Understanding Private Credit Funds – and How They Create Returns for Investors

What is private credit?
Private credit is the provision of loans to borrowers by private lenders rather than loans provided by traditional banks.

What is a private credit fund?
A private credit fund is an investment vehicle that pools money from investors and lends it directly to borrowers.  Investors earn returns from the interest and fees paid on these loans, with the fund manager selecting, monitoring, and managing the underlying loans to protect capital and generate income.

What are the loan types?
Private credit funds typically provide 4 different types of loans, which all have 4 very different types of risk and return profiles for investors,

• 1st Mortgage Loans that are secured by a registered 1st mortgage, and rank at the top (first) of the capital stack. These loans are also referred to as senior secured loans.
• 2nd Mortgage Loans that are secured by a registered 2nd mortgage behind the 1st mortgage lender and rank 2nd in the capital stack. These loans are also referred to as mezzanine finance loans or junior secured loans.
• Preferred Equity Loans that are typically secured against the borrower’s equity, have no registered mortgage and rank 3rd in the capital stack.
• Corporate Loans that are secured against the balance sheet of the borrower, rather than a single asset.

What are the loan security types?
Loans are typically ‘secured’ against 4 different types of assets, which all have 4 very different types of risks and liquidity profiles for investors.

• Asset Backed Loans are ‘secured’ when a physical asset(s) is used as collateral, or security, against the loan. If the loan can’t be met, the lender can sell the asset(s) to repay the loan principal, interest and fees.
• Balance Sheet Loans are ‘secured’ by the balance sheet and the cashflow of the borrower rather than a single asset. If the loan can’t be met, the lender will need to sell and/or breakup the business to repay the loan.
• Income-backed Loans are serviced and repaid from the predictable income the borrower receives (e.g., rent, business cash flow, project pre-sales). The lender focuses on the stability and adequacy of this income stream.
• Commodity-backed Loans are secured against a commodity or inventory (e.g., gold, grain, oil). The lender can take possession of the commodity if the borrower defaults, with its market value forming the basis of security.

What types of loans do private Credit funds invest in?
Private credit funds can invest in one single loan type or in a mix of multiple loan types.  Funds that invest in a single loan type are called ‘non-blended’ funds and funds that invest in multiple loan types are called ‘blended’ funds. Each loan type has very different risk and return profiles, so it’s important to understand what type of loans the fund invests in, so you can understand the risk and return of the fund.

• Non-blended funds have a single loan type (e.g. 1st mortgage) and a single loan security type (e.g. asset backed). The fund is restricted from investing in other loan types under the fund PDS/IM. These types of funds are typically more transparent, making it much easier for investors to see the true risk and return of the fund and compare funds.
• Blended Funds have a mix of loan types (e.g. 1st mortgage, 2nd mortgage, preferred equity and corporate loans) and include a mix of loan security types (e.g. asset backed and balance sheet backed). This makes it much more difficult for investors to understand the true risk and return of the fund.

How are returns generated for investors?
Investor returns in a private credit fund are generated primarily from the interest and fees borrowers pay on their loans. The fund lends money to borrowers at agreed interest rates, and those repayments flow back to investors as income.

Some funds also use leverage or gearing to increase returns to investors, but these fund structures typically carry higher risk.

The relationship between risk and return
In private credit, risk and return go hand in hand. Investors earn income based on the level of risk the fund takes—higher-risk loans generally pay higher interest, while lower-risk loans offer steadier, more predictable returns. It’s important for investors to understand exactly what types of loans the fund is making, how the loans are monitored, and the strength of the security behind them. This helps determine whether they are being fairly compensated for the level of risk they are taking. And remember, not all private credit funds are the same—their strategies, loan quality, oversight, and transparency can vary significantly.