Describe private credit, including the usual lenders and borrowers, and contrast it with other forms of lending and with fixed-income securities.
The idea
Private credit is lending to companies by non-bank institutions. The lenders are mainly asset managers running closed-end funds and business development companies, backed by money from pension funds, insurers and sovereign funds. The typical borrower is a mid-sized firm, often owned by a private equity sponsor, that is too small or too leveraged for the public bond or broadly syndicated loan market. Loans are usually senior secured and floating rate, paying a base rate such as SOFR plus a spread. They are negotiated bilaterally or with a small club of lenders, and held to maturity. Contrast with bank loans: the lenders are funded by investor capital rather than deposits, and they face no bank capital rules. Contrast with bonds and syndicated loans: there is no liquid market price, covenants are customised, and the lender has information rights. Exam trap: private credit is a loan, not a traded security.
Formulas
Annual cost of a loan with an upfront fee or discount
annual cost = spread + upfront ÷ life
- spread
- the spread over the base rate
- upfront
- the upfront fee or original issue discount
- life
- the expected life of the loan in years
Spreads the fee evenly over the expected life. Adding the whole fee to one year's spread overstates the cost.
A practice question
Which description best fits the usual lender and borrower in private credit?
- A non-bank asset manager or fund lending directly to a mid-sized, often sponsor-owned company - correct
- A commercial bank funding a large listed corporation mainly from retail deposits and wholesale debtWhy not: Describes traditional bank lending, not private credit, whose lenders are non-bank institutions funded by investor capital.
- A government agency lending to households and small businesses at below-market ratesWhy not: Confuses private credit with public or subsidised lending programmes; borrowers are firms and lenders are private investors.
- A broker-dealer underwriting investment-grade bonds that are then sold to the publicWhy not: Describes the public bond market, which is traded securities rather than negotiated direct loans.
Private credit is direct lending by non-bank institutions, mainly asset managers, business development companies and funds backed by pensions and insurers, to mid-sized firms often owned by private equity sponsors. Banks, agencies and underwriters of public bonds sit outside this definition.
A harder one
A sponsor-owned firm needs USD 300 million for an acquisition within three weeks, expects to ask for covenant waivers during integration, and does not want to be rated. Which financing is most consistent with these needs?
- A public high-yield bond, because dispersed bondholders can easily and quickly agree to waiversWhy not: Bonds have many dispersed holders so consent solicitations are slow; this misjudges which structure is easier to renegotiate.
- A broadly syndicated loan, because it avoids any negotiation with the lenders and needs no rating at allWhy not: Syndication needs ratings, a marketing period and a wide lender group, so it is slower and less flexible than a direct loan.
- A bank deposit facility, because deposits are the source of capital for private credit funds and for sponsorsWhy not: Private credit funds are financed by investors, not deposits; deposits fund banks, and this does not answer the speed and flexibility need.
- A unitranche direct loan from a private credit fund, because one lender can agree terms quickly and later amend them - correct
Speed, certainty, confidentiality, no rating and the ability to renegotiate with one or a few lenders are the reasons borrowers choose direct lending over syndicated loans or bonds, usually at a higher spread.
The hardest tier
A borrower compares a broadly syndicated loan at SOFR + 3.75% with a 0.5% upfront fee against a direct loan at SOFR + 5.50% with a 2.0% original issue discount. Both have an expected life of four years and the fees and discount are spread evenly over the life. The extra annual cost of the direct loan is closest to:
- 1.75%Why not: Compares stated spreads only and ignores the difference in upfront fee and discount.
- 3.25%Why not: Adds the full fee and discount to the spread as if they were annual costs rather than spreading them over four years.
- 2.13% - correct
- 2.25%Why not: Spreads fees over three years instead of the stated four-year life.
Direct loan cost = 5.50 + 2.0/4 = 6.00%; syndicated cost = 3.75 + 0.5/4 = 3.875%. Difference = 2.125%, about 2.13%. The premium compensates the lender for illiquidity, bespoke terms and speed.
In the app: 6 practice questions on this outcome, spaced review that brings it back before you forget it.
Start free →More in The Rise and Risks of Private Credit
- Explain how private credit has grown and what it returns, and compare its track record of returns against that of other asset classes.
- Characterise and judge the risks and weak points of private credit, and show how it can threaten financial stability.
- Weigh up policy proposals that might reduce the risks that private credit brings.