The Pros and Cons of Private Debt Funds: What Investors Need to Know

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Key Takeaways

• They provide access to higher potential yields and diversification benefits, which are appealing to investors looking for alternatives to traditional fixed income assets.
• These funds provide more hands-on control over lending and typically feature tougher covenants that can protect investor interests.
• Private debt investments are typically less liquid than public debt, so investors should be prepared for longer holding periods and limited accessibility to their capital.
• Private debt fund fees are complicated and not unexpected. Transparency and due diligence are key.
• Human elements, such as fund manager talent, relationship sourcing, and workout skills, matter a lot in private debt strategies.
• A strategy approach such as due diligence, risk mitigation, and portfolio alignment goes a long way for investors to navigate the private debt market’s particular risks and opportunities.

Private debt funds provide a means for investors to provide loans to companies beyond banks and the public markets. They typically offer consistent income and better yields than certain other fixed-income choices.

However, risks involve greater illiquidity, large minimum buy-ins, and lighter regulation than public funds. That’s a lot for investors to consider before they jump in.

To assist with transparent decision-making, this blog dissects the primary pros and cons of private debt funds.

What is Private Debt?

Private debt refers to lending outside the traditional banking system. This type of lending is predominantly by funds or private investors that provide loans to companies, real estate developments, or other projects that might not receive straightforward bank financing. Unlike bank loans or public bonds, these are private deals and they often fill holes where banks either can’t or won’t lend.

The private debt market has expanded significantly in the aftermath of the 2008–09 financial crisis, currently accounting for approximately 10 to 15 percent of all assets managed by private investors. Private debt’s assets soared to $812 billion by 2019, indicating just how much the asset class has taken flight across the globe.

Most private debt funds are closed-end structures. That means investors commit their capital to the fund for a fixed period, typically five to ten years, and cannot withdraw it prematurely. These funds aggregate capital from numerous investors so they can provide bigger individual loans to borrowers.

Capital is drawn down over years rather than all at once which allows managers to select investments as they observe strong opportunities. In exchange, investors receive interest payments, usually quarterly, which can provide a consistent cash flow despite the investment being locked up for years. This structure stands in contrast to public debt, where you can typically buy or offload your position with much greater ease.

Private debt has an important role to play in assisting underserved markets by banks or bond markets. Thus, while small and medium sized businesses may require loans for growth, these businesses don’t have the credit ratings or size to get bank loans. Private debt funds can fill this gap with loans that are customized to these borrowers’ specific needs.

That’s not only good news for the businesses or projects, but provides investors a path to higher returns for accepting additional risk. Sometimes private debt finances real estate, infrastructure, or new tech firms that banks would consider too risky.

In the bigger picture, private debt gives more choices in the financial system. It lets investors lend in new ways and helps borrowers who don’t fit the standard mold. There are some worries too. Unlike public markets, private debt deals are less clear and there is less data to judge risks.

When borrowers use too much leverage, there’s a risk they can’t pay back during hard times. Even so, private credit—one type of private debt—has quickly become a key option for nonbank lending in today’s markets.

The Appeal of Private Debt

Private debt has emerged as an important source of capital to companies, particularly since banks became more cautious with their lending in the wake of the 2008 financial crisis. This asset class, which now totals more than $1.8 trillion and is expected to hit $2.64 trillion by 2029, appeals to investors for a few pragmatic reasons.

Private debt funds deliver appeal through potentially higher yields, diversification benefits to portfolios and greater control over risk. These attributes render it an attractive investment choice for investors who are able to tolerate diminished liquidity and extended lock-up duration.

Key reasons investors are attracted to private debt:

• Opportunity for outsized returns compared to public debt or government bonds.
• Opportunity to diversify away from traditional stocks and bonds.
• Regular cash flow through quarterly interest payments.
• Access to investments with strong covenants and protections.
• Direct influence over lending terms and borrower oversight.

1. Higher Yields

Private debt can frequently provide investors with access to yields that exceed those available in public debt markets. Recent one-year total returns have been as high as 16.4 percent, with five-year annualized returns of roughly 8.2 percent.

These numbers stack up compellingly to a lot of public bonds, whose yields have held far too low. Private debt’s risk-return profile can be more attractive, in part because investors are rewarded with a premium for assuming illiquidity and credit risk. Market conditions play a role: when banks cut back on loans, private funds can step in, driving up yields for investors willing to fill that gap.

2. Portfolio Diversification

It can be a way to cut overall portfolio risk because it tends to move differently than stocks, public bonds, or real estate. Its lower correlation with these asset classes means it can help buffer losses in case other parts of the portfolio falter.

For many investors, private debt is a way to diversify credit risk and limit exposure to rising interest rates. For instance, a diversified approach might mix private debt with stocks and government bonds. Such a blend can provide more stable returns and mitigate downside in turbulent markets.

Private debt can assist investors to smooth income. Quarterly interest payments deliver a consistent cash stream, which is handy for income-oriented seekers.

3. Stronger Covenants

Tougher covenants are protections for investors baked into lending agreements. They can cap how much debt a borrower incurs or mandate periodic financial check-ins.

By establishing specific terms, covenants serve to reduce the likelihood of default and hold borrowers to account. In private deals, these covenants are frequently more stringent than in public markets because lenders can directly negotiate terms. This active involvement ensures that investors have more influence and greater safeguards for their capital.

4. Floating Rates

Private debt tends to be floating rate loans. They let interest rates float with market levels. This can assist investors when rates rise, as their income increases as well.

The mechanics are simple: the loan resets its rate based on a benchmark, like LIBOR or EURIBOR, plus a margin. For instance, if rates rise, they generate higher returns for investors compared with fixed rate bonds that can lose value. This arrangement is attractive to individuals concerned about inflation or increasing interest rates.

5. Direct Influence

Private debt funds can be appealing to investors who want more control over where their money goes. Active management allows fund managers to engage with borrowers, customize loan terms, and track developments.

At times, this hands-on role can produce superior outcomes, in particular if managers identify issues before they become apparent or assist firms to optimize. For instance, a fund can negotiate tighter covenants or modify loan terms to defend capital. This direct and involved approach isn’t feasible in most public debt markets, and it’s a defining characteristic of private debt.

The Inherent Risks

Private debt funds have risks that distinguish them from public debt markets. These include limited liquidity, more complexity, and more exposure to credit events. Knowing about these risks is critical prior to investing, as private debt often doesn’t have the transparency and secondary trading common in public markets.

Investors need to identify the key risk elements and understand how shifting market dynamics, like rising interest rates or economic slowdowns, can affect their portfolios.

Primary Risks Checklist:

• Illiquidity: Difficulty selling positions before maturity due to thin or nonexistent secondary markets.
• Credit Risk: Borrower defaults or weakened cash flows, especially when average Interest Coverage Ratios (ICR) drop.
• Complexity: Complicated structures and agreements with limited market data for proper risk assessment.
• Fee Structures: Varied and sometimes unclear fees that may erode returns.
• Economic Sensitivity: Vulnerability to downturns or rate hikes, which could raise default rates and payment challenges.
• Size and Structure: Larger average loan sizes and riskier junior capital positions.

Illiquidity

Private debt, for example, almost never has a liquid secondary market. Unlike public bonds, an investor might not be able to offload a position quickly if at all before the loan matures or is refinanced. Investors have to be willing to tie up their money for years.

Capital can be significantly restricted, particularly in times of market strain or deteriorating economic conditions. For instance, if a borrower has payment issues because of a cash flow crunch, investors might receive returns later.

Higher returns frequently come attached to this illiquidity. Investors demand a premium for locking up capital. This trade-off can boomerang if the market or borrower encounters difficulties.

Liquidity risk is generally managed by diversifying across vintage years, loan types and industries. Some maintain a modest cash buffer or use laddered maturities to facilitate capital availability.

Credit Risk

Credit risk is the possibility a borrower won’t be able to repay the loan as agreed. In private debt, this matters because loans are made to smaller or riskier companies, often in junior capital positions.

When defaults increase, returns can get smacked. Recent drops in average ICRs indicate increasing danger, particularly should cash flows deteriorate further in a hard economy. Bigger loans, now frequently over $80 million, contribute to this worry. If a borrower fails, the fallout is greater.

Thorough credit analysis is the secret to reduced risk. This encompasses close examination of financial stability, loan composition, and sector outlook. These practices span from ongoing monitoring to performing stress tests under different scenarios.

Complexity

Private debt transactions are more complicated than the typical public bond. Terms are dealt with behind closed doors and contracts can be lengthy and cryptic. There’s less standardization, which means more work to vet each deal.

Less-experienced investors might struggle to balance risks or even understand what they’re buying. The absence of market data makes it more difficult, so experience and research are essential.

Complexity can drag decisions. Teams have to parse unique structures, bespoke covenants, or special features. This may slow down investment decisions, particularly on newer or rapidly evolving deals.

Fee Structures

Private debt funds have widely varying fees. Managers might levy a management fee and a performance fee. Others apply flat or tiered models. Such fees can eat into overall returns, particularly if performance underperforms.

Opaque fee disclosures are an issue. Investors ought to insist on transparent breakdowns before investing.

Navigating Economic Cycles

Private debt funds have their own risks and upsides as they navigate upturns and downturns. When the economy expands, borrowers generally have less trouble repaying their loans, so private debt funds tend to experience fewer defaults. Investors might observe that private debt returns have historically remained above public market returns, exhibiting 200 to 800 basis points of excess throughout the years. That additional yield has made private debt enticing, even when public bond yields are low.

As interest rates increase, a few companies have a hard time. For example, in 2024, approximately 28% of firms had negative free cash flow at prevailing rates. Even if rates were to fall by 2.5%, 22% would still be negative. As rates increase and cash flows decrease, there is an increased risk of default. As of early 2025, private credit default stood at 2.4% and high-yield bonds at 1.5%, both below the 3% long-term average. The risk is present, particularly when coverage ratios are dipping below 2 times—indicating companies could struggle to make debt payments.

Economic indicators steer private debt. Metrics such as interest coverage, free cash flow and default rates provide a real-time view of how much stress borrowers are under. These figures are what fund managers pay attention to. If too many companies report negative free cash flow or coverage ratios fall, managers might scale back risks or request tighter loan covenants.

The deal sizes mirror the cycle. In 2024, high-yield deals averaged more than $700 million and leveraged loans were about $450 million each, demonstrating the sheer volume of capital in motion even as markets transition. Meanwhile, non-bank lenders such as hedge funds and insurers now own nearly half of the global financial assets, thus their decisions can influence markets.

Adapting private debt goes beyond simply selecting the appropriate loans. In volatile markets, managers might increase rates, require additional collateral, or prefer senior secured loans to mitigate losses. They could diversify loans among additional industries or nations to mitigate risk.

As the market changes, bigger managers are taking more share: in 2024, the biggest 10 private debt managers raised 32% of capital, up from 26.6% in 2021. It takes longer to raise a new fund today, at 20.3 months in 2024 compared to 15.1 months in 2019. This means investors are more careful and want evidence a fund can navigate risk in a hard cycle.

The Human Element

Private debt funds are formed by more than metrics. The human side, including judgment, experience, trust, and relationships, often determines the actual result. These investments have vintage risk, cash drag, and are illiquid. They further allure opportunities for enhanced returns, particularly as conventional bonds or savings accounts provide little in a low interest rate environment.

It’s the human factor, how humans make decisions, connect, and solve problems, that is at the heart of both the benefits and the challenges.

Manager Selection

Choosing the right manager is paramount. Investors seek a manager’s track record, years in the field, history of steady returns, and how they’ve managed difficult decisions. A good-fellowship manager attracts good-fellowship deals and partners.

Due diligence is not check-the-box; it means looking into historical fund performance, team turnover, and fee structure. For instance, performance fees can often range from 10 percent to 20 percent after a hurdle rate of 6 percent to 8 percent. This brings managers in line with investors, but only if their track record demonstrates competence and honesty.

Experienced managers can identify risks such as cash drag in advance and adapt, safeguarding capital across cycles that can be five to 10 years in length.

Relationship Sourcing

In private debt, deals tend to be who-you-know. A manager well connected to borrowers, banks, and other funds can find out about good deals before others. Networking isn’t just social; it’s a legitimate edge in a market where access is not available to everyone.

When managers know the humans behind a business, they can get better terms and identify red flags that numbers miss. For example, a fund that originated a direct loan via well-established sector connections secured more lenient covenants and tougher collateral.

These relationship-led deals can increase ROI for accredited investors or qualified purchasers who have larger income or asset requirements. Not all investors receive these opportunities. Regulatory guidelines restrict access to those who pass specific benchmarks, such as a net worth exceeding $1 million or an income of more than $200,000 per year.

Workout Capabilities

Workouts and restructurings challenge a manager’s ability and judgment. When a borrower stumbles, a fund’s capacity to guide discussions, renegotiate terms, or enforce rights can determine whether losses are averted or returns preserved. This requires expertise, a relaxed demeanor, and solid jurisprudence.

A fund that led a distressed borrower through a workout rather than pushing for a quick sale might save value and keep investors’ interests upfront, for instance. With multi-year lock-up periods in closed-end funds, investors entrust these skills for up to a decade at a time, so the human element in workouts cannot be overlooked.

A Strategic Approach

A strategic approach is essential in private debt investing because of the asset class’s relative newness and increasing proportion of assets under management by private investors, which is between 10 and 15 percent. Aligning a clear, well-defined investment strategy with personal or institutional goals can help manage risks, improve returns, and ensure that private debt complements the broader portfolio.

Investors with a concentrated strategy tend to have greater access to infrastructure debt, enjoy diversification, and can select loan types and pricing that suit their risk appetite. For instance, strategies focusing on first-lien direct lending are on the rise as those loans now constitute a greater portion of the market. Clever investors tend to put between 1 and 2 percent, but in some cases, the allocation is in the low double digits. It is a matter of risk tolerance and goals.

Due Diligence

Due diligence is private debt’s backbone. It enables investors to look beyond headline figures and see what’s behind each loan. Smart due diligence involves more than just skimming accounts; it requires really getting into the borrower, terms, and quality of collateral.

This is particularly crucial given that the average private debt loan size has now crossed $80 million, so each investment is larger. Key components of an effective due diligence process include:

• Borrower’s credit quality and financial health
• Loan structure, including lien position and covenants
• Collateral, particularly emphasizing the increasing proportion of first lien loans
• Market conditions and sector-specific risks
• Historical performance and default rates

Deep diligence and continuous monitoring are critical, as default rates across private credit, especially direct lending, have historically been lower than those in the syndicated loan or high-yield bond markets.

Portfolio Role

Private debt has a special place in a diversified portfolio. It occupies the middle ground between traditional bonds and equities, with the prospect of superior yields. Direct lending has returned 2 to 4 percent more than syndicated leveraged loans over the past decade.

Private debt enhances risk-adjusted returns and brings stability, with default rates that are lower than comparable public credit markets. Others employ private debt to split a tiny wedge of just 1 to 2 percent. Some may step up further, seeking better yield and downside cushioning.

For instance, an investor may combine private debt with real estate, infrastructure, or public equities to buffer returns.

Risk Mitigation

A strategic approach to managing risk is at the heart of private debt strategies. No one-size-fits-all solution here. A toolbox approach wins.

Key strategies include:

1. Diversify across sectors, loan types, and geographies.
2. Favor first-lien, senior-secured loans for stronger protection.
3. Use active management to monitor borrower performance.
4. Tweak allocations for market risk and loan size.

Continuous tracking aids in catching red flags. Frequent reviews on both the individual loan and portfolio level help you identify problems and course correct fast.

Conclusion

Private debt funds offer new routes for people who want to veer away from the stock market. These funds may provide a consistent cash flow and offer additional options for risk diversification. That said, no strategy works all the time. Market dips, rule shifts and the need for deeper checks on deals require sharp eyes and a cool head. Smart moves mean examining both the positives and negatives, and then making the best fit for you. Like many investment vehicles, private debt is best used as part of a broader strategy. To consider your next steps, chat with a trusted adviser or read up on real life experiences from others who use private debt in their own mix.

Frequently Asked Questions

What are private debt funds?

Private debt funds essentially lend money to firms or projects beyond public markets. They offer alternatives to bank loans and typically seek higher yields for investors.

What are the main advantages of investing in private debt?

Private debt may provide higher yields relative to conventional bonds, more predictable income, and portfolio diversification. These funds are less exposed to public market fluctuations, which can mitigate risk.

What risks are associated with private debt funds?

Principal risks are borrower default, illiquidity, and limited transparency. Economic downturns can increase default rates and affect returns. Investors cannot easily liquidate their stake.

How do private debt funds perform during economic cycles?

Private debt funds cons. Good fund managers can use this to help protect capital by smart borrower selection and loan structuring.

Who typically invests in private debt funds?

Institutional investors, like pension funds and insurance companies, are the primary investors in private debt. High-net-worth individuals are involved, lured by the potential returns and diversification.

Are private debt investments accessible to individual investors?

Private debt funds typically have high minimums and are only available to accredited or experienced investors. Retail investors have limited access in most jurisdictions.

How do fund managers add value in private debt investing?

Fund managers evaluate borrower quality, structure loans, and track repayments. Their know-how minimizes risk and maximizes returns, making their involvement essential for private debt success.