Private credit has become one of the most discussed areas of alternative investing in India. The idea is straightforward: instead of a company borrowing through a conventional bank loan or issuing a widely traded public bond, a private fund provides negotiated financing directly to the borrower.
The reality is more complex. Private-credit deals can offer contractual interest income and stronger lender protections than ordinary unsecured debt, but they can also involve illiquidity, concentrated borrower exposure, difficult valuations and long recovery processes when things go wrong.
In India, many private-credit strategies operate through Category II Alternative Investment Funds. SEBI does not publish a separate official industry total for “private credit” within Category II, so investors should avoid treating the entire Category II AIF market as private credit. As of March 31, 2026, Category II AIFs had about ₹12.74 lakh crore of commitments across private equity, debt funds and other Category II strategies.
For the wider AIF framework, see our Category I, II and III AIF guide. For structural comparisons, read AIF vs PMS vs mutual funds.
Important: Private credit is not a fixed deposit or guaranteed-income product. High contractual yields usually compensate investors for credit, liquidity, complexity and recovery risk. This article is educational, not a recommendation to invest.
What Is Private Credit?
Private credit is lending that occurs outside broadly syndicated public bond markets. A fund raises capital from investors and lends to businesses through privately negotiated agreements.
The borrower may use the money for:
- Growth capital
- Acquisitions
- Refinancing existing debt
- Working capital
- Promoter financing or structured situations
- Bridge funding before an equity raise or asset sale
- Special situations and stressed-asset opportunities
Because the loan is negotiated privately, lenders may have more flexibility to structure repayment schedules, collateral, covenants and security packages than they would through a standard public bond.
How Private Credit Fits Into India’s AIF Framework
SEBI’s AIF framework identifies debt funds as a Category II strategy. Category II AIFs generally cannot use leverage as an ordinary investment strategy, although limited borrowing and other permitted arrangements may apply under current rules.
That does not mean the underlying borrower is unleveraged. A company receiving private credit may already have bank loans, bonds or other liabilities. Investors therefore need to examine the borrower’s entire capital structure, not just the AIF’s own leverage.
Category II AIFs are generally closed-ended, which aligns naturally with private credit because loans may need years to mature or be refinanced.
Why Companies Use Private Credit
Borrowers may choose private credit because traditional lenders cannot or will not provide the exact financing required.
Speed and certainty
A private lender may negotiate and approve a bespoke deal more quickly than a large syndicated transaction.
Flexible structure
The loan can potentially be tailored around cash flows, collateral, repayment dates and business milestones.
Complex situations
Private lenders may finance businesses with unusual ownership structures, acquisition plans, temporary cash-flow pressure or assets that do not fit a bank’s standard underwriting model.
Avoiding immediate equity dilution
Founders or private-equity owners may prefer debt to issuing new shares. But this benefit to owners creates additional fixed obligations for the company.
Where Investor Returns Come From
Private-credit returns can come from several sources:
- Cash interest: Periodic contractual interest paid by the borrower.
- PIK interest: Interest that is added to the loan balance rather than paid immediately in cash.
- Upfront or arrangement fees: Fees charged when the financing is originated.
- Prepayment fees: Compensation if the borrower repays early.
- Equity-linked upside: Some structured deals may include warrants or other participation features.
- Distressed recovery: Special-situation funds may buy or originate credit at a discount and profit from restructuring or recovery.
A high stated coupon is therefore only one part of the return. Investors should ask how much of the expected return depends on actual cash interest versus fees, PIK accruals or optimistic recovery assumptions.
Senior Secured vs Mezzanine vs Special Situations
| Type | Position | Typical Return Source | Main Risk |
|---|---|---|---|
| Senior secured | Higher priority, usually backed by collateral | Interest and fees | Collateral may be insufficient or difficult to enforce |
| Unitranche | Combines senior and subordinated economics | Higher blended yield | More structural complexity |
| Mezzanine | Below senior debt, above equity | Higher interest plus possible equity-linked upside | Lower recovery priority |
| Special situations | Highly deal-specific | Restructuring, stressed pricing, asset sales | Execution and legal risk |
“Secured” should not be confused with “safe.” Collateral can decline in value, be legally disputed, rank behind another lender or take years to realise.
What Are Covenants?
Covenants are contractual conditions designed to protect lenders. They may require the borrower to maintain financial ratios, limit additional borrowing, restrict asset sales or provide regular financial reporting.
Examples include:
- Maximum debt-to-EBITDA ratio
- Minimum interest-coverage ratio
- Restrictions on dividends
- Limits on new secured borrowing
- Minimum cash balances
- Requirements to obtain lender approval before major transactions
Strong covenants can provide an early warning system, but they do not eliminate losses. A covenant breach may simply begin a negotiation about waivers, restructuring or enforcement.
The Illiquidity Premium
Private credit may offer a higher expected yield than comparable liquid debt partly because investors give up easy access to their money.
This is the illiquidity premium: compensation for holding an asset that may be difficult to sell quickly.
But illiquidity is not free return. If a borrower weakens, the fund may be unable to sell the loan at a reasonable price. Investors may remain locked into the fund while recovery plays out.
Our alternative-investments guide explains why an illiquidity premium is expected compensation rather than a guarantee.
Credit Risk: The Core Risk
The central question in private credit is whether the borrower will repay.
Assess:
- Operating cash flow
- Debt already outstanding
- Interest coverage
- Industry cyclicality
- Promoter quality and governance
- Dependence on refinancing
- Collateral quality
- Legal enforceability
- Exit or repayment source
A company may appear able to pay interest today while relying on a future equity raise, IPO, asset sale or refinancing to repay principal. That creates refinancing risk.
Default and Recovery Risk
When a borrower defaults, the contractual coupon becomes less important than recovery value.
Recovery may require:
- Negotiating a maturity extension
- Reducing interest
- Converting debt into equity
- Enforcing collateral
- Selling pledged shares
- Using insolvency proceedings
- Bringing in a new investor
These processes can take time and generate legal costs. The stated security value at loan origination may not equal the amount eventually recovered.
Valuation Risk
Public bonds trade in markets that continuously reveal prices. Private loans often do not.
A fund therefore uses valuation methodologies to estimate fair value. That can make reported returns appear smoother than economic reality, especially before a borrower’s problems are formally recognised.
Investors should ask:
- Who performs the valuation?
- How often is it updated?
- How are credit deterioration and covenant breaches reflected?
- Are comparable market yields used?
- How much of NAV is based on manager estimates?
Concentration Risk
A private-credit AIF may hold far fewer borrowers than a diversified bond mutual fund. One default can therefore have a material effect on returns.
Review:
- Largest borrower exposure
- Top-five borrower concentration
- Sector concentration
- Promoter-group exposure
- Geographic exposure
- Average loan size relative to fund corpus
Diversification does not guarantee safety, but extreme concentration increases the consequences of underwriting errors.
Private Credit vs Bonds
| Feature | Private Credit | Listed Bond |
|---|---|---|
| Liquidity | Usually low | Varies, but generally more observable |
| Pricing | Modelled/negotiated | Market price where actively traded |
| Documentation | Bespoke | Standardised issue documents |
| Diversification | Can be concentrated | Depends on portfolio |
| Yield | May be higher to compensate for risk and illiquidity | Reflects public-market credit and interest-rate risk |
| Exit | Often requires maturity, refinancing or negotiated sale | Can potentially sell in secondary market |
A higher private-credit yield is not automatically superior. The investor is accepting a different package of risks.
Private Credit vs Bank Fixed Deposit
The two should not be treated as close substitutes.
A bank deposit is a liability of a regulated bank and eligible deposits are subject to the applicable deposit-insurance framework. A private-credit AIF is a market-linked investment vehicle whose loans can default and whose units can lose value.
The existence of collateral or a contractual interest rate does not convert a private-credit fund into a deposit.
Fees Can Consume the Illiquidity Premium
A private-credit fund may charge management fees, performance fees/carry and fund expenses. If the gross yield advantage over liquid debt is modest, a large fee layer can materially reduce what investors retain.
Ask for:
- Gross portfolio yield
- Expected credit losses
- Management fee
- Performance fee/carry
- Fund expenses
- Expected net investor return
Our AIF fees guide explains the economics in detail.
How to Evaluate a Private-Credit Manager
- Origination: Where do deals come from, and why are borrowers choosing this lender?
- Underwriting: How does the team stress cash flows and collateral values?
- Documentation: Are security, covenants and inter-creditor rights robust?
- Monitoring: How frequently are borrower financials reviewed?
- Workout experience: Has the team actually managed defaults and recoveries?
- Valuation: Is valuation sufficiently independent?
- Concentration: What is the maximum borrower and sector exposure?
- Alignment: How much manager capital is invested alongside clients?
- Track record: Examine realised recoveries, not only current NAV.
- Fees: Compare net returns after every expense layer.
For a broader manager review, use our AIF due-diligence checklist.
Performance Metrics That Matter
Because many private-credit AIFs call and return capital over time, IRR can be useful—but it should not stand alone.
Also review:
- MOIC: Total value relative to invested capital.
- DPI: Cash actually returned.
- TVPI: Distributed plus remaining value.
- Loss ratio: Capital impaired by defaults.
- Recovery rate: Amount ultimately recovered after default.
- Cash yield: Actual cash income rather than accrued PIK.
See our IRR vs MOIC vs DPI vs TVPI guide for worked examples.
Red Flags
- Marketing the fund as “FD-like” or “assured return”
- Very high yields without a clear explanation of borrower risk
- Heavy reliance on promoter share pledges
- Weak disclosure of defaults or restructurings
- Large related-party transactions
- Concentrated exposure to one promoter group
- Returns driven mainly by PIK rather than cash
- Unclear valuation processes
- Track record shown gross of fees
- Manager has little workout or recovery experience
Frequently Asked Questions
Are private-credit funds Category II AIFs?
Many Indian private-credit and debt funds operate as Category II AIFs. Category II also includes other strategies such as private equity, so Category II industry data should not be treated as private-credit-only data.
Is private credit safer than equity?
Debt generally ranks ahead of equity in a capital structure, but a poorly underwritten loan can still suffer significant losses.
Is private credit the same as a corporate bond?
No. Private credit is usually negotiated and less liquid, while a listed bond has standardised issue documentation and may trade in the secondary market.
Does collateral guarantee repayment?
No. Collateral can fall in value, be legally disputed or take years to realise.
What is PIK interest?
Payment-in-kind interest is added to the loan balance rather than paid in cash immediately. It increases the amount owed but does not provide current cash flow.
Why do private-credit funds offer higher yields?
Potentially because investors are accepting credit risk, illiquidity, complexity, concentration and recovery risk.
What metric should I use to judge a private-credit AIF?
Use multiple metrics: net IRR, MOIC, DPI, realised losses, recovery rates, cash yield and concentration.
Key Takeaways
- Private credit is negotiated lending outside standard public debt markets.
- Many Indian private-credit funds operate as Category II AIFs.
- High yields compensate for credit, liquidity and complexity risk; they are not guaranteed returns.
- Collateral and covenants reduce some risks but do not eliminate default losses.
- Evaluate cash yield, realised recoveries, DPI and net returns—not just the stated coupon.
- Manager workout experience is as important as deal origination.
Conclusion
Private credit can provide a useful return source for investors who can tolerate illiquidity and understand credit underwriting. Its attraction comes from negotiated structures, contractual cash flows and the potential illiquidity premium.
Those same features create the risks. Loans are difficult to trade, valuations can be subjective, defaults can take years to resolve and a high coupon may simply be compensation for a weak borrower.
Evaluate private credit as a lending business—not as a high-yield savings product. The quality of underwriting, documentation, monitoring and recovery capability matters more than the headline coupon.