When Banks Stop Funding Mid-Size Companies, Private Credit Steps In

The global lending landscape has fundamentally shifted over the past two decades, and most investors have barely noticed. What began as a gradual retreat by traditional banks from certain lending categories has accelerated into a structural transformation of how capital reaches businesses. Private credit emerged not as a niche alternative, but as a necessary response to a banking system that chose to shrink its balance sheet rather than serve middle-market borrowers.

This matters because the companies that drive economic growth—those with annual revenues between $50 million and $1 billion—found themselves increasingly underserved by the institutions meant to finance them. Regional banks, once the backbone of middle-market lending, consolidated or failed in the wake of regulatory changes after 2008. Large banks redirected resources toward bigger deals that offered greater economies of scale. The result was a financing gap that private credit funds stepped in to fill.

The opportunity this created is substantial. Private credit managers now oversee roughly $1.5 trillion in assets globally, and that figure continues growing as institutional investors seek alternatives to an environment where traditional fixed income offers yields barely above inflation. For investors willing to accept the constraints that come with private market investing, this shift opened access to lending relationships that previously existed only between banks and their most trusted corporate clients.

The structural advantages embedded in these arrangements matter as much as the yield premium. Private lenders negotiate terms that public bond investors can only dream of—first lien positions, detailed covenants, and active monitoring rights that transform a passive debt holding into an instrument with genuine protective power. These aren’t theoretical benefits. They represent real mechanisms that have preserved capital through economic downturns and shifted recovery outcomes in lenders’ favor.

Understanding Private Credit as an Asset Class

Private credit refers to debt financing provided by non-bank institutions directly to borrowers, structured through private agreements rather than traded on public exchanges. The essential distinction from traditional fixed income isn’t simply that these loans aren’t rated by Moody’s or S&P. It’s that the lending relationship operates on entirely different terms than anything available in the public markets.

Consider the contrast with traditional bank financing. When a company approaches a bank for a term loan, the bank underwrites the credit, structures the facility, and typically retains the loan on its balance sheet. The borrower gets financing; the bank earns interest. In the private credit model, a fund raises capital from institutional investors and then deploys that capital across a diversified portfolio of loans to companies that banks have declined to serve—or that seek better terms than banks are willing to offer.

The borrowers in private credit transactions are typically middle-market companies with enterprise values between $50 million and $500 million. These businesses generate meaningful cash flows, own tangible assets, and have legitimate financing needs, but they lack the scale to access the high-yield bond market or negotiate with the largest lenders. They occupy the awkward middle space where traditional banks once thrived but increasingly choose not to compete.

For investors, the implications are significant. Unlike public bondholders who must accept whatever terms the market collectively negotiates, private credit funds actively structure each transaction. They determine collateral packages, negotiate covenant requirements, and decide what information they’ll receive from borrowers on an ongoing basis. This active management of credit risk—rather than passive holding—creates the potential for superior risk-adjusted returns, but it also means that outcomes depend heavily on manager capability.

The asset class encompasses a range of strategies, from conservative senior lending to opportunistic distressed investing. What unites them is the private nature of the lending relationship and the institutional structure of the capital providing it.

Senior Secured Lending vs. Mezzanine vs. Distressed Strategies

The private credit landscape divides into distinct strategies that offer markedly different risk-return profiles. Understanding these differences is essential for any investor considering allocation to the asset class, because the same yield premium can come from fundamentally different risk sources depending on which strategy you choose.

Senior secured lending represents the most conservative approach within private credit. These loans hold first lien positions on borrower assets, typically backed by accounts receivable, inventory, equipment, or other tangible collateral. The structuring emphasizes collateral coverage and cash flow coverage ratios, with lenders typically requiring that collateral value exceeds the loan balance by a meaningful margin. Senior lenders typically achieve yields in the 8-12% range, depending on market conditions and borrower quality. The priority in liquidation means these lenders expect to recover most of their principal even if the borrower performs poorly.

Mezzanine financing sits one step down the capital structure, typically subordinated to senior debt but senior to equity. These instruments often combine a lower-priority loan with an equity component like warrants, creating a return profile that targets 12-18% yields. The subordination means higher risk of loss in default, but the equity kicker provides upside participation that can compensate for that risk. Mezzanine lenders accept lower collateral coverage in exchange for higher returns and the potential for equity conversion if borrowers perform exceptionally well.

Distressed and special situations strategies pursue the highest returns but with substantially greater risk and complexity. These funds target companies experiencing operational challenges, restructuring situations, or other distress where traditional lenders have fled. Returns in the 15-25% range are theoretically available, but achieving them requires deep credit analysis, workout expertise, and the willingness to endure multi-year timelines. Many distressed investments result in losses; the outsized returns come from the minority of positions where the manager’s thesis proves correct.

The choice among these strategies should reflect not just return targets but genuine tolerance for different loss scenarios. An investor who cannot accept any principal loss shouldn’t be in mezzanine or distressed strategies regardless of the yield premium offered.

Historical Performance Across Market Cycles

Evaluating private credit performance requires looking beyond headline returns to understand how different strategies have behaved across varying economic conditions. The data reveals that private credit has generally delivered on its yield premium promise, though with meaningful variation by strategy, vintage, and market environment.

Over the past fifteen years, private credit funds targeting senior secured lending have generated net returns in the 8-12% range, consistently outperforming comparable public high-yield benchmarks by 2-4 percentage points annually. This premium persisted through the 2015-2016 period of energy sector distress, the COVID-19 shock of 2020, and the subsequent inflation-driven repricing of 2022. The consistency of this outperformance suggests it’s structural rather than cyclical—built into the inefficiencies of the middle-market lending market rather than dependent on favorable economic conditions.

Mezzanine strategies have shown higher absolute returns but greater variability. Funds launched in the 2014-2017 vintage period benefited from a benign credit environment and generated net IRRs in the 12-16% range. Those deploying capital in 2021-2022 faced a more challenging environment as interest rates rose and merger activity slowed, compressing returns for newer vintages. The picture for mezzanine funds depends heavily on the exit environment—how and when portfolio companies refinance or sell—which varies substantially with financial market conditions.

Distressed strategies exhibit the widest performance dispersion. Top-quartile managers generated 15-20%+ returns during the post-2008 restructuring wave and again during COVID-related dislocations. Median distressed funds have delivered more modest results, while bottom-quartile managers have lost capital. This dispersion underscores that manager selection matters enormously in distressed investing, more so than in the relatively standardized senior lending space.

Performance Benchmarks: Private Credit vs. Traditional Fixed Income

The data demonstrates that private credit’s yield premium comes with lower volatility than equivalent-yield public alternatives. This counterintuitive result reflects the illiquidity premium embedded in private lending returns and the stabilizing effect of holding loans to maturity rather than mark-to-market pricing.

Risk Factors in Private Credit Investing

Private credit carries distinctive risks that investors must understand before committing capital. These risks differ qualitatively from those in traditional fixed income, and their management requires different capabilities and expectations.

Credit risk—the possibility that borrowers fail to meet their obligations—represents the fundamental risk in any lending strategy. Private credit managers mitigate this through due diligence, structuring, and ongoing monitoring, but they cannot eliminate it entirely. The key insight is that private credit credit risk manifests differently than in public markets. Private lenders often see problems developing before they become public knowledge, giving them time to work with borrowers or restructure positions. Public bondholders, by contrast, discover credit deterioration only when ratings change or prices collapse.

Liquidity risk deserves special attention because it’s the price paid for private credit’s yield premium. Unlike public bonds that can be sold in seconds, private credit positions may be held for their full duration—often five to seven years—or sold only at substantial discounts to estimated fair value. This illiquidity isn’t a flaw to be overcome; it’s a structural feature that enables the returns available in the asset class. Investors must honestly assess whether they can commit capital for the required horizons without needing liquidity for other purposes.

Manager skill is the third pillar of private credit risk, and perhaps the most underappreciated one. Two funds pursuing identical strategies can deliver dramatically different results based on deal sourcing capabilities, structuring expertise, workout experience, and organizational stability. The private credit landscape includes excellent managers who have built franchises over decades and lesser-known firms still establishing their track records. Evaluating manager quality requires examining not just returns but how those returns were generated, what loss experience occurred, and whether performance is repeatable.

Concentration risk also warrants consideration. Many private credit funds hold 15-30 positions, meaning a single default can meaningfully impact portfolio returns. This concentration is somewhat offset by the diversification benefits of lending to companies in different industries and geographies, but it differs from the thousands of holdings possible in public bond index funds.

Default Recovery Rates and Loss Given Default

Understanding recovery rates—the percentage of principal recovered when borrowers default—provides crucial insight into the downside protection built into different private credit strategies. These figures aren’t theoretical averages; they’re based on decades of historical experience across multiple credit cycles.

Senior secured lending positions demonstrate the strongest recovery characteristics. Historical data across multiple cycles shows first-lien lenders typically recover 60-80% of principal in default scenarios. This recovery comes from collateral liquidation, refinancing proceeds, or restructuring exchanges. The variation within this range depends on collateral quality, industry conditions, and the broader economic environment at the time of default, but the important point is that senior secured positions have consistently preserved the majority of investor capital even when borrowers fail.

Mezzanine positions face substantially lower recovery expectations. Subordinated lenders historically recover 30-50% of principal in default, reflecting their junior position in the capital structure and the reality that senior creditors are made whole before any recovery flows to mezzanine holders. The warrant or equity conversion features attached to mezzanine instruments can provide additional upside if portfolio companies perform well, but they offer no protection in downside scenarios.

Distressed and special situations investments present the widest range of recovery outcomes. Historical recoveries for distressed debt positions range from 20-40% on average, but individual investments can produce anything from total loss to full recovery plus substantial gains depending on the specific situation and manager’s ability to influence outcomes. This variability is inherent to distressed investing, where returns derive from both the recovery process and the manager’s skill in navigating complex restructuring situations.

Recovery Rate Summary by Position Seniority

These recovery rates explain why yield premiums in private credit aren’t purely compensation for default risk. The high recovery rates on senior positions mean that even if a portion of the loan book defaults, portfolio-level losses remain manageable. A senior lending portfolio with 5% annual default rate and 70% average recovery would experience net losses of only 1.5%—well within the yield cushion provided by the 9-11% interest rates these loans carry.

Structural Protections and Collateral Frameworks

Private credit agreements embed protections that public bond investors cannot access. These protections aren’t incidental features; they’re structural elements that fundamentally alter the risk profile of private lending compared to publicly traded debt.

Collateral packages in private credit transactions typically include first liens on tangible assets, which may encompass accounts receivable, inventory, equipment, intellectual property, or real estate depending on the borrower’s business model. The collateral coverage ratio—the relationship between collateral value and loan amount—usually exceeds 1.0x for senior lending, meaning the pledged assets exceed the loan balance. This cushion provides protection against both asset value depreciation during the loan term and potential liquidation discounts if enforcement becomes necessary.

Affirmative and negative covenants govern borrower behavior throughout the loan lifecycle. Affirmative covenants require ongoing actions: financial reporting, insurance maintenance, and compliance with financial ratios like debt-to-EBITDA or fixed-charge coverage. Negative covenants restrict harmful actions: additional indebtedness, asset sales, dividend payments, or changes to the business without lender consent. These covenants give private lenders meaningful influence over borrower decisions in ways that public bondholders cannot exercise.

Information rights in private credit agreements typically far exceed those available to public bondholders. Senior lenders often receive monthly or quarterly financial statements, regular cash flow reports, and access to management for calls or meetings. This information flow enables early identification of developing problems and proactive engagement before situations deteriorate to default.

Standard Private Credit Structural Protections

The combination of collateral, covenants, and information rights creates a fundamentally different relationship between lender and borrower than exists in public markets. Private credit holders aren’t passive investors waiting for payment; they’re active participants in credit monitoring who can influence outcomes when problems arise.

Common Fee Structures in Private Credit Funds

Understanding how private credit fund managers are compensated is essential for accurate return expectations. Fee structures in this asset class differ substantially from traditional investment vehicles, and they materially affect net investor returns.

Management fees represent the ongoing cost of fund operations and typically range from 1.5% to 2.0% annually for private credit funds. These fees cover deal sourcing, due diligence, monitoring, and administrative functions. Some managers charge fees on committed capital during the investment period and then switch to fees on invested capital afterward, which partially aligns the manager’s interests with investor deployment. Others maintain flat fee structures throughout the fund life.

Performance allocations—often called carried interest—give fund managers a share of profits beyond their management fees. The standard arrangement allocates 20% of profits to the manager after returning investor capital, though some funds operate on 15-18% arrangements and a few charge higher rates. The preferred return, or hurdle rate, that must be achieved before performance fees kick in varies by fund, with 8% being common but anything from 5% to 12% possible.

Transaction and monitoring fees add another layer of compensation. Managers often receive origination fees when loans are funded, typically ranging from 0.5% to 2.0% of loan principal. Ongoing monitoring fees may also be charged. These fees flow to the manager and reduce the effective yield passed through to investors.

Fee Impact Illustration: Senior Lending Fund

The practical implication is that investors must look beyond headline yields to understand what managers actually deliver net of fees. A fund advertising 12% gross yields might produce 9-10% net returns after standard fee structures, which remains attractive relative to public alternatives but requires adjusting expectations accordingly.

Liquidity Terms and Investment Minimums

Private credit demands genuine commitment from investors, and the illiquidity embedded in the asset class is the most significant practical constraint for most potential allocators. Understanding these terms before committing capital prevents costly surprises and ensures appropriate sizing within broader portfolio strategy.

Lockup periods in private credit funds typically span seven to ten years, during which investor capital remains committed and cannot be withdrawn. During the investment period—usually the first three to five years—capital is drawn down as investments are made. After the investment period ends, distributions may occur as loans are repaid or exited, but investors have no right to demand redemptions. Some funds offer periodic distributions, but these cannot be counted on and vary with portfolio performance.

Redemption provisions, where they exist at all, are highly restrictive. Certain funds permit annual or semi-annual redemption windows, often requiring substantial advance notice and imposing penalties or holdback provisions. Even funds with more flexible redemption terms may suspend redemptions during market stress or when portfolio liquidity is constrained. The fundamental reality is that private credit is designed for investors who can commit capital for the full fund life.

Investment minimums create meaningful access barriers. While individual commitments can theoretically be as low as $25,000 in some vehicles, typical institutional-focused funds require $250,000 to $1 million for accredited investors and often $5 million or more for individual participation in larger funds. Fund-of-funds structures and interval funds offer lower minimums but charge additional layers of fees in exchange for that access.

Key Liquidity Terms Summary

These constraints mean private credit allocation should be sized based on genuine long-term capital availability. Investors should not allocate to private credit any capital they might need access to within five to seven years, regardless of how attractive the yield premium appears.

Portfolio Allocation Framework for Private Credit Exposure

Determining appropriate private credit allocation requires balancing the asset class’s return potential against its illiquidity constraints and risk characteristics. The right answer varies significantly by investor circumstances, and no single framework applies universally.

For conservative investors with low risk tolerance and significant liquidity needs, private credit exposure of 3-5% of total portfolio may be appropriate. This allocation captures some yield premium while limiting the impact of illiquidity on overall portfolio flexibility. Senior secured lending strategies are most suitable for this group given their lower risk profile and stronger recovery characteristics.

Moderate-risk investors with medium-term time horizons—ten years or more until major capital needs—can plausibly allocate 8-12% to private credit. Within this allocation, a core holding in senior lending combined with satellite positions in mezzanine strategies can enhance returns while maintaining reasonable downside protection. The key is accepting that this capital will be unavailable for the full lockup period.

Aggressive investors with long time horizons and high risk tolerance may allocate 15-20% or more to private credit, including meaningful distressed and special situations exposure. These investors understand that higher allocations to higher-yielding strategies mean accepting greater return volatility and potential loss scenarios. The potential returns justify the risks only for investors with genuine capacity to absorb losses.

Portfolio Allocation Guidelines by Investor Type

Beyond percentage allocation, investors should consider how private credit fits within their fixed income allocation. Rather than treating private credit as a satellite position, many sophisticated investors view it as a partial replacement for high-yield or investment-grade bonds, sizing it based on the yield enhancement desired and the liquidity tradeoff acceptable.

Conclusion: Integrating Private Credit into Your Investment Approach

Private credit has evolved from an obscure corner of alternative investing into a mainstream allocation option for sophisticated investors. The asset class offers genuine benefits—yield premiums, structural protections, and diversification from public market volatility—but these benefits come with meaningful tradeoffs that must be honestly acknowledged.

The case for private credit rests on structural inefficiencies in middle-market lending that create opportunity for investors willing to commit capital for extended periods. Banks will not return to their previous role in middle-market finance; regulatory economics and strategic priorities have permanently altered their lending behavior. This structural gap creates ongoing opportunity for private lenders, and investors who participate in that opportunity share in the returns it generates.

The case against private credit centers on illiquidity, fee structures, and manager dependence. Capital committed to private credit cannot be accessed when needs arise elsewhere. Fee structures—management fees, performance allocations, and transaction costs—eat into headline yields significantly. And manager quality varies enormously, meaning selection risk compounds the inherent risks of the asset class.

Private Credit Investment Readiness Checklist

Before allocating to private credit, investors should confirm:

• Sufficient time horizon to meet fund lockup requirements without liquidity need
• Appropriate risk tolerance for potential loss scenarios
• Understanding of fee impact on net returns
• Due diligence completed on manager track record and organization
• Appropriate position sizing within overall portfolio constraints

Private credit deserves consideration within a diversified portfolio, but only when investors understand what they’re buying, what they’re giving up, and how the investment fits their broader objectives. When those conditions are met, the asset class offers a legitimate source of yield enhancement and diversification that public markets cannot replicate.

FAQ: Common Questions About Private Credit Investment Returns

What yield premium does private credit offer over traditional fixed income benchmarks?

Private credit typically generates yields 2-4 percentage points above comparable traditional fixed income instruments. Senior secured private lending achieves 9-11% yields compared to 7-8% for public high-yield bonds. Investment-grade corporate bonds offer 4-5%, making the private credit premium particularly pronounced at the higher-quality end of the spectrum. This premium reflects the illiquidity investors accept and the additional due diligence required for private market investing.

How does risk vary across senior lending, mezzanine, and distressed credit strategies?

Senior lending carries the lowest risk within private credit, with first-lien positions and strong collateral coverage limiting loss scenarios. Mezzanine strategies accept subordination risk in exchange for higher yields and equity upside participation. Distressed strategies pursue the highest returns but face substantial risk of principal loss, requiring expertise in workout situations and longer timelines to realize returns. Risk assessment must account for both the probability of default and the expected recovery rate given the position seniority.

What collateral protections typically exist in private lending transactions?

Private lending transactions include first lien security interests on borrower assets, financial covenants limiting leverage and requiring maintenance tests, ongoing information rights providing visibility into borrower operations, and control provisions requiring lender consent for significant actions. These protections exceed what public bond investors can access and provide meaningful downside mitigation beyond the yield premium itself.

What are the typical fund structures and lockup periods for private credit investments?

Private credit funds typically have 7-10 year lifespans with initial investment periods of 3-5 years during which capital is deployed. Lockup provisions prevent redemption during the fund life, though some structures offer limited periodic distribution rights. Investors should expect capital commitment for the full fund term rather than planning for earlier exit.

How should private credit allocation be sized within a diversified portfolio?

Appropriate sizing depends on liquidity needs, risk tolerance, and time horizon. Conservative investors might allocate 3-5% primarily to senior lending. Moderate investors may allocate 8-12% with senior and mezzanine exposure. Aggressive investors with long time horizons might allocate 15-20% or more including distressed strategies. The key constraint is that allocated capital must be genuinely long-term, as private credit illiquidity cannot be managed through position sizing within shorter timeframes.