Private Credit: Definition, Types, and How It Works

Written by Kelly Bailey

Reviewed by Jeff Schmidt

Read Time 6 minutes

What Is Private Credit?

Private credit is debt financing provided by non-bank lenders directly to companies or projects through privately negotiated agreements. These loans are not issued or traded on public markets. Private credit gives businesses access to tailored funding solutions and helps fill the gap left by traditional bank lending.

Private credit has expanded rapidly as companies seek flexible financing options and investors search for higher yields in a low-interest-rate environment. Stricter bank regulations and reduced risk appetite since the 2008 financial crisis have limited traditional lending. This gap created space for private funds to step in and meet borrower demand.

What is Private Credit?

Key Highlights

Private credit is privately negotiated lending provided by non-bank lenders to companies and projects.

Private credit provides an alternative financing source for businesses to raise capital or refinance debt when traditional financing is unavailable or too restrictive.

Financial modeling and valuation analysis are essential in private credit for assessing borrower performance, credit risk, and fair value in deals.

Who Uses Private Credit?

Businesses often turn to private credit for capital to fund expansion or acquisitions, while institutional investors use private credit as an alternative source of yield and portfolio diversification.

For businesses, private credit offers speed, discretion, and customized loan structures that banks often can’t provide. Private credit funds also lend capital to mid-sized and startup companies that might not meet the financial and risk standards for bank loans.

For institutional investors, private credit can provide attractive risk-adjusted returns, consistent cash flows, and low correlation to public markets. Investors like pension funds and insurance companies have increased allocations to private credit to diversify their portfolios.

How Does Private Credit Work?

Private credit transactions involve direct lending from private credit firms, such as Apollo Global Management, Blackstone, and Ares Management, to a company. The process begins with the lender evaluating the borrower’s financial statements, business model, and creditworthiness.

Based on this analysis, the lender structures loan terms and repayment schedules according to the company’s risk profile.

Once the deal is finalized, funds are disbursed, and the borrower begins making scheduled interest and principal payments. Since private credit loans aren’t traded publicly, investors typically hold them to maturity and receive steady cash flows throughout the loan term.

This structure allows for flexible financing arrangements but requires rigorous due diligence and active portfolio monitoring by lenders.

What Are the Main Types of Private Credit?

Private credit includes several categories that vary by structure, repayment priority, and risk level. Each type serves different borrower needs, from financing growth to managing financial leverage or restructuring debt. Understanding these categories helps analysts evaluate return potential, security, and liquidity before structuring or investing in a deal.

Direct Lending

Direct lending involves loans made directly to private companies without an intermediary bank. These loans are typically used for business expansion, acquisitions, or refinancing. Because they are privately negotiated, lenders can customize interest rates, debt covenants, and repayment schedules to match the borrower’s financial situation.

Mezzanine Debt

Mezzanine debt blends characteristics of debt and equity. It ranks below senior secured loans but above common equity in repayment priority. Borrowers use mezzanine financing to fund growth or acquisitions when senior debt alone isn’t sufficient. Investors accept higher risk in exchange for higher returns, often through a combination of interest payments and equity warrants.

Distressed Debt

Distressed debt refers to loans or bonds from companies experiencing financial difficulties or facing bankruptcy. Private credit investors in this space seek to profit by purchasing the debt at a discount and working toward a turnaround or restructuring that increases its value. These investments require deep financial analysis and active management.

Asset-Based Lending

Asset-based lending (ABL) involves loans secured by collateral such as accounts receivable, inventory, or real estate. The loan amount depends on the value of the pledged assets, reducing credit risk for lenders. ABL is common among businesses with strong asset bases but limited cash flow or short-term financing needs.

Benefits and Risks of Private Credit

Private credit affects borrowers, investors, and lenders in different ways. Each group faces distinct advantages and potential challenges depending on their role in a transaction.

The table below summarizes the main benefits and risks for each stakeholder in a private credit transaction.

Stakeholder	Benefit	Risk
Borrowers	Access to flexible financing with customized loan structures that can support growth, acquisitions, or refinancing needs.	Higher borrowing costs and stricter covenants compared with traditional bank loans, which can limit financial flexibility.
Investors	Attractive risk-adjusted returns and steady income streams through interest payments and negotiated loan terms.	Illiquidity and valuation uncertainty since private loans are not publicly traded and must often be held to maturity.
Lenders (Private Credit Funds)	Ability to negotiate terms, pricing, and collateral directly with borrowers, allowing for better risk control and higher potential yields.	Credit losses from borrower defaults or economic downturns, which can reduce returns across the lending portfolio.

Modeling for Private Credit

Financial modeling plays a key role in analyzing private credit deals. Analysts build models to evaluate a borrower’s ability to service debt, assess risk exposure, and estimate fair value. Accurate models help lenders price loans appropriately, anticipate downside scenarios, and monitor ongoing performance throughout the investment’s life.

Cash Flow Modeling

With cash flow modeling, you can project a borrower’s future inflows and outflows to ensure it can meet principal and interest payments. You can test different scenarios, such as revenue declines or margin compression, to determine whether debt service coverage remains sufficient under various market conditions.

DCF Valuation Modeling

Private credit analysts often use a discounted cash flow (DCF) approach to valuation. The model discounts projected cash flows at a rate that reflects credit risk, illiquidity, and loan-specific terms. Adjustments for covenants, collateral, and market conditions ensure the valuation aligns with the investment’s true risk profile.

Leveraged Buyout (LBO) Modeling

Many private credit funds finance buyouts through unitranche or mezzanine loans. An understanding of LBO modeling can help you evaluate how the debt structure and leverage levels influence deal outcomes. It also clarifies how cash flow coverage affects both lenders and sponsors.

Private Credit - Sources & Uses: Refinance Target Debt — Source: CFI’s **Leveraged Buyout (LBO) Modeling** course

Private Credit vs. Private Equity

Private credit and private equity both provide capital to private companies but differ in how they participate and earn returns. Private credit involves lending money with fixed repayment terms, while private equity involves taking ownership stakes and profiting from long-term growth and eventual exits.

Private credit investors focus on generating stable income through interest payments and principal repayment. Their priority is preserving capital while managing credit risk.

Private equity investors, on the other hand, take a direct ownership role to increase company value over several years. Their returns depend on the business’s appreciation and a successful sale or IPO.

Some investment firms operate in both areas, offering credit and equity financing to meet different company needs within the same capital structure.

Examples of Private Credit in Action

Private credit financing is commonly used by mid-sized and privately held companies that need flexible funding to support growth, acquisitions, or restructuring. These transactions show how private lenders and borrowers design customized deals that balance risk, return, and business objectives.

Consider a manufacturing company seeking $50 million to expand production capacity. Instead of issuing public debt or relying on a traditional bank loan, it partners with a private credit fund. The fund provides a five-year term loan with quarterly interest payments and negotiated covenants tailored to the company’s cash flow.

For the borrower, this structure provides access to capital with greater flexibility. For investors, it offers a higher yield and steady income through interest payments, reflecting the private nature and longer holding period of the investment.

Key Takeaway: Private Credit

Private credit is privately negotiated debt financing that allows companies to access tailored funding outside traditional bank channels. It’s become a major source of capital for mid-sized and private businesses while giving investors higher yield potential, portfolio diversification, and steady cash flows in exchange for added risk and lower liquidity.

FAQs: Private Credit

What is the difference between private credit and private debt?

The terms private credit and private debt are often used interchangeably. Both refer to non-bank lending in private markets. Some firms use “private credit” to describe the overall lending activity and “private debt” to describe the specific loan instruments used in those transactions.

Is private credit the same as direct lending?

No. Direct lending is one of several strategies within private credit, where private credit funds originate loans directly to companies without involving traditional banks or intermediaries. Other strategies include mezzanine financing, distressed debt investing, and asset-based lending, each with different risk and return profiles.

Who invests in private credit?

Institutional investors, such as pension funds, endowments, and insurance companies, are the main participants. They’re drawn to private credit for its higher yields, predictable cash flows, and diversification benefits compared with traditional fixed-income investments.

Next Step: Build the Skills Behind Private Credit Analysis

Understanding private credit relies on core finance skills like financial modeling and valuation. CFI’s online courses teach these capabilities through practical, hands-on training used in real corporate finance and deal-making scenarios.

Explore CFI’s finance courses to strengthen the skills behind better lending, investment, and valuation decisions.