A manager's guide to direct lending

What is direct lending?

Direct lending is a form of corporate debt provision where non-bank lenders, known as direct lenders, provide loans directly to companies, typically without intermediaries like investment banks. These lenders provide flexible financing solutions, often targeting middle-market companies that may find it difficult to secure capital from traditional banks due to regulatory constraints or strict lending criteria.

In a direct lending arrangement, your goal as a fund manager is to generate income for your investors through contractually agreed-upon interest payments and the eventual repayment of the loan principal. This strategy is a major component of the broader asset class known as private credit (or private debt), and private credit investing has become a popular alternative to traditional equity-based funds. Today, experts place the size of the global private credit market at over $1 trillion.

This focus on debt and income generation marks a fundamental difference from the equity-centric models of venture capital (VC) and private equity (PE). For you as a fund manager, this shift is not just strategic but also operational. Your entire back-office infrastructure must be retooled, moving the focus from managing complex cap tables to administering even more complex loan agreements.

How direct lending differs from other private fund strategies

For a fund manager, the shift from an equity-based strategy to a debt-based one impacts every aspect of the back office. Unlike public markets or mutual funds where assets are traded daily, direct lending deals involve illiquid assets that require specialized handling. The core asset, primary risks, and key performance metrics are all different for various types of private funds, requiring a purpose-built approach to loan operations.

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Why fund managers pursue direct lending

From your perspective as a general partner (GP) or fund CFO, direct lending offers several strategic advantages, including access to a market with at least $70 billion in annualized bank lending revenue at stake, presenting significant investment opportunities. Consequently, institutional investors are increasingly looking to increase their allocation to this asset class to meet their investment objectives.

These advantages include the potential for predictable income streams from interest payments, downside protection through seniority in a company’s capital structure (which impacts its debt-to-equity ratio), and portfolio diversification away from equity market volatility or assets like real estate. However, these strategic benefits create specific, non-negotiable operational mandates for your fund's finance team.

For example, the goal of providing predictable income for your limited partners (LP) translates into an operational necessity. Your fund must have a system that can flawlessly track, calculate, and collect interest payments across a diverse portfolio of direct lending loans, a task that quickly becomes unmanageable with manual processes.

Common direct lending strategies

After establishing the what and why of direct lending, it's important to understand the different types of strategies your fund can employ. The specific investment strategy you choose as a fund manager will directly determine the complexity of your fund's operational workload and administrative needs. These loans often support specific borrower needs, such as buyouts, refinancing, restructuring, or recapitalizations.

Senior secured loans

This strategy involves providing senior debt, which is first-lien debt that holds the highest priority for repayment in the borrower's capital stack. This seniority offers a degree of security, distinguishing it from high yield bonds, investment grade securities, or unsecured debt, but it also presents a significant operational challenge. Your back-office team must manage a high volume of individual loans, each with its own bespoke terms, amortization schedules, and covenants.

Unitranche loans

Unitranche loans are a hybrid credit instrument, similar in nature to mezzanine debt, that blends senior and subordinated debt into a single credit facility with one set of terms. This structure can be attractive to both borrowers and lenders for its simplicity in negotiation compared to syndicated loans, where multiple lenders are involved.

However, this simplicity on the front end creates complexity for your back office. Your fund's general ledger (GL) must account for a blended interest rate and unique repayment terms, a growing challenge as pricing narrows and unitranche loans are increasingly clustering in the S+450–500 range. This complicates both the day-to-day accounting and the eventual distribution waterfalls required for investor distributions.

The operational challenges of a direct lending fund

While the strategy of direct lending is appealing, the execution is fraught with operational hurdles. Generic accounting software and spreadsheets are not built to handle the unique complexities of a credit portfolio, creating significant pain points for you as a fund CFO or controller.

Complex loan administration

The daily administrative burdens of managing a loan portfolio—from origination to payoff—which fall under the umbrella of loan operations, make traditional tools inadequate. These challenges require a system designed specifically for the nuances of private credit.

• Floating rates: Many direct loans have floating interest rates tied to a benchmark like the Secured Overnight Financing Rate (SOFR), which was selected as its recommended alternative to LIBOR in 2017. When this rate changes, the interest on every loan in your portfolio must be recalculated. Performing this task manually is not only time-consuming but also a massive source of potential error.

• PIK interest: Some loans feature payment-in-kind (PIK) interest, a form of debt financing where interest is paid with more debt rather than cash. This creates accounting complexity, as the accrued interest is added to the loan's principal balance, affecting all future interest calculations.

• Covenant monitoring: Tracking financial and reporting covenants like EBITDA and leverage ratios is a high-stakes activity. A missed test can trigger a default, and your systems must provide early warnings, not after-the-fact notifications.

Carta's Private Credit Solutions provide a purpose-built system of record that automates these complex workflows, delivering the control and accuracy that manual processes lack.

Fund accounting and valuation

The accounting process for a credit portfolio is fundamentally different from that of a PE or VC fund. PE and VC rely on periodic, model-driven portfolio valuations, whereas credit requires continuous, event-driven accounting. Every interest payment, principal repayment, and accrual is a transaction that must be recorded on the GL in real time.

An accurate, daily net asset value (NAV) is not a luxury for a direct credit fund; it's a requirement. As noted during Carta’s Audit Mastery: The Essentials You're Not Thinking About webinar, valuing debt assets requires a deep understanding of the loan's specific terms, underwriting details, and repayment history. If a borrower misses a payment, the valuation methodology may need to shift from a discounted cash flow model to a recovery method, a nuance standard accounting systems can't handle. Carta's event-based fund accounting software provides the single source of truth needed for an accurate, up-to-the-minute view of the fund's financial position.

LP reporting and compliance

Credit funds face intense scrutiny from both LPs and auditors, a reflection of a broader trend across private markets. LPs scrutinize past performance heavily, and after years of limited exits, LP liquidity has become the central one theme in the industry, causing investors to be more focused on DPI (distributions to paid-in capital) than ever before. This heightened scrutiny has tangible consequences; for example, the number of new PE funds closed fell by 38% from 2022 to 2023 as LPs grew more selective with their capital.

A dedicated auditor portal transforms the annual audit from a painful, manual exercise into a streamlined, collaborative review. By giving auditors secure, permissioned access to fund documents, disclosures, and transaction histories, you can demonstrate compliance and build trust with your key stakeholders.

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Managing the direct lending fund lifecycle

Your credit fund's lifecycle can be broken down into distinct stages, from launch to wind-down. At each stage, the operational requirements for a credit fund differ from those of a traditional VC or PE fund.

Fund formation and closing

The formation of a credit fund involves drafting a limited partnership agreement (LPA) with unique terms. These provisions define the overall fund structures and can include rules for using leverage, recycling capital from repaid loans, and highly specific investment mandates. A professional and seamless LP onboarding process is critical to building investor trust from day one.

For lean firms, managing these complexities can be a major hurdle. As J.B. Handley, co-founder of Bochi Investments, explained, "If it weren’t for Carta, I probably wouldn’t be back in business as a smaller firm because of how daunting the legal and compliance side of things can be." Using a platform like Carta for fund formation and closings helps you and your legal counsel structure the fund correctly and digitize the subscription process, making it easier for LPs to commit capital.

Capital deployment and monitoring

Once you raise capital and establish your deal flow, you deploy it into loans according to your fund's strategy. The strategic aspect of portfolio management extends beyond simple portfolio monitoring to track whether a loan is performing. It involves understanding how the entire portfolio's performance impacts fund-level returns and liquidity.

As a fund CFO, you need to run portfolio stress testing to model scenarios and forecasts, such as the impact of early loan repayments or a rise in defaults, on your fund's overall health and its ability to meet LP expectations.

Building an institutional-grade back office

Direct lending demands a modern, integrated technology platform. A fragmented approach that relies on spreadsheets for everything from loan servicing to management company administration holds your firm back from scaling effectively, especially in a market that rewards lean operations.

Emerging fund managers, for example, are finding success by using integrated services that can do all the overhead for them, which eliminates the need to “set up an admin or back office team.” Effective asset management requires scalable solutions, especially as your AUM (assets under management) grows.

The right fund administration partner is a strategic asset that can help your firm execute its direct lending strategy with confidence. For Brian Montgomery, CFO of Legalist, a private credit investment advisor, this partnership was key to growth. He notes, "A platform that allows us quick access to real-time information lets us grow our investor base of accredited investors and, following, our asset base." By centralizing operations on a unified platform, you can streamline everything from capital calls to investor reporting, allowing your leadership to focus on core activities.

Request a demo to see how Carta’s private credit solutions can help you build an institutional-grade back office for your direct lending fund.

Strengthen your loan operations

Simplify your workflow with a connected loan solution that’s designed specifically for private credit.

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Frequently asked questions about direct lending

What are the typical economics for a direct lending fund?

While direct lending funds still use a management and performance fee structure, performance hurdles are often tied to achieving a preferred return based on income generated, not just a multiple on invested capital.

How does a floating interest rate affect fund administration?

Floating rates require an automated accounting system that can dynamically recalculate interest accruals across the entire loan portfolio whenever a benchmark rate changes, which eliminates the risk of manual error.

What is the role of a private equity sponsor in a direct lending deal?

A PE sponsor (often private equity firms acting as the GP within a PE fund structure) often provides an extra layer of diligence and operational oversight for the borrowing company.