What is private credit? The complete guide

What do you do when you’re trying to grow your business but can’t find a bank to lend you the all-important capital?

Giving up isn’t the entrepreneurial answer, which is why private credit exists.

Banks are most people’s default source of business finance, but some small and medium enterprises (SMEs) simply don’t tick the required boxes. Challenger banks are trying to change this, but they can’t do it all.

If you’re considering private credit for your SME, it’s critical that you fully understand what’s involved, the pros, cons and risks involved.

 

What is private credit?

Private credit is the name for a business loan provided by any lender that isn’t a bank or building society. You might also see it called non-bank financing, direct lending or alternative lending.

For larger sums (typically from £10m up to hundreds of millions), private credit is often provided by private equity firms, asset managers or pension funds.

For smaller amounts (eg. six- or low-seven-figure loans), private credit might be provided by high-net-worth individuals, angel investors or even friends and family. 

 

Why is private credit so important to UK businesses?

According to the Bank of England’s December 2023 Financial Stability Report, the private credit market has grown faster than any other type of business finance since 2015 and twice as fast as leveraged loans.

The 2020s have created a difficult environment for SMEs:

• Pandemic-related loans were wide-reaching, but added to SME debt load

• Appetites for lending outside of those schemes shrank

• Borrowing has become more expensive, as interest rates have risen

• Entire sectors, like hospitality, were effectively blacklisted by some banks given the difficult trading environment

On the other hand, private credit is more flexible than a traditional bank loan. Private lenders can create deals for unique or niche scenarios, as well as offering more flexible repayment schedules.

While traditional loans are harder, more expensive and challenging to secure than ever, private credit is supporting SMEs with flexible and accessible finance.

 

The different types of private credit available in the UK

Private credit is famously flexible, so there are many different ways and reasons non-bank financial institutions can offer capital where banks might refuse.

 

Direct lending

This is the most straightforward form of private credit - it’s a loan like you might get from a bank. Direct lending through private credit is usually agreed with a fixed term and variable rate.

 

Mezzanine financing

If a business needs £1 million but a lender only offers £750,000, they can secure the remaining £250,000 from a so-called ‘junior’ lender. This is mezzanine finance.

In terms of repayment priority, mezzanine finance sits between direct lending and equity finance (selling shares in the company). It’s considered riskier lending, as, in the event of a default, senior lenders will have first claim to any assets before the mezzanine lender.

Some mezzanine finance deals allow the lender to convert its debt into equity (shares in the company) if the business defaults. In some scenarios, this could see the lender take a controlling stake in the business.

 

Distressed debt

Distressed debts occur when a company:

• Is in or approaching bankruptcy

• Has breached an agreement with its lender

• Cannot repay its debts when the final loan payment is due

The business sells its existing debts for a discount, in a last attempt to raise the cash it needs to continue operating.

These debts are incredibly high-risk, given their connection with bankruptcy. Brave or confident investors choose to buy the distressed debts for a couple of reasons:

• They’re hopeful that the situation will improve or not lead to bankruptcy, at which point they can sell the debts for a higher price

• They believe they can earn a positive return from asset stripping the business

 

Special situations

Bank lending tends to fit into quite clear categories - like asset finance and commercial mortgages; growth finance is more versatile, but lenders still have clear red lines.

The more unique a situation, the harder it can be to find finance. The risks are often too high or hard to calculate, or there’s no historical precedent to lean on.

Private credit is much more flexible and bespoke. There’s plenty of due diligence, of course, but private credit lenders are receptive to unique opportunities. Many also operate in specific niches, so can make more educated decisions than generic lenders.

 

Venture debt

Venture debt helps fund early-stage and high-growth companies that are already backed by venture firms.

It doesn’t involve any equity sale or shares decreasing in price and is usually for smaller amounts than a venture capital firm would invest. It’s typically used to fund working capital and add some more liquidity (cash into the business), especially between funding rounds.

 

Real estate finance

You can also use private credit for real estate projects. Harking back to the previous section about ‘special situations’, private credit has more scope for supporting unique properties.

You might also find a private credit lender that specialises in a specific subset of properties – castles, for example. Their due diligence, forecasting and overall knowledge of the market might make them preferable for borrowers hoping to enter that market.

 

Cashflow finance

Businesses use cashflow finance to fill gaps caused by late payments or irregular revenue streams. Cashflow loans are secured against your future revenue, rather than any existing assets.

 

How does private credit work?

Loans organised with private credit lenders aren’t hugely different from a loan you’d get from a bank.

Non-bank financial institutions don’t write blank cheques or throw good money after bad, they’re serious investors and need to be confident your debt will earn them a reliable return. Take a top-level look at the private credit process below.

 

Step 1) Loan origination

The very first step in the process is to apply for a loan.

The lender you choose will depend on many different factors, including the reason you need the money (eg. distressed debt and venture debt are very different), the amount you need and the industry you operate in.

 

Step 2) Due diligence

As with any loan, the lender will need to do their due diligence. Each lender will have its own process to follow, but should expect:

• Financial records and forecasts, including the last three years of completed accounts

• Proof of identity for all directors and persons with significant control

• Debt load, EBITDA (earnings before interest, taxes, depreciation and amortisation) and other accounting metrics

• Explanation and evidence of company structure

• Reason the company wants to borrow money

• What the company does and how it makes its money

• An explanation of future plans

 

Step 3) Structuring the loan

You’ll need to agree on the term and rate for your private credit agreement. Private credit deals usually use fixed terms and variable interest rates.

The repayment schedule can be quite flexible, too, ranging from monthly, quarterly, annually, interest-only with the principal paid at maturity, or balloon payments. It’s also possible to have an interest-only private credit agreement with a set maturity date.

Again, the structure of your loan will be dictated by the lender and the reason for the loan.

 

Step 4) Funding

If all the due diligence, terms and other legal bits and bobs suit both parties, you’ll sign the contract and be paid your loan (either as a lump sum or in tranches, depending on the terms you sign).

 

Step 5) Repayment and monitoring

Once you’ve got the funds, you’re going to have to start repaying. The lender will stay in contact, especially if you fail to make a payment.

 

The benefits of private credit

Private credit has long been an option for businesses, but it’s grown rapidly in recent years.

There are plenty of reasons for the growth in private credit, including some specific benefits that we explain below.

 

Retaining ownership

Private credit doesn’t touch equity (shares in your business). Many founders think that non-bank financing requires diluting their shareholding, but that’s not the case.

Plenty of institutional investors are willing to make direct loans to SMEs without taking an equity stake.

 

Flexibility

Private credit is usually more flexible than a bank loan, with each deal originated and structured for the applicant.

This flexibility makes finance more accessible to more SMEs, as there are fewer boxes to tick and hoops to jump through.

Access to capital

Possibly the clearest benefit of private credit is that it provides capital where it might otherwise have been impossible.

Sometimes, a business problem (or opportunities) simply needs cold hard cash. If you don’t have the money you need in the bank and can’t find a lender to borrow from, then private credit can be the answer.

 

Faster growth

If you are looking to expand your business further than its current horizon, private credit can help you achieve that growth.

Private credit is provided by non-bank financial institutions that have an appetite for riskier investments, which can suit ambitious business leaders.

 

The risks and challenges of private credit

For all of its flexibility and accessibility, private credit comes with some drawbacks as well. It’s important that you know the negatives as well as the positives, so you can make a truly informed decision.

 

Regulatory challenges

Non-bank financial institutions aren’t subject to the same regulations and monitoring as banks, which means they are in a freer position to call a loan for repayment or be inflexible on terms in times of hardship.

From a macroeconomic perspective, a large unregulated lending market presents risks. As the International Monetary Fund (IMF) notes: “this ecosystem is opaque and highly interconnected”.

“Valuation is infrequent, credit quality isn’t always clear or easy to assess and it’s hard to understand how systemic risks may be building given the less than clear interconnections between private credit funds, private equity firms, commercial banks, and investors.”

 

Operational risk

Traditional banks are a more secure lender than non-bank financial institutions, largely thanks to the support of central banks.

If a non-bank financial institution collapses, your debts could be bought as distressed securities and face new terms of repayment. You’d also have to continue making repayments to the administrators.

It’s not a likely outcome, but businesses do fail and, without the security of central bank backing, non-bank financial institutions could leave SMEs in a messy situation.

 

Credit capacity

In taking on private credit, you will increase your debt load. That’s not necessarily a bad thing, but there is a limit to how much you can safely borrow at any given time.

If you’ve got a clear financial plan for how you’ll use your loan and what the future of the business looks like, you can better manage your risk.

If you fail to forecast future debt needs, you could end up being overleveraged and not be able to borrow more in the future.

 

Liquidity risk

Private credit is typically provided with a variable interest rate, so a big change in rates could threaten your liquidity and eat into your normal cashflow.

With most private credit agreed as ‘senior’ debt, it’ll be the priority for repayment in the event of insolvency. Junior or secondary debt (typically unsecured debts, like a working capital loan) and shareholders will only be repaid after senior debts are repaid, either fully or to an agreed composition order.

 

Comparing private credit to other financial instruments

Private credit is just one way to borrow money for your business. It’s a good choice in some scenarios, but it’s not the only choice.

You should make sure you’re aware of all the options available to you before committing to a loan.

 

Business banks

Business owners often turn to private credit when they can’t secure finance from a bank, but not all banks are the same.

The traditional ‘big six’ can be slow-moving, risk-averse and difficult to work with. Challenger banks, like Allica Bank, have been built to be the opposite.

Using Allica as our example:

• Every loan application is reviewed by our underwriting team

• There are no blanket rejections, decided by mysterious algorithms

• We use schemes like the Growth Guarantee Scheme to support us in considering applications outside of our usual credit appetite

• We put humans at the heart of our business, so we can speak to the humans at the heart of yours

The tides of banking are changing, swollen by challengers that want to be genuinely helpful to – and supportive of – Britain’s SMEs. Don’t discount all banks just because the more familiar names won’t help.

 

Equity financing

If you aren’t comfortable with borrowing money from a private lender, you could always consider equity financing (selling shares in your business).

Not only does equity financing help you raise money, it can bring valuable expertise into your company in the form of experienced investors and industry heavyweights.

 

Trade credit

Trade credit sees you buy goods and pay for them at a later date.

If you have good relationships with suppliers and customers, you could use trade credit agreements to boost your finances by:

• Filling a cashflow gap

• Extending your cash reserves

• Getting a short-term cash boost

Trade credit will help you navigate smaller financial challenges, but, if you have a larger cash need, it might not always be enough.

 

Asset-based lending

If you’re struggling to borrow the money you need outright, using your assets as securities for a loan can be a useful way to access more funding.

This can unlock your access to banks and other regulated lenders. Many non-bank financial institutions will accept asset-backed lending, too, which can potentially improve your borrowing through private credit arrangements (eg. getting a lower interest rate or higher loan amount).

 

Finance for (almost) every situation

Private credit is another valuable option in your financial toolbox. Its greatest appeal is its flexibility - in terms of reasons for borrowing and repayment terms.

It comes with some greater risks, but no business finance is risk-free. Provided you do your own research, seek advice from a trusted professional and still feel comfortable, private credit is a valid option for borrowing.

If you’re interested in seeing how a challenger bank like Allica can help you fund your growth plans, we’d love to hear about your plans.

Learn what we can do for you by speaking with your local relationship manager.

Links were live and information was correct at the time of writing the article.