conversely, equity holders assume the most risk and are last to be paid.

Direct lenders primarily focus on investing in first lien senior secured debt, however, some debt managers also have the ability to invest across other tranches of the capital structure, as outlined below.

First Lien
Holders of senior secured debt generally have the highest recovery rates in restructuring scenarios because they have first claim on a company’s cash flows and assets.

Second Lien
Holders of second lien debt are subordinate to first lien debt providers, placing them second in line with respect to liquidation of collateral.

Unitranche
A unitranche term loan is a first lien loan that combines what would otherwise be distinct senior and subordinated debt tranches into a single debt facility. As such, the interest rate reflects a blend of senior and subordinated debt. From a security perspective, unitranche loans are first lien.

Senior Unsecured
Loans that rank senior to junior unsecured debt but are not backed by the company’s assets. In the event of a default, the lender has more risk to their recovery as there may not be sufficient residual value after the secured debt is paid off.

Mezzanine
Debt that is both unsecured and expressly subordinated to the senior debt. It offers a higher yield to senior debt but comes with higher associated risk. Mezzanine debt usually comes with a fixed rate coupon.

Common Equity
Represents the most upside potential but is first in line to absorb losses. As such the equity serves as a cushion supporting the debt in the capital structure. It is possible for the equity to lose some or all of its value, while the debt remains “money good”.

Corporate Capital Structure¹⁶

Loan Economics

Private credit loan returns are typically comprised of floating rate coupons, up-front deal fees, pre-payment penalties and amendment fees. In certain cases, a lender may also receive an “equity kicker” alongside the loan which may come in the form of an equity co-investment.

Interest Rates
Interest rates are typically structured as a spread over a base rate, usually the Secured Overnight Financing Rate (SOFR).

Base Rate Floors
Loan agreements will typically include a “base rate floor,” meaning that if the base rate falls below a pre-agreed level, the effective base will be the floor.

Deal Fees
Lenders typically charge deal fees at close, which are often referred to as original issue discount, arranger fees, commitment fees, or structuring fees.

Call Protection
Private loans will also frequently include prepayment penalties, referred to as call protection.

As shown in the exhibit, for managers with healthy underlying portfolios, in a high rising interest rate environment, the floating rate nature of the of the benchmark rate is accretive to an investor’s overall return.

Floating Rate Coupon¹⁷

Key Terms

Capital Structure
How a company finances operations using a mix of debt, equity, and other funding sources. The capital structure plays a crucial role in determining a company’s overall financial health, risk profile, and cost of capital.

Covenant
A protective clause in a loan or bond agreement that a borrower must abide by to comply with the terms of the funding. Covenants set limits to protect the lender(s), such as on the borrower’s ability to incur more debt, or its ability to repay debt with available cash. A covenant breach can trigger a technical default, which can allow the lender(s) to demand immediate repayment of the loan, to take control of assets, or to force a reorganization of the borrower’s capital structure.

Direct Lending
The origination of debt financing by private credit funds without intermediaries such as banks. Direct lending strategies establish direct relationships with companies and/or fund general partners to make investments and provide various debt instruments and customized deal structures.

Due Diligence
An analysis carried out prior to committing capital to a fund or portfolio company to determine its desirability and value as an investment.

LBO | Leveraged Buyout
The purchase of a controlling share in a business using a combination of equity and debt capital, typically backed by the assets or cash flows of the acquired company.

For a full list of terms, visit the Advisor Academy Glossary >

Notes & Disclosures

1. Source: Ion Analytics LBOs on the rebound: How leveraged loans are stealing the spotlight from direct lenders in 2024 | DebtDynamics North America Oct. 3, 2024
2. Past performance is not a guarantee of future results; investments are subject to a loss, including a complete loss, of capital.
3. Source: S&P Global Market Intelligence and Preqin Private equity dry powder growth accelerated in H1 2024 July 12, 2024
4. Sources: Preqin, North America focused Buyout funds only; Thomson Reuters 3Q 2024 Middle Market Lending Review. Statements made represent current views and opinions as of Nov. 13, 2024, and are subject to change.
5. Sources: (All data as of Nov. 13, 2024) US Investment Grade corporate bonds, from S&P 500 Investment Grade Corporate Bond Index; High Yield Bonds from S&P U.S. High Yield Corporate Bond Index; Leveraged Loans from MorningStar LSTA US Leveraged Loan 100 Index; Private Credit Senior Loans yield calculated based on observed market spreads of +/-525 basis points, 452 basis points Secured Overnight Financing Rate (SOFR) and upfront fees of 1.5–2.0% amortized over 2.5 years. Statements made represent current views and opinions as of Nov. 13, 2024, and are subject to change.
6. US Investment Grade from S&P 500 Investment Grade Corporate Bond Index as of November 13, 2024.
7. High Yield Bonds from S&P U.S. High Yield Corporate Bond Index as of November 13, 2024.
8. Leveraged Loans from MorningStar LSTA U.S. Leveraged Loan 100 Index as of November 13, 2024.
9. Private Credit Senior Loans yield calculated based on observed market spreads of +/-525bps, 452bps SOFR as of November 13, 2024 and upfront fees of 1.5–2.0% amortized over 2.5 years.
10. Statements made represent current views and opinions as of November 13, 2024 and are subject to change.
11. Debt financing demand is a combination of private equity implied debt demand and cumulative loan maturities from prior slide.
12. Source: Preqin, North American focused Direct Lending Private Credit funds, as of November 13, 2024.
13. Sources: Pitchbook Leveraged Commentary & Data 2Q23 Institutional Loan Default Review as of September 2023; S&P Global Market Intelligence as of August 2024.
14. Source: Pitchbook Leveraged Commentary & Data 2Q 2023 Leveraged Buyout Review as of September 2023.
15. For illustrative purposes only; the structures do not necessarily represent the structure or fund terms of any Adams Street investment vehicle; the structure and fund terms of any Adams Street investment vehicle are subject to, and qualified in their entirety by, the final governing documents of such offering.
16. Above is for educational and discussion purposes only and does not represent a complete description of such private credit strategies, tranches, or other investment characteristics. Many factors may be involved in determining the ultimate risk of an investment in the capital structure of a company and the above is for illustrative purposes only The use of graphs, charts, formulas or other devices are subject to inherent limitations and difficulties; investors should not make investment decisions, including whether to purchase or sell or the timing of such actions, based solely on the information presented in such devices.
17. The chart is provided for illustrative and educational purposes only and there can be no guarantee that any particular deal will be structured in a manner described herein.

Important Considerations: This information (the “Paper”) is provided for educational purposes only and is not investment advice or an offer or sale of any security or investment product or investment advice. Offerings are made only pursuant to a private offering memorandum containing important information. Statements made herein generally represent a mixture of (i) objective data attained through a variety of sources which are available upon request, as well as (ii) Adams Street’s analysis and related beliefs, opinions and views based on market observations, historical deal flow, experience and/or other factors; provided, however, that there can be no guarantee that this represents a complete universe of relevant data or opinions. Statements made represent current views and opinions as of February 2025 and are subject to change without any further obligation to update. All information has been obtained from sources believed to be reliable and current, but accuracy cannot be guaranteed. References herein to specific sectors, general partners, companies, or investments are not to be considered a recommendation or solicitation for any such sector, general partner, company, or investment. This Paper is not intended to be relied upon as investment advice as the investment situation of individuals is highly dependent on circumstances, which necessarily differ and are subject to change. The contents herein are not to be construed as legal, business, or tax advice, and individuals should consult their own attorney, business advisor, and tax advisor as to legal, business, and tax advice. Past performance is not a guarantee of future results and there can be no guarantee against a loss, including a complete loss, of capital. Certain information contained herein constitutes “forward-looking statements” that may be identified by the use of forward-looking terminology such as “may,” “will,” “should,” “expect,” “anticipate,” “estimate,” “intend,” “continue,” or “believe” or the negatives thereof or other variations thereon or comparable terminology. Any forward-looking statements included herein are based on Adams Street’s current opinions, assumptions, expectations, beliefs, intentions, estimates or strategies regarding future events, are subject to risks and uncertainties, and are provided for informational purposes only. Actual and future results and trends could differ materially, positively or negatively, from those described or contemplated in such forward-looking statements. Moreover, actual events are difficult to project and often depend upon factors that are beyond the control of Adams Street. No forward-looking statements contained herein constitute a guarantee, promise, projection, forecast or prediction of, or representation as to, the future and actual events may differ materially. Adams Street neither (i) assumes responsibility for the accuracy or completeness of any forward-looking statements, nor (ii) undertakes any obligation to update or revise any forward-looking statements for any reason after the date hereof. Also, general economic factors, which are not predictable, can have a material impact on the reliability of projections or forward-looking statements. Adams Street Partners, LLC is a US investment adviser governed by applicable US laws, which differ from laws in other jurisdictions.