Lending to Companies Instead of Owning Them

Private credit is lending outside the banking system — funds, not banks, lending directly to companies. You are the lender, and the borrower's interest payments are your return. Your outcome depends on borrowers making their payments, not on what the market thinks a security is worth — the most contractual return stream in this book, and the most exposed to a single variable.

A direct lending fund originates loans, holds them to maturity or refinancing, collects interest, and passes that income through as distributions. Each loan is negotiated one-on-one rather than syndicated, so the fund writes its own terms — the rate, the collateral, the covenants, and the remedies if things go wrong.

Most of this lending is senior and secured. Senior means first in line for repayment, ahead of subordinated debt and equity. Secured means a lien on the borrower's assets — collateral to pursue if the company fails, not a general claim. Together they set a floor, not a guarantee: lenders take losses when collateral proves worth less than the loan, more often in a downturn than in any model.

Loans typically carry floating rates, quoted as a spread over a short-term base rate. When short-term rates rise the income rises with them — the opposite of a fixed-rate bond. When rates fall the income falls, and a portfolio assuming a high base rate persists is making an unstated bet on rates.

After the 2008 financial crisis, banks tightened standards under new capital rules, and sound middle-market companies — too big for a community bank, too small for the public bond market — found borrowing harder and slower, and private credit funds moved into that gap. The premium buys speed, flexibility, confidentiality, and certainty of execution — worth real money to a company with a closing date.

A significant share of private credit lending goes to companies owned by private equity sponsors, and almost nobody says so out loud. When a buyout fund acquires a business, a private credit fund increasingly finances it rather than a bank. An investor holding both private equity and private credit may own two sides of the same transaction, and both depend on the same middle-market companies performing.

Contractual interest is the engine — the base rate plus the negotiated spread. Origination and amendment fees add to it — the fund charges to write the loan and again to change its terms. Some loans are issued at a discount to face value, adding to the return as they pay down. Some carry an equity component, though a credit fund reaching for equity upside is drifting from its mandate.

Three things erode that income. Defaults come first: a borrower that cannot pay turns contractual income into a recovery process that costs time and money even when the collateral is real. Tax comes second — the income is generally ordinary, taxed at your full marginal rate, so the distribution is worth less to a high earner than the headline suggests. Fees and fund-level leverage come third, cutting both ways.

The risk that concerns me most is not a single default — it is underwriting drift. When capital chases direct lending, funds compete for the same borrowers, and competition shows up first as loosened terms: weaker covenants, more permitted debt, looser definitions of earnings. A fund that holds its stated yield by accepting worse documentation has bought tomorrow's losses at today's price. Covenant quality is the tell, visible in the credit agreements.

Consider an investor who wants more income than a bond portfolio produces. A private credit fund makes senior secured loans to middle-market companies — each negotiated directly, each backed by collateral, most paying a floating rate — and it collects and distributes the interest quarterly.

A fund holding forty loans across several industries can absorb a handful of problems; a fund holding eight cannot, no matter how carefully each was underwritten. I look at borrower count, industry concentration, and average position size first — those numbers decide whether the strategy is income or speculation.

The honest counterweight is a recession. Defaults rise fastest among exactly the leveraged mid-sized borrowers this asset class serves, and a slowing economy with falling short-term rates can pressure income and credit quality at once — the two risks are not independent. The premium is compensation for credit risk, never a substitute for it.

Private credit is the closest thing in this book to a bond substitute. It belongs in the income part of a portfolio, funded from fixed income rather than equity, and produces contractual cash flow that supports a spending plan — a natural fit for income planning. But Treasuries rally when investors are frightened; private loans to leveraged companies do not.

Account placement matters more here than in most of this book. Because the income is generally ordinary, a taxable account can surrender a meaningful share of the return to tax every year, while a tax-deferred account keeps that share compounding. Retirement accounts bring their own complications with private funds, though, including unrelated business taxable income where the fund borrows. Work that through with your CPA before you subscribe; fund structures and fees covers the mechanics.

In lending, the diligence is the product. Everything separating a good private credit fund from a poor one happened before you saw the offering — how the loans were underwritten, how the documents were negotiated, and how much discipline the manager kept when borrowers had options. You cannot inspect that work, but you can inspect its traces: covenant packages, borrower concentration, and how the manager handled the last cycle's problem credits.