Alternative Investments

Private Credit: Direct Lending, Unitranche and ABF

Private credit is lending by nonbank investors through negotiated, privately held loans rather than traded bonds or syndicated loans. Its main strategies are direct lending to companies, unitranche facilities that combine senior and junior debt in one loan, asset-based lending against receivables and inventory, and specialty finance secured by pools of contractual cash flows.

What is private credit?

Private credit refers to loans originated and held by investors other than banks, typically funds, insurance balance sheets and other institutional pools of capital. The loans are negotiated bilaterally or among a small club of lenders, are not registered securities, and usually trade infrequently if at all. Borrowers accept a higher cost of capital in exchange for speed, certainty of execution, flexible structures and a single counterparty they can call when something goes wrong. Investors accept illiquidity in exchange for a yield premium, stronger covenants than public markets typically offer, and direct access to borrower information.

How does direct lending work?

Direct lending is the largest private credit strategy. Lenders provide senior secured term loans, delayed draw facilities and sometimes revolvers to middle market companies, most often in support of private equity acquisitions. Loans are usually floating rate, priced as a spread over a base rate, with an upfront discount or fee, call protection in the early years and maintenance covenants. The lender performs its own diligence, often relying on sponsor provided quality of earnings reports, and sizes the loan to a leverage multiple and coverage test.

The core risk in direct lending is credit selection in a concentrated portfolio. A single default in a fund with a few dozen loans has a visible effect on returns, so underwriting focuses on business durability, sponsor support and recovery value. Lenders also negotiate information rights such as monthly financials and lender calls, which give them earlier warning than a public bondholder would ever receive. Lenders that originate directly rather than buying allocations in syndicated deals also control documentation, which lets them insist on tighter definitions, lower addback caps and meaningful restrictions on moving collateral away from the lending group.

What is a unitranche loan?

A unitranche loan combines what would traditionally be a senior loan and a subordinated loan into a single facility with one interest rate, one set of documents and one set of covenants. The borrower gets simplicity and speed, and the blended rate sits between senior and junior pricing. Behind the scenes, lenders sometimes divide the loan into first out and last out pieces through an agreement among lenders, so that one lender takes a safer, lower yielding position and another takes a riskier, higher yielding one, while the borrower still sees a single loan.

For underwriters, the key point is that a unitranche is priced and sized as one instrument, so leverage through the unitranche is usually higher than a stand alone senior loan would reach. Recovery analysis should treat the whole unitranche as one class and, where a first out and last out split exists, model each piece separately using the waterfall in the agreement among lenders. Voting rights deserve attention as well, because the agreement among lenders determines who can waive defaults, approve amendments and direct enforcement, and a last out holder can find its interests diverging sharply from the first out holder in a workout.

How do asset-based and specialty finance strategies differ?

Asset-based lending advances against a borrowing base of receivables, inventory and sometimes equipment or real estate, with availability recalculated regularly. The lender relies on collateral liquidity and monitoring through field exams and appraisals more than on enterprise value. It suits companies with substantial working capital, volatile earnings or turnaround situations that cash flow lenders would avoid. Private lenders often take the riskier end of this market, such as last out tranches behind a bank revolver, stretched advance rates on inventory, or term loans secured by equipment and intellectual property alongside working capital.

Specialty finance, often called asset-based finance in the private credit market, lends against pools of contractual cash flows: consumer and small business loans, equipment leases, royalties, litigation proceeds, rental fleets and similar assets. These loans are usually made to special purpose vehicles with advance rates against eligible collateral, performance triggers tied to delinquency and loss, and cash flow waterfalls. Underwriting focuses on historical pool performance, originator quality and servicing risk rather than corporate earnings. Because the collateral pool is diversified across many small obligations, loss behavior can be modeled statistically, but originator fraud and servicing disruption remain risks that no static pool analysis captures.

• Direct lending: cash flow loans to sponsor backed companies
• Unitranche: single facility blending senior and junior risk
• Asset-based lending: borrowing base against working capital
• Specialty finance: loans against pools of contractual receivables
• Opportunistic and distressed: rescue financing and discounted debt

How should an investor evaluate private credit returns?

Headline yield is only the starting point. An investor should decompose return into base rate, spread, fees and discount, then subtract expected credit losses, fund expenses and the drag from cash that is committed but undrawn. Because loans are floating rate, returns move with the base rate, which means a portion of recent private credit performance reflects interest rates rather than manager skill. Loss rates should be examined over a full credit cycle, and reported marks deserve skepticism because private loans are valued with models rather than market prices, which can delay recognition of losses.

Structure deserves as much attention as yield. Two loans with the same spread can carry very different risk if one has maintenance covenants, tight addback caps and a strong sponsor while the other has loose definitions, permissive baskets and a borrower already stretching for liquidity. Investors should also look at how a manager behaves in workouts: whether it has the staff to take control of a business, how often it amends and extends rather than enforces, and whether payment in kind interest is being used to mask underlying weakness. Those behaviors drive realized recoveries more than any headline loss statistic.

Estimating the loss adjusted yield on a unitranche loan

1. Assume a $50,000,000 unitranche loan priced at a 4.50% base rate plus a 5.75% spread, so the cash coupon is 4.50% + 5.75% = 10.25%.
2. The loan is issued at 98, a 2 point discount. Spread over an assumed 3 year average life, the discount adds about 2.00% / 3 = 0.67% per year, for an approximate yield of 10.25% + 0.67% = 10.92%.
3. Assume an annual probability of default of 2.0% and loss given default of 40%. Expected annual loss = 2.0% x 40% = 0.80%.
4. Loss adjusted yield is approximately 10.92% - 0.80% = 10.12% before fund fees and expenses.
5. If the base rate falls 1.50 points, the loss adjusted yield drops to about 8.62%, which illustrates how much of the return is driven by rates rather than credit risk premium.

How underwriters apply this

• Decompose yield into base rate, spread, fees and discount before comparing deals or managers.
• Underwrite unitranche leverage and recovery as one class, then model any first out and last out split.
• For asset-based and specialty finance, rely on collateral data, eligibility rules and performance triggers.
• Negotiate monthly reporting and lender calls; information rights are a core advantage of private loans.
• Stress the portfolio for concentration, since one default matters more in a small book.
• Treat model based marks cautiously and compare them with observable comparable loan pricing.

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Educational content written by practitioners. Not investment, accounting, legal or tax advice.