Columbia Law School
Sky Blog
There’s a growing buzz around private credit that’s almost impossible to ignore. In a recent paper, I discuss the background, key participants, distinctive features, and potential concerns associated with this asset class and explore the reasons for its rising prominence.
Private credit is a form of lending outside the traditional banking system that involves lenders negotiating directly with borrowers to originate privately held loans that are not traded in public markets. The story of private credit is largely the story of disintermediation in corporate lending: eliminating middlemen from the lending process and creating direct relationships between borrowers and lenders without involving banks or other regulated entities.
The business models of banks and private credit are often referred to as the “moving” business and the “storage” business, respectively. Banks underwrite loans to corporate borrowers with the aim of selling them to a large number and variety of investors – institutional and retail – with high overall liquidity needs. Private credit firms, however, manage investments for a small group of sophisticated investors with low liquidity needs and can underwrite loans with the intention of holding them for years. Unlike private credit firms, banks are subject to interest rate spikes and regulatory requirements.[1] As a result, banks are more conservative and risk-averse in their lending, especially to borrowers with lower credit ratings. A lot of those borrowers are PE-sponsored companies with high or imminent liquidity needs and, being conservative, banks generally don’t participate in these mid-market deals. Here, private credit steps in as a reliable alternative. Unlike banks, private credit managers are under no regulatory obligations in their assessment of loans and have no pressure to meet short-term liquidity needs of a large number of investors. They have, therefore, far more freedom in choosing borrowers, even ones with low credit ratings.
Is Private Credit Better than Bank Lending?
For both banks and private credit firms, underwriting a loan is the easy part; the challenge is to get the money back.[2]Private credit’s pitch here is that because of its business model, it has better incentives to do this. By syndicating debt across multiple lenders, banks make lending more complex, diluted, time-consuming, volatile, and conditional. With private credit lenders, borrowers negotiate loans directly with the eventual holder of the debt, which is valuable because they know and trust that creditor. These loans do not require the borrowers to have credit ratings.[3] Further, borrowers can avoid the high fees banks charge for underwriting and arranging syndicated loans.[4]
For PE-sponsored deals, private credit offers greater value than banks – fewer lenders and a more customized arrangement with underwriters increase the lender’s certainty of being involved and its ability to deal with bumps along the way .[5] Further, the fact that private credit firms have skin in the game helps reassure investors. Fundamentally, private credit provides for current income from contractual cash flows i.e. interest payments and fees.[6] It also offers strong legal and downside protections in the form of negotiated covenants for mostly first-lien loans that are backed by cash flows and assets.[7] Since these loans are priced above the base rate[8] and periodically reset to the market’s cost of capital (as a product of a floating rate[9]), they provide investors with yield protection against rising interest rates and generate current income through the quarterly payment of coupons and fees from origination and management of the loans.[10]
Deal Structure
Two interesting features of private credit transactions are covenants and unitranche debt.
Covenants
Private credit historically benefited from lender-friendly loan agreements that tended to have multiple financial covenants, which would be tested on a quarterly basis.[11] Typically, these transactions included incurrence and maintenance covenants.[12] Activities conventionally monitored by a maintenance covenant[13] include coverage,[14]leverage,[15] current ratio,[16] tangible net worth[17] and capital expenditure.[18]
Until about five years ago, what distinguished private credit loans from syndicated loans was the requirement for maintenance covenants in private-credit loan agreements. Syndicated loans are generally “cov-lite,” which essentially means that they tend not to have strict covenants and, most important, do not have maintenance covenants for the benefit of the term loan lenders.[19] These loans typically have a revolving credit facility[20] and have a “springing” leverage covenant for revolving credit lenders.[21] Other than that, no maintenance covenant is included and leverage is tested only on an incurrence basis (for example, when incremental debt is incurred or distributions to equity-holders are paid).[22]
“Cov-lite” loan agreements are starting to appear in private credit deals as a means to compete with the syndicated loan market and increase market share in the upper-mid to large-cap market segments.[23] While some private credit firms still insist on maintenance covenants, others are increasingly willing to waive them. Nonetheless, keeping a maintenance covenant has significant practical value. This is particularly true in unpredictable macroeconomic circumstances under which a diversified credit portfolio will experience at least some strain due to certain borrowers. [24]
One response to this situation seems to be the middle path of “cov-loose”[25] agreements, which are neither “cov-free” nor “cov-lite” and retain a leverage covenant in the documentation while offering sponsors flexibility.[26] “Cov-loose” essentially means that a maximum leverage covenant will be included and tested quarterly on a maintenance basis but will require a highly material level of financial underperformance to be breached.[27]
Unitranche Debt
The other trend in private credit financing arrangements is the rise of single-tranche or “unitranche” loans, which eliminate the complex capital structure of first- and second-lien debt in favor of a single facility.[28] The unitranche structure entails higher risk but also features a higher yield than traditional senior financings. It may also offer borrowers a lower average cost of capital over the entire debt structure.[29]
As PE auctions become more competitive, it is increasingly important for bids to have financing locked up and ready to be deployed before a company is acquired.[30] Given these circumstances, the simplicity and speed of execution makes unitranche loans from private credit lenders highly appealing.[31] However, unitranche loans also come with risks to investors in the form of side arrangements that allow these loans to be divided and sold as debt in secondary markets.[32] Since these side arrangements are untested in bankruptcy and restructuring situations, it is in the best interest of lenders not to leave any room for these in their loan agreements.[33]
Regulatory and Other Concerns
Though some critics fear that private credit may eventually create a financial bubble similar to the one involving banks in 2008, private credit firms are not leveraged to the extent that banks were then – and may even be reducing risks by handling risky debt that banks might otherwise have held.
Further, private credit funds primarily rely on investments from accredited investors,[34] who are presumed to be financially sophisticated and able to bear the risks of investing in private, less liquid funds. As a result, they can generally avoid the SEC’s more stringent registration and disclosure requirements, even though they must still comply with some baseline rules related to reporting, disclosure, and anti-fraud provisions.[35]
These exemptions enable private markets to flourish as intended – privately. The key concern with respect to regulation, however, is whether the rapidly increasing market share of private equity and now private credit funds calls for more regulation. The issue of inflated valuations in private markets, for example, attracted attention from the SEC, which proposed new rules for private fund advisers in August 2023. The rules were designed to increase competition, transparency, and efficiency in the private funds market. However, in June 2024, a three-judge panel of the Fifth Circuit Court of Appeals unanimously vacated the rules on the grounds that the SEC had overstepped its authority. This ruling combined with the overturning of the Chevron doctrine[36] in 2024[37] may indicate that private funds activity will avoid close scrutiny from administrative agencies like the SEC, though that is not yet certain.
Looking Ahead
Private credit is not a new asset class, and it has already weathered storms like the financial crisis and COVID-19, proving itself a relatively reliable investment class. As private credit increases its share of the lending market and explores new strategies and geographic areas, it will be interesting to see how it evolves while reacting to external factors such as fluctuating interest rates and possible regulator changes.
ENDNOTES
[1] such as which prescribe asset quality ratings, levels of loan quality and liquidity metrics. See Commercial & Industrial Lending, FDIC Bank Resource Center,
https://www.fdic.gov/resources/bankers/credit/commercial-and-industrial-lending/.
[2] Greenwich Economic Forum, The Private Credit Elite: Opportunities & Risks in Private Credit, YouTube ( Nov 19, 2021), https://www.youtube.com/watch?v=4OXIu_mGgK8.
[3] Id.
[4] Robin Blumenthal, Inside the love-hate relationship between banks and private credit, Private Debt Investor (April 2, 2024), https://www.privatedebtinvestor.com/inside-the-love-hate-relationship-between-banks-and-private-credit/.
[5] Bloomberg Television, Golub Capital CEO on State of Private Credit Market, YouTube (Jan 9, 2024), https://www.youtube.com/watch?v=hiMOqGMh7UU.
[6] Understanding Private Credit, Morgan Stanley (September 15, 2023), https://www.morganstanley.com/ideas/private-credit-outlook-considerations.
[7] Philip Godfrey, Private Credit: Key Investment Characteristics, Highground Advisors (March 1, 2023),
[8] The interest rate set by the Fed.
[9] Unlike bonds that are primarily fixed interest rate instruments, debt in private credit often has a floating rate (typically tied to a benchmark such as Secured Overnight Financing Rate or SOFR, often with a rate floor).
[10] Philip Godfrey, Private Credit: Key Investment Characteristics, Highground Advisors (March 1, 2023),
[11] Private Credit Deep Dives – Leverage Covenants and Auto-Resets (Europe), Proskauer Rose LLP (June 19, 2023), https://www.proskauer.com/alert/private-credit-deep-dives-leverage-covenants-and-auto-resets.
[12] Incurrence covenants are only applicable at the time of incurrence of a specific action whereas maintenance covenants are applicable at regular intervals and requires the borrower to maintain predetermined levels of specified activity.
[13] Guide to Private Credit for Borrowers and Investors (Canadian Edition), Alternative Credit Council, https://acc.aima.org/research/borrower-s-guide-to-private-credit-canada-edition.html.
[14] minimum level of cash flow or earnings relative to the interest/debt service charges.
[15] maximum level of debt relative to equity or cash flow (some of the most commonly used metrics are the debt-to-EBITDA ratio and loan-to-value ratio).
[16] minimum ratio of current assets to current liabilities.
[17] minimum level of net worth often with a build-up provision which requires increase in minimum value by a percentage of net income or equity issuance.
[18] maximum expenditure on capital assets for a given period.
[19]Private Credit Deep Dives – Leverage Covenants and Auto-Resets (Europe), Proskauer Rose LLP (June 19, 2023), https://www.proskauer.com/alert/private-credit-deep-dives-leverage-covenants-and-auto-resets.
[20] Revolving credit is a line of credit that allows the borrower to borrow money and pay it back over time. It remains available even after payment of the full balance. Non-revolving credit, on the other hand, requires a fixed number of payments over a set period of time.
[21] This implies that the covenant only applies if the revolving facility is actually drawn to a certain extent, commonly 40%. Term loan lenders would have a cause of action only via the cross-acceleration provisions, upon those revolving facility lenders accelerating their loans. See Private Credit Deep Dives – Leverage Covenants and Auto-Resets (Europe), Proskauer Rose LLP (June 19, 2023), https://www.proskauer.com/alert/private-credit-deep-dives-leverage-covenants-and-auto-resets.
[22] Id.
[23] Id.
[24] Id.
[25] Id.
[26] Id.
[27] Id.
[28] Evan Gunter, Private Debt: A Lesser-Known Corner Of Finance Finds The Spotlight, S&P Global (October 12, 2021), https://www.spglobal.com/en/research-insights/featured/special-editorial/private-debt.
[29] Id.
[30] Bloomberg Television, Why Unitranche Deals Are So Popular, YouTube (Nov 27, 2019), https://www.youtube.com/watch?v=hVGdNQipG7M.
[31] Id.
[32] Id.
[33] Id.
[34] individuals or entities that meet certain financial thresholds, such as having a net worth of over $1 million (excluding their primary residence) or earning income exceeding $200,000 ($300,000 for joint income) in the last two years.
[35] For example, filing Form ADV to disclose business practices and operations, and ensuring transparency regarding fund performance and risks.
[36] The Chevron doctrine originates from the Supreme Court’s 1984 decision in Chevron v. Natural Resources Defense Council. The decision essentially purports that if federal legislation is ambiguous or leaves an administrative gap, the courts must defer to the regulatory agency’s interpretation if the interpretation is reasonable. See Sarah Bardeen and Brian Gray, Unpacking the Supreme Court’s Recent Ruling on the “Chevron Doctrine”, Public Policy Institute of California (July 27, 2024), https://www.ppic.org/blog/unpacking-the-supreme-courts-recent-ruling-on-the-chevron-doctrine/#:~:text=The%20Chevron%20doctrine%20stems%20from,if%20the%20interpretation%20is%20reasonable.
[37] Shay Dvoretzky, Parker Rider-Longmaid, Boris Bershteyn, Emily J. Kennedy and Steven Marcus, Supreme Court’s Overruling of Chevron Deference to Administrative Agencies’ Interpretations of Statutes Will Invite More Challenges to Agency Decisions, Skadden, Arps, Slate, Meagher & Flom LLP (July 9, 2024), https://www.skadden.com/insights/publications/2024/07/the-supreme-courts-overruling-of-chevron-deference.
This post comes to us from Devyani Aggarwal at the University of California, Berkeley Law School. It is based on her recent article, “The Promise and Peril of Private Credit,” available here.