I’ve been watching the explosive growth of the $1.5+ trillion private credit market with a mix of fascination and caution. The narrative is usually focused on the lenders—how these non-bank funds are stepping in where traditional banks stepped out. But I wanted to take a step back and look at this from a different angle: ours.
As equity investors—whether we are private equity sponsors, limited partners (LPs), or company founders—what does it actually mean when our portfolio companies borrow from private credit funds instead of traditional commercial banks? We are the ones holding the equity cushion that sits directly beneath this debt. Are we safer, or are we taking on risks we can’t fully see yet?
Here is my thought process as I untangle how this new era of bespoke debt changes the math for equity owners.
Question 1: Why are our companies choosing expensive private credit over cheaper bank loans?
At first glance, it feels counterintuitive. Why would we want our portfolio companies to borrow from private credit funds when the absolute cost of capital—interest rates and fees—is generally much higher than traditional bank financing?
The answer I keep coming back to is that we are trading cost for extreme flexibility and speed. Banks are heavily regulated, which makes their loans rigid and standardized. Private debt, however, is negotiated directly between our company and the lender. This means we can customize the repayment schedules to fit our exact business needs.
Furthermore, if we are in a competitive bidding war to acquire a company, private credit gives us absolute certainty of funding. We don’t have to worry about the loan failing to “syndicate” to dozens of other banks. But this comes at a steep price. The higher interest rates of private credit eat directly into our free cash flow. It means we have to drive much higher operational growth just to hit our required equity return targets.
Question 2: Are “covenant-lite” loans actually protecting our equity?
In the old days, bank loans came with strict quarterly “maintenance covenants.” If our company missed a financial target, the bank could step in. Today, to win our business, private lenders are increasingly offering “covenant-lite” (cov-lite) structures. These loans don’t test our financials regularly; they only test them if we take a specific action, like trying to take on more debt.
On the surface, I love this. It means if our company has a bad quarter, we don’t automatically trigger a technical default. We get to keep control of the board and fix the business without a lender breathing down our necks.
But thinking deeper, this is a dangerous double-edged sword. Those old maintenance covenants acted as an early warning system. Without them, a default is often delayed until the company hits a total liquidity wall—like missing payroll. By the time that happens, the company’s value has usually plummeted so far that our entire equity cushion is completely wiped out. We trade early intervention for total loss down the road.
Question 3: Is Payment-In-Kind (PIK) a lifeline or a leverage trap?
I’m seeing PIK toggles everywhere now, even in senior loans. PIK allows our companies to stop paying cash interest and instead add that interest to the total loan principal.
In the short term, this feels like a brilliant lifeline. It preserves our cash so we can fund operations, survive a supply chain hiccup, or invest in growth. But the math gets terrifying over a long hold period. Because the interest compounds on an ever-growing principal, it creates massive “hidden leverage”.
When it comes time to finally sell the company, that bloated debt stack might consume the entire enterprise value. We might successfully grow the business, sell it, and still walk away with zero returns for our equity holders because the PIK debt ate all the profits. I constantly have to ask: are we using PIK strategically, or are we just kicking the can down the road because the company is secretly distressed?.
Question 4: What is a “shadow default,” and why should we care?
Because of cov-lite loans and PIK toggles, the official default rates in private credit look artificially low. A company can look perfectly healthy on paper because it hasn’t technically breached its credit agreement.
But as equity investors, we have to look for “shadow defaults.” This happens when a company avoids legal default only through extreme measures. For example, if we as sponsors are constantly injecting emergency equity just to cure a covenant, or if we are converting cash interest to “bad PIK” just to keep the lights on, the company is fundamentally in distress. We can’t rely on headline default metrics; we have to rigorously audit the true, unadjusted cash flows of our portfolio companies.
Question 5: How aggressive should we get with restructuring if things go south?
If one of our companies gets into deep trouble, we have a hard decision to make. Because private credit agreements are highly flexible, savvy equity sponsors are finding loopholes to protect their investments. We can use “Liability Management Exercises” (LMEs) to move valuable assets out of the current lenders’ reach and use them to raise new debt.
This “creditor-on-creditor violence” can preserve our equity value and buy us time. But I worry about the long-term cost. Private credit relies heavily on relationships. If we aggressively burn our lenders on one deal by exploiting loopholes, will they ever fund our next acquisition?. Plus, experience shows that these aggressive moves often just delay an inevitable bankruptcy rather than actually fixing the core business.
Where does this leave our equity strategy?
I haven’t concluded that private credit is inherently bad for us as equity investors. In fact, it’s an incredibly powerful tool that has allowed the private equity industry to scale massively.
However, it fundamentally shifts our risk profile. We aren’t just betting on finding a good company with a great product anymore; we are betting on our ability to navigate and outmaneuver complex debt structures. We need to stop relying purely on top-line revenue growth models and start rigorously evaluating PIK compounding, covenant loopholes, and unadjusted leverage. Ultimately, our equity upside is only as safe as the debt beneath it.