Understanding Private Credit in 2025

Understanding the Landscape

The lower middle market lending space has evolved over the past few years. As traditional banks face increased regulations and stricter underwriting requirements, private credit filled the gap with innovative financing solutions.

Often backed by family offices and institutional capital, these firms bring a different approach to structuring deals that can better align with a growing company's needs.

The Core Economics

Let's start with the fundamental costs. Private credit typically comes with interest rates in the low to mid-teens, which is notably higher than traditional bank financing. However, this pricing reflects not just the cost of capital but also the increased flexibility and reduced constraints compared to conventional bank loans.

The total cost structure usually includes:

• Base interest rate in the low to mid-teens

• Origination fees or Original Issue Discount (OID) at closing

• Potential exit fees upon loan repayment

• Sometimes warrant coverage for additional upside potential

Overall, private credit is solving for a total return in the high teens and above, attained with a mix of the items listed.

Flexible Structure: The Key Differentiator

What truly sets private credit apart is its structural flexibility. Unlike traditional bank loans with rigid payment schedules, private credit takes a more customized approach:

First, they determine an acceptable debt service coverage ratio for your business. This becomes the foundation for structuring payments that align with your cash flow realities. From there, they can craft a solution that might include:

• Customized monthly or quarterly payment schedules

• Split between cash interest and amortization payments

• PIK (Payment-in-Kind or non-cash) interest options where appropriate

• Flexible amortization schedules, including interest-only periods

• Cash flow sweeps to accelerate principal reduction when excess cash is available

The Five-Year Horizon

One important consideration is the typical five-year maximum term. This limitation stems from the funding sources these lenders rely on – usually family offices and institutional investors who prefer shorter investment horizons.

While five years might seem short, it is usually enough for companies to execute their growth strategies, and then move to traditional financing options.

When Private Credit Makes Sense

Private credit isn't right for every situation, but it can be an excellent solution when:

1. Traditional Bank Financing Isn't Available:

If your business doesn't meet conventional bank criteria, whether due to industry type, growth stage, or other factors, private credit can step in.

2. You Need Structural Flexibility:

Companies with seasonal cash flows or rapid growth trajectories often benefit from customized payment structures that better match their business reality.

3. Cash Flow Optimization is Critical:

Interest-only periods or PIK interest can significantly reduce monthly payments, preserving cash for growth initiatives or working capital needs.

Understanding the Trade-Offs

While private credit offers compelling benefits, it's important to understand the trade-offs:

• Higher cost of capital compared to bank financing

• Shorter term lengths requiring refinancing sooner

• Potential equity dilution if warrants are included

• More intensive monitoring and reporting requirements

However, these costs pale in comparison to the opportunity cost of losing out on growth initiatives, or being constrained by inflexible bank structures.

The Role of Family Offices and Institutions

Private credit typically sources their capital from family offices and institutional investors. This funding structure influences their approach in several ways:

• Need to generate returns that satisfy their investors

• Ability to be more flexible in structuring than regulated banks

• Focus on relationship-driven lending

• Understanding of entrepreneurial businesses

• Greater risk appetite than banks

Making the Right Choice

When evaluating private credit options, some items to consider:

• Your company's growth trajectory and cash flow patterns

• Ability to service higher-cost debt

• Need for flexibility versus cost sensitivity

• Long-term capital structure goals

• Relationship potential with the lender

The Bottom Line

Private credit has become an essential tool in the modern business financing landscape. While it comes at a premium to bank financing, the flexibility and availability of capital make it an attractive option for growing businesses.

The key is to understand when these solutions make sense and how to structure them appropriately for your situation.

Remember: The best financing solution is one that aligns with your business goals, cash flow patterns, and growth strategy. Private credit offers another powerful tool in achieving these objectives.

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