Private debt: direct lending, mezzanine, venture and distressed debt

What is private debt, and why did it grow?

Private debt is debt that investors provide directly to private entities. It grew quickly in the years after the 2008 financial crisis, when tighter regulation reduced lending by traditional lenders and private lending funds filled the gap between what borrowers wanted and what banks would supply.

As in private equity, an investor can lend directly to a specific operating company, or indirectly by buying into a fund that pools money from many investors and lends to a set of companies. Either way, the investor receives interest and the return of principal after a set term. The debt is typically secured and protected by covenants. Unlike a bond issued to many holders and traded publicly, a private loan comes from a small number of lenders.

What types of private debt are there?

There are four main categories: direct lending, mezzanine debt, venture debt and distressed debt. Unitranche debt and specialty loans complete the picture.

Private debtloans from investors and funds to private borrowers

• Direct lending Memorize senior, secured, covenants, fixed schedule
  • Leveraged loans Use it the lender borrows to fund the loans
• Mezzanine debt Memorize subordinated to senior, senior to equity; warrants or conversion rights
• Venture debt Memorize start-ups with little cash flow; avoids dilution
• Distressed debt Memorize firms in or near default; priced on expected recovery
  • Debtor-in-possession (DIP) financing Use it operating funds for a firm already in bankruptcy
• Unitranche debt Memorize secured and unsecured blended into one loan and one rate
• Specialty loans Know the idea niche situations, such as litigation finance

Type	What it is	Risk and features
Direct lending	loans from a fund to (mostly mid-market) companies	usually senior, secured, with covenants, paid on a fixed schedule
Leveraged loans	the lender itself borrows to fund the loans	higher return and risk from leverage
Mezzanine debt	subordinated to senior debt, senior to equity	higher rate plus warrants or conversion rights
Venture debt	loans to start-ups with little cash flow	lets founders avoid dilution; may include equity rights
Distressed debt	debt of firms in or near default	priced on expected recovery; may include debtor-in-possession (DIP) financing
Unitranche debt	secured and unsecured tranches blended into one loan	one rate between the secured and unsecured rates
Specialty loans	niche situations (for example litigation finance)	idiosyncratic risks

Seniority decides who is paid first, and so how risky each type is.

Claims on a borrower, first in line at the topseniority sets the risk

• Senior secured debt Memorize direct lending; lowest risk and return of these
• Unitranche debt Memorize between senior and subordinated; one blended rate
• Mezzanine debt Memorize subordinated, usually unsecured; higher rate plus equity kickers
• Equity Know the idea last in line; unlimited upside

How does direct lending work, and what are leveraged loans?

In direct lending a private debt firm (or a private equity firm with a private debt arm) raises a fund from investors who want higher-yielding debt, then lends to borrowers. Typical borrowers are mid-market companies, or a private equity fund raising money for acquisitions. Payments come on a fixed schedule, like a bank loan, and the debt is usually senior and secured with covenants. Private debt funds charge higher rates to borrowers that lack good alternatives, perhaps because banks are unwilling or unable to lend to them. Managers do thorough due diligence before they lend.

In leveraged loans the lender is itself levered: it borrows money first and then lends it on, which can enhance the return on its loan portfolio.

What is mezzanine debt?

Mezzanine debt is private credit that is subordinated to senior secured debt but senior to equity. It gives borrowers an extra pool of capital beyond senior debt and often finances buyouts, recapitalizations and acquisitions. Because it is junior and usually unsecured, it is riskier than senior secured debt, so investors commonly demand higher interest rates and may ask for equity participation. Typical extra features are warrants (the right to buy equity) or conversion rights (the right to convert the debt into equity).

What is venture debt?

Venture debt is private debt that backs start-up and early-stage companies with little or negative cash flow, often as a line of credit or a term loan. Entrepreneurs use it to add financing without diluting shareholders, and it can complement an equity round so that current owners keep ownership and control for longer. Like mezzanine debt, it may carry features that pay the lender for the extra default risk and for the lack of assets to use as collateral, such as the right to buy equity in certain circumstances.

What is distressed debt?

Distressed debt means buying the debt of mature companies in financial difficulty: firms in bankruptcy, in default or likely to default. Some investors back a company with a temporary cash flow problem and a good business plan, expecting the debt and the company to recover in value. Turnaround investors go further and take an active role in restructuring and reviving the business.

Distressed debt is priced on the expected recovery rate. Investors therefore need specialized skills: judging the likelihood of default and the likely recovery, and understanding how to restructure companies and debts. Bankruptcy processes can be long, complex and capital intensive. Some funds focus on debtor-in-possession (DIP) financing , which supplies operating funds to a firm that is already in bankruptcy. A DIP loan is often a sign that lenders are confident the company can reorganize and repay.

What is unitranche debt?

Unitranche debt blends tranches of secured and unsecured debt into one loan with a single interest rate. As a blend, its rate generally falls between the rates usually demanded on secured and on unsecured debt. In priority it is usually structured between senior and subordinated debt.

The exam only needs the idea that the rate is in between. The formula below shows the logic as a weighted average, with $w$ the weight on the senior secured part, $s$ its spread over the reference rate and $j$ the spread on the unsecured part.

$$u = w\,s + (1 - w)\,j$$

Specialty loans are extended to niche borrowers in specific situations. In litigation finance, for example, a specialist funder lends to a plaintiff to cover legal fees and expenses in exchange for a share of any judgment.

How are private debt coupons set, and why do they pay more?

Private debt rates are usually quoted relative to a reference rate, for example SOFR + 375 bps. The coupon is a floating rate : it moves up and down with the reference rate.

$$\text{Coupon} = \text{Reference rate} + \text{Spread}$$

Private debt can offer higher yields than public bonds for three reasons. Investors earn an illiquidity premium , the extra return required for giving up liquidity. They bear more credit risk. And funds that take opportunistic positions can exploit market inefficiencies. Borrowers get more flexible financing, with entry and exit points arranged with the lender.

Returns depend on specialized knowledge: the company’s life cycle stage (earlier debt carries higher risk and higher return), the structure of the debt (for example collateralized loan obligations), and the underlying assets, especially for secured lending such as real estate. Senior private debt offers a steadier yield and moderate risk. Mezzanine debt offers equity upside and more risk. Overall, private debt is riskier than traditional bonds, with illiquidity and a heightened default risk when lending to riskier borrowers. Data are scarce and reported returns are artificially smooth, so modeling returns is not straightforward.

How does loan to value work for secured lenders?

When a loan is secured on property, the lender watches the loan to value (LTV) ratio: the loan outstanding divided by the value of the collateral.

$$\text{LTV} = \dfrac{L}{V}$$

Exam tip To place a loan, ask two questions: who is the borrower (start-up, mature firm, firm in default) and where does it rank (senior, in between, junior)?

Go deeper Why DIP financing often ranks first

A lender that funds a firm already in bankruptcy takes a risk that existing creditors did not. To make that worthwhile, courts and loan terms commonly give DIP lenders priority over the claims that already exist, so the loan usually ranks ahead of the debt it joins. It also tends to carry a high spread over the reference rate. The exam point is the purpose: operating money for a firm that is already in bankruptcy and expected to reorganize.

Go deeper Loans to property funds and syndication

A private debt fund may underwrite a large property loan and then syndicate it, selling parts to banks or institutions. Both steps depend on LTV. The borrower cannot draw the loan if the aggregate LTV breaches the cap, and the lender cannot syndicate it for the same reason. Any property that departs from the ratio must be cured, either by repaying part of the loan or by adding collateral. You will see this again in real estate lending.