By Harry Prabandham · Updated September 27, 2026
Investing & Markets
Private Credit and Direct Lending: How It Works and What Can Go Wrong
Private credit is lending by non-bank funds directly to companies, usually at floating rates, trading liquidity and transparency for extra yield.
Private Credit and Direct Lending: How It Works and What Can Go Wrong
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What is private credit?
- Private credit is lending by funds and other non-bank lenders directly to companies, with loans negotiated privately rather than sold as public bonds.
- The largest segment, direct lending, mostly finances mid-sized businesses owned by private equity firms.
- Loans are usually floating rate and held to maturity rather than traded, so prices are estimated, not observed daily.
- The market grew after 2008 as banks pulled back from riskier lending and borrowers valued speed and certainty of terms.
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What is private credit?
- Private credit is lending by funds and other non-bank lenders directly to companies, with loans negotiated privately rather than sold as public bonds.
- The largest segment, direct lending, mostly finances mid-sized businesses owned by private equity firms.
- Loans are usually floating rate and held to maturity rather than traded, so prices are estimated, not observed daily.
- The market grew after 2008 as banks pulled back from riskier lending and borrowers valued speed and certainty of terms.
Strategies under the private credit label
- Senior and unitranche loans sit first in line for repayment and are secured by the borrower's assets.
- Second-lien and mezzanine loans rank lower, charge more, and may pay part of their interest in additional debt (PIK) or include warrants.
- Asset-based lending is secured by receivables, equipment, or other specific collateral rather than overall company cash flow.
- Specialty and opportunistic strategies include venture debt, royalty financing, and buying loans of distressed companies.
Where does the return come from, and what eats into it?
- Lenders earn a base rate plus a negotiated spread, along with upfront fees or discounts and prepayment penalties.
- Default losses, management and incentive fees, and the cost of any fund-level borrowing all reduce what investors keep.
- Because rates float, income tends to fall when rates fall, while high rates can strain borrowers' ability to pay interest.
- A rising share of interest paid in kind rather than cash can be an early sign that borrowers are under stress.
What are the main risks?
- Credit risk: borrowers are often highly leveraged, and senior status reduces but doesn't remove the chance of losses.
- Liquidity risk: drawdown funds can lock capital for years, and semi-liquid funds can limit or suspend redemptions when many investors want out.
- Valuation risk: infrequent, model-based pricing can make reported volatility look lower than the underlying economic risk.
- Terms risk: competition for deals can loosen covenants and underwriting, and results vary widely from one manager to another.
How do individuals invest, and how is it taxed?
- Publicly traded business development companies (BDCs) trade daily but their prices can swing well above or below reported asset value.
- Non-traded BDCs and interval funds offer periodic liquidity, often a set percentage per quarter, and may impose suitability or income minimums.
- Private drawdown funds are generally limited to accredited investors or qualified purchasers and may issue K-1s.
- Distributions are mostly taxed as ordinary income rather than qualified dividends, which affects which account type many investors use.
Questions for evaluating a manager
- How has the manager handled defaults and workouts in past downturns, and how are losses and non-accruals reported?
- Where do deals come from, and how concentrated is the portfolio by sector, sponsor, and borrower?
- How much fund-level leverage is used, and what are the redemption terms and gates?
- What are total fees, including incentive fees, and how are loans valued between sales?
Key takeaways
- Private credit offers floating-rate income in exchange for credit risk, illiquidity, and less transparency than public bonds.
- Smooth reported values don't mean low risk; losses can appear late and all at once.
- Vehicle choice determines liquidity, fees, and tax reporting as much as the loans themselves.
- This is educational only and not a recommendation; private investments can lose value, including principal.
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