Direct lending

Direct lending is the biggest part of private credit: a fund lends directly to a middle-market company, usually to pay for an acquisition, a buyout by a private equity firm, growth, or to refinance older debt.

Where a loan sits decides who's paid first. Senior secured loans have a claim on the company's assets (a lien) and are repaid before anything else. With two layers, the first lien loan is paid first from the collateral and the second lien loan only after it, so second lien pays a higher rate. Below them may sit unsecured or mezzanine debt, then the owners' equity, which takes the first loss.

A unitranche loan combines the senior and junior layers into one loan with one set of documents and one blended rate. Borrowers like it because it's simpler and quicker. Behind the scenes the lenders sometimes split it into a first-out piece (repaid first, lower return) and a last-out piece, in an agreement among the lenders that the borrower doesn't need to deal with.

Most direct loans are sponsor deals: the company is owned by a private equity firm (the sponsor), which bought it with a mix of its own equity and the loan. A sponsor brings an equity cushion, a plan, and often the willingness to put in more money in a rough patch to protect its investment. Non-sponsor deals (founder- or family-owned companies) can pay more and have tighter terms, but there's no deep-pocketed owner behind the company.

Pricing has a few parts. The coupon is a base rate (SOFR in US dollar loans) plus a spread, with a floor so the base rate never counts as lower than, say, 1%. Upfront fees or an original issue discount (OID) mean the lender sends less cash than the loan's face amount, for example 98 for every 100. Call protection makes early repayment cost something, often a step-down premium such as 2% in year one and 1% in year two, so the lender earns its expected return even if the company refinances quickly.

sofr, floor = 0.0375, 0.01
spread = 0.055
oid = 0.02          # the lender pays 98 for every 100 of loan
life = 3            # years the loan is expected to stay out
coupon = max(sofr, floor) + spread
print(f"coupon {coupon:.2%}, yield about {coupon + oid / life:.2%}")

That last line is a quick rule of thumb: spread the OID over the years the loan is expected to stay out (often about three, because loans are usually refinanced early) and add it to the coupon. A full yield calculation discounts every payment, but the rule of thumb is close enough to compare deals on a desk.