Private Credit's Rise: Navigating Blended Debt-Equity Structures in a Stressed PE Landscape

The private credit market has emerged as a critical player in the post-2020 financial ecosystem, driven by a perfect storm of regulatory shifts, capital scarcity, and the structural challenges facing private equity (PE). With total assets nearing $2 trillion by 2023 and projected to surpass $3.5 trillion by 2028, private credit is no longer a niche asset class but a cornerstone of modern capital markets. At the heart of this growth lies a seismic shift in how stressed PE-backed assets are refinanced—a process increasingly dominated by blended debt-equity structures. For investors, understanding the strategic advantages and risks of these structures is essential to navigating today's extended holding-period environment.

The Bank Retreat and the Rise of Private Credit

Banks are no longer the dominant lenders to PE-backed companies. Regulatory pressures, particularly the Basel III endgame proposals set to take effect in 2025, have forced banks to bolster capital reserves for longer-duration loans. This has reduced their appetite for riskier, lower-rated borrowers, creating a vacuum that private credit funds, insurers, and asset managers have eagerly filled. The result? A structural shift from bank balance sheets to nonbank entities, with private credit now accounting for a significant share of refinancing activity for aging or stressed PE assets.

Blended debt-equity structures—such as unitranche loans, synthetic risk transfer (SRT) arrangements, and hybrid instruments like preferred equity and paid-in-kind (PIK) notes—have become the preferred tools for this new era. These structures offer flexibility, speed, and creative solutions for borrowers facing liquidity constraints. For example, in 2024, companies like Paraxel and Mavis Tire executed $3.2 billion and $2.5 billion refinancings using broader syndicated loan (BSL) transactions, reducing interest costs by up to 300 basis points. Such cases highlight the growing sophistication of private credit in addressing the unique needs of PE portfolios.

The Double-Edged Sword of Blended Structures

While blended debt-equity structures offer clear advantages, they also introduce heightened risks—particularly for junior tranches. The Proskauer Private Credit Default Index, covering 739 loans with $143.6 billion in original principal, reveals a nuanced picture. By Q2 2025, the overall default rate had declined to 1.76% from 2.42% in Q1, signaling improved risk management. However, smaller companies with EBITDA under $25 million saw a slight uptick in defaults (1.8%), underscoring the fragility of marginal borrowers.

Junior tranches, often unsecured or subordinated, are inherently more volatile. In a "higher for longer" interest rate environment, cash flow constraints for PE-backed companies are more pronounced, increasing the likelihood of covenant defaults. For instance, a company with a 7% interest rate and a seven-year holding period now requires 4.2% annual earnings growth to achieve a 20% IRR—double the 1.7% needed at a 3% rate. This math forces sponsors to rely on operational improvements and AI-driven productivity gains, but it also amplifies the risk of refinancing failures.

Banks are mitigating their exposure by offloading junior tranches via SRTs, a practice that has grown to €155 billion in Europe alone in 2023. While this allows banks to comply with Basel III requirements, it shifts risk to private credit managers, who must now underwrite these tranches with limited transparency. The lack of public market discipline in private credit—combined with the complexity of blended structures—creates a "black box" effect, where investors may not fully grasp the true risk exposure.

Strategic Opportunities and Investment Advice

For investors, the key lies in balancing the upside potential of blended structures with rigorous due diligence. Junior tranches offer higher yields—often 400 basis points above senior components—but require a deep understanding of borrower fundamentals. The Cliffwater Direct Lending Index, which returned 12% in 2023, demonstrates the rewards of disciplined underwriting. However, these returns come with caveats: illiquidity, covenant-heavy terms, and the need for active portfolio management.

Investors should prioritize private credit funds with strong sector expertise and a track record in managing stressed assets. For example, funds that specialize in asset-backed facilities or repurchase transactions may offer better risk-adjusted returns than generalist managers. Additionally, secondary trading platforms for private credit are emerging, potentially enhancing liquidity for junior tranches—a critical factor in a market where exits are constrained.

The Road Ahead: Competition and Innovation

Private credit is not just a tool for PE refinancing—it's also a direct competitor to PE for capital. As investors seek alternatives to traditional buyout funds, private credit's lower volatility and higher transparency make it an attractive option. However, this competition is a double-edged sword: while it drives innovation in structuring and risk management, it also compresses spreads and margins.

Looking ahead, the interplay between private credit and PE will remain dynamic. Banks like Wells Fargo are already testing partnerships with private credit managers, signaling a potential return to more active roles in the space. Meanwhile, PE firms will continue to rely on value creation—operational, commercial, and strategic—to offset the challenges of high rates and extended holding periods.

For investors, the takeaway is clear: private credit's blended debt-equity structures offer a powerful toolkit for navigating today's market, but they demand a nuanced approach. The rewards are substantial, but so are the risks. As the sector evolves, those who can marry innovation with discipline will be best positioned to capitalize on the opportunities ahead.