Private Credit Funds: Structuring and Governance

A private credit fund is an investment fund that lends to private borrowers, such as corporations, middle-market companies and individuals, outside the traditional banking system. Also known as direct lending or private debt funds, these vehicles can tailor maturities, interest rates and covenants to the borrower, and take closed-ended, open-ended and business development company forms.

Key takeaways

• Private credit funds provide capital to businesses and borrowers as an alternative to bank lending.
• Common strategies are senior secured lending, mezzanine debt, distressed debt and real estate debt.
• Credit risk is the primary risk; funds manage it through borrower due diligence and diversification across loans, borrowers and industries.
• Private loans are less liquid than publicly traded securities, which affects exit strategies, redemption terms and valuation.
• Regulatory, compliance and tax treatment varies by jurisdiction, and investors may be taxed in their own jurisdictions.

What is a private credit fund?

Private credit funds have emerged as a significant source of finance. They are investment funds that specialise in extending credit to private entities, such as corporations, middle-market companies or individuals, and so provide an alternative source of capital outside the traditional banking system.

They serve as an alternative to bank lending, which has become more stringent and more heavily regulated since the global financial crisis of 2008. For managers considering a Cayman vehicle, the starting point is the choice of fund type, which is covered in our overview of Cayman investment fund structures and regulation, and Bell Rock's Cayman fund formation service.

How are private credit funds structured?

Private credit funds can take various forms, including closed-end funds, open-end funds and business development companies (BDCs). Each has its own investment objectives and structure, and the choice affects how investors subscribe, how long capital is committed and how loans are held and realised.

Closed-ended structures, where investors commit capital for the life of the fund, are a natural fit for longer-dated loans. The Cayman framework for those vehicles is explained in our guide to the Cayman private funds regime.

Why borrowers use private credit

One of the primary characteristics of private credit funds is flexibility. Unlike banks, which often have rigid lending criteria, private credit funds can tailor their lending terms to the needs of each borrower.

That flexibility can include structuring loans with different maturities, interest rates and covenants. It gives borrowers access to capital that may not be readily available through traditional channels, which makes private credit a resource for businesses seeking finance for growth, acquisitions or special situations.

Private credit fund strategies

The strategies employed by private credit funds are diverse, reflecting the breadth of opportunities in the market.

Senior secured lending

Senior secured lenders provide loans with a high-priority claim on the borrower's assets.

Mezzanine debt

Mezzanine debt occupies a subordinate position in the borrower's capital structure but offers higher potential returns.

Distressed debt

Distressed debt funds target companies facing financial distress or insolvency, aiming to benefit from restructuring and turnaround opportunities.

Real estate debt

Real estate debt funds extend credit for property acquisitions and development projects.

How private credit funds manage risk

Risk management is a critical part of private credit fund operations. These funds can offer higher yields than traditional fixed-income investments, but they are not without risk.

Credit risk, the risk of borrower default, is the primary concern. To manage it, private credit funds conduct thorough due diligence on potential borrowers, assessing their financial health, business models and collateral. Some funds also diversify, spreading investments across a portfolio of loans to reduce exposure to any single borrower or industry.

Because loans have no quoted market price, how the fund values them matters to investors and to the board. The principles are set out in our guide to hedge fund valuation policies.

The role of private credit funds for investors

Private credit funds bridge the gap between borrowers seeking flexible financing and investors seeking yield. They offer an alternative to traditional fixed-income investments such as bonds.

For institutional investors, including pension funds and endowments, private credit funds have become a component of portfolio diversification, offering the potential for higher returns while managing risk through careful underwriting.

Challenges and considerations

Liquidity

Liquidity risk can be a concern, because investments in private debt are typically less liquid than publicly traded securities. Exit strategies, such as selling loans in the secondary market, can be more complex and time-consuming.

Regulation, compliance and tax

Regulatory and compliance requirements vary by jurisdiction. Investors need to understand the tax implications of investing in private credit funds, since they may be taxed in their own jurisdictions on the returns they receive.

Investor due diligence

Investors should assess their risk tolerance and carry out due diligence before participating in this alternative asset class.

Frequently asked questions

What is the difference between private credit and bank lending?

Private credit funds lend from pooled investor capital rather than bank balance sheets. They can tailor maturities, interest rates and covenants to the borrower, where banks often apply more rigid lending criteria.

What types of private credit fund are there?

The main strategies are senior secured lending, mezzanine debt, distressed debt and real estate debt. Funds can be structured as closed-end funds, open-end funds or business development companies.

How liquid is an investment in a private credit fund?

Generally less liquid than an investment in publicly traded securities. Private loans can be harder to sell, and selling loans in the secondary market can be complex and time-consuming.

Related reading

• Setting up a Cayman venture capital fund
• How Cayman master-feeder funds are structured
• Filing the Cayman private fund annual return
• Cayman Exempted Limited Partnership: Formation, Registration and Ongoing Obligations

To plan a Cayman private credit vehicle, see Bell Rock's fund formation service.