Private Credit: Direct Lending and Mezzanine

Private Credit: Direct Lending and Mezzanine
Private credit is one of the most dynamically developing segments of alternative investments with total assets under management (AUM) exceeding $1.7 trillion in 2025 and projected growth to $2.8 trillion by 2028 (Preqin, McKinsey). The structural growth of private credit is driven by a fundamental shift in the architecture of the financial system: tighter banking regulation after the 2008 financial crisis (Dodd-Frank Act, Basel III/IV — increased capital and liquidity requirements) has significantly limited the ability of banks to lend to the middle market, creating a structural vacuum now filled by non-bank lenders — direct lending funds, BDCs (Business Development Companies), and specialized credit platforms. For a large portfolio manager, private credit offers an attractive combination of high current yield, interest rate protection, and an illiquidity premium.

Direct Lending: Lending to Middle Market Businesses

Direct lending is the provision of loans to middle market companies (Middle Market Companies) with EBITDA from $10M to $100M directly, bypassing the banking system and the public bond market. The typical borrower profile is a private company or a portfolio company of a private equity fund, with an established business model, positive cash flow, and a need for financing — LBO (Leveraged Buyout), refinancing existing debt, growth capital, or add-on acquisitions.

Key parameters of a direct lending deal: loan size $25M–$500M; rate SOFR + 475–650 bps (total yield 9.5–12% in the current environment); term 5–7 years with bullet maturity (repayment at the end of the term) or scheduled amortization (planned amortization of 1–5% per annum); collateral — first lien on all company assets (First Lien, Senior Secured); LTV 40–55% for high credit quality transactions.

The structure of senior secured debt ensures the highest priority in the capital structure (Capital Structure Priority): in case of borrower default, the senior secured lender has first claim on the company’s assets, which provides a recovery rate of 60–80% historically (Moody’s Default Study data).

Unitranche is a hybrid structure, combining senior and subordinated debt into a single credit instrument with a single rate, simplifying the deal structure for the borrower and giving the lender an increased yield (SOFR + 550–700 bps) due to acceptance of subordinated risk within a single tranche. The Agreement Among Lenders (AAL) defines the waterfall distribution between the “first-out” and “last-out” tranches within the unitranche.

Covenants are financial conditions of the credit agreement, a breach of which gives the lender the right to demand early repayment. Maintenance Covenants (maintenance conditions) require the borrower to maintain financial performance at a certain level at each reporting date:

• Maximum Leverage Ratio (Debt/EBITDA ≤ 5.0x);
• Minimum Interest Coverage Ratio (EBITDA/Interest ≥ 2.0x);
• Minimum Fixed Charge Coverage Ratio (EBITDA – CAPEX) / (Interest + Principal + Taxes) ≥ 1.2x;
• Maximum CAPEX limits.

In contrast to the public leveraged loan market, where more than 80% of transactions have become “covenant-lite” (cov-lite), Direct Lending retains full maintenance covenants, providing early warning of financial difficulties for the borrower and the right to intervene before default occurs.

Mezzanine: Subordinated Debt with Equity Kicker

Mezzanine financing occupies an intermediate position in the capital structure between senior debt and equity. Mezzanine carries higher risk (subordination to senior debt), compensated by significantly higher yield.

Typical parameters: rate SOFR + 800–1200 bps (cash coupon) + PIK (Payment-In-Kind) component of 2–4% (interest capitalized into the principal); equity kicker — warrant or conversion option, giving the lender a share in the borrower's equity (usually 3–10% of fully diluted capital). The total target yield of mezzanine: 14–20% IRR (Internal Rate of Return), of which 10–14% is coupon income and 4–8% is equity upside through warrants.

Structural features of mezzanine deals: the intercreditor agreement defines the relationship between the senior lender and mezzanine lender — standstill period (usually 90–180 days, during which the mezzanine lender cannot initiate enforcement), turnover provisions (the mezzanine lender is obligated to transfer to the senior lender any payments received in violation of priority). Purchase option — the mezzanine lender often has the right to purchase the senior debt at par in the event of default, allowing control over the restructuring process and maximizing recovery.

Mezzanine investment yields: historical data (Preqin, Cambridge Associates) show a median net IRR of 10–14% for vintage years 2010–2020, with the top quartile at 15–20%+. Loss rates for mezzanine funds historically have been 2–5% per annum of portfolio value, which is significantly lower than might be expected based on subordinated status, due to thorough underwriting (credit analysis) and active portfolio monitoring.

Key risks of mezzanine investments: subordination risk (in default the mezzanine receives payments only after full satisfaction of the senior debt); illiquidity risk (mezzanine has virtually no secondary market); concentration risk (a typical mezzanine fund contains 15–25 positions, creating significant idiosyncratic exposure).

Private Credit Portfolio Construction

An optimal private credit portfolio for a UHNWI investor includes:

• 50–60% Senior Direct Lending (the portfolio core — stable income with limited credit risk);
• 20–25% Unitranche (higher yield with moderate increase in risk);
• 15–20% Mezzanine (maximum yield through equity kicker).

Diversification is achieved through:

• investing in 3–5 funds from different managers (Manager Diversification) to mitigate manager idiosyncratic risk;
• sector diversification — avoiding more than 20% portfolio concentration in a single industry;
• vintage year diversification — spreading commitments over 3–4 years to smooth out cyclic risks;
• geographic diversification — US Direct Lending + European Direct Lending to reduce allocation to a single economic region.

Due Diligence in selecting private credit funds: manager track record (at least 3 full cycles — 10+ years); loss rate and recovery rate by historical portfolio; team stability (key professionals must have been with the company for 5+ years); alignment of interests — GP commitment (general partner’s own capital in the fund, usually 2–5% of fund size); fee structure — management fee 1.0–1.5%, carried interest 15–20% with a preferred return of 7–8% (hurdle rate).

Private credit portfolio monitoring: quarterly fund reports with analysis of portfolio metrics — weighted average leverage, weighted average interest coverage, PIK percentage (share of PIK in total coupon — PIK growth is an early warning of problems), covenant compliance by borrowers, watch list (list of problem loans).