A Framework for Private Credit Portfolio Construction
- Strategy insight
May 22, 2025 | 9 min read
The private credit market has soared in popularity since the Great Financial Crisis, transforming from a lender of last resort to an institutional asset class that rivals the scope of the high yield bond and leveraged loan markets.1 In the U.S. and Canada alone, 42% of institutional investors plan to increase their allocations to private debt over the next three years,2 and assets under management (AUM) in the sector are expected to reach $3 trillion by 2028.3
As investors increase their exposure to private credit, a framework for portfolio construction can help navigate the increasing complexity of this market. In this paper, we define the different segments of the private credit market, offer a recommended framework for portfolio construction, and weigh some of the tradeoffs associated with the different implementation options.
Defining the private credit universe
As private credit continues to take market share from traditional banks and public fixed income markets, the number of financing strategies within the asset class has expanded significantly. These strategies can be categorized into three broad segments:
Corporate credit
Typically used to initiate a leveraged buyout, M&A, or other corporate purpose. It Includes senior direct lending as well as junior credit strategies.
Asset-based lending
Financing that is collateralized by a specific asset or pool of assets, allowing the owner of the asset to borrow against its value.
Niche strategies
These smaller, specialty funds provide non-traditional financing strategies; examples include litigation finance, strategies that securitize pharmaceutical or music royalties, and venture lending.
How to build a private credit portfolio
There are four crucial steps for determining broad allocations to the credit segments listed above. These include strategic sub-segment positioning, diversification implications, and relative risk/reward considerations.
Step 1: Choose allocations to broad segments of the private credit market
The first step in building a private debt portfolio is deciding how much to allocate to each of the three credit segments discussed above. Allocators typically devote the largest allocation of a private debt portfolio to the corporate credit segment, given the breadth of the opportunity set, the more easily quantifiable nature of its risk profile, and the ability to mitigate idiosyncratic credit risk through broad-based portfolio diversification.4 In this segment, loans are backed by the cash flows of the borrower, which allow the lender to assess the reliability of the borrower’s cash flows and the quality of the borrower’s management team in executing on its overarching strategy. Of the three credit segments, direct lending historically has the lowest historical return, but also the lowest risk profile, as shown in Figure A below.
We believe asset-based lending should represent the next largest segment of a diversified private credit allocation. These loans are often collateralized by physical assets, which means they should be less correlated to the corporate earnings cycle and have an inherent recovery value in the event of a default. However, given the intrinsic tie to the perceived value of collateralized assets, it requires specialized expertise on the part of the lender. Thus, it is imperative to select managers with narrowly defined, subject matter expertise of managing and valuing the collateralized assets. Figure A below shows that as one moves from corporate credit to asset-based strategies, the expected return increases; however, so does the dispersion of performance, as measured by standard deviation, within the category.
Lastly, a smaller percentage can be assigned to what we call niche strategies. These strategies have more of an absolute return orientation and are intended to be highly idiosyncratic and uncorrelated to other market segments. This market segment can include strategies that collateralize music or pharmaceutical royalties, or litigation finance strategies that provide capital to support legal actions in exchange for receiving a portion of the proceeds that are earned in a court decision. Manager skill is a paramount consideration when making an allocation to one of these narrowly defined market segments. While not every allocator needs to extend out on the risk spectrum to include niche strategies, they can play a diversifying role in an existing allocation to corporate credit or asset-based lending. As shown in Figure A, these strategies present the highest return potential of the three categories. However, they are also considered to be the riskiest given the wide dispersion of performance returns across funds in the category.
Figure A
Private credit segment risk/return comparisons
Source: Preqin, as of 12/31/2024.
Step 2: Choose sub-allocations within corporate credit
After determining the overall portfolio allocation among corporate credit, asset-based lending, and niche strategies, one needs to consider the portfolio’s corporate credit sub-allocations to senior vs. junior credit, as well as the split between sponsored and non-sponsored credit.
Sponsored vs. non-sponsored
Sponsor-backed businesses are owned by private equity sponsors and benefit from both professional management and the dedicated sector expertise of the PE sponsor. By contrast, the non-sponsored market often entails lending to family- or entrepreneur-owned businesses, which broadens the opportunity set but also introduces additional risks. For example, the owner of a family-owned business might have more trouble discerning the true value of their company due to the family’s psychological attachment. They might also have non-financial objectives, like maintaining a certain equity stake for the founding family, even if future generations may not be equipped to run the business. Lastly, financial reporting may not be as clean and as thorough as for a sponsored-backed business, introducing additional uncertainty in the underwriting process. In turn, the non-sponsored market has typically experienced a higher default rate than the sponsored market but has also commanded a yield premium over time to account for these incremental risks.
We believe there is a role for both sponsored and non-sponsored lending in a private credit portfolio but suggest sizing these positions to reflect the incremental risks associated with non-sponsored lending. Historically, non-sponsored deals represent about one-third of the private credit market, as shown in Figure B below. We think that is a reasonable place to start when deciding how much to allocate to this market segment.
Figure B
Historical deal lending 2014-2024
Source: LSEG LPC 1Q25 US Sponsored Market Private Deal Analysis.
Senior vs. junior credit
Senior credit sits atop the capital structure and is first in line to be repaid coupon and principal payments in the event of a default. Junior credit sits below senior credit but above equity in the capital structure. In return for taking a subordinated position, junior credit providers get paid a higher yield for assuming this incremental risk.
The junior credit market is much smaller than the senior market and tends to be more bespoke in nature. For example, junior credit deals are sometimes structured to pay coupon payments in cash; other times they are structured to pay their interest in-kind, referred to as payment-in-kind securities. Additionally, junior market deals may be structured as fixed-rate securities, or structured as a spread over a floating, short-term interest rate like the 3-month Secured Overnight Financing Rate (SOFR). The senior credit market is structured to be almost exclusively floating rate.
Junior credit can play a valuable role in a broadly diversified private credit portfolio. Junior credit introduces an opportunity to generate incremental yield and higher returns, while offering valuable diversification by allowing LPs to get fixed-rate exposure, which is particularly valuable in a market environment like today’s where the trajectory of monetary policy and interest rates is highly uncertain. A rough rule of thumb: If one were to bifurcate the corporate segment of private credit into senior and junior exposures, the senior market would represent about two-thirds of the overall market, which intuitively makes sense since the senior tranche is about twice as large as the junior tranche in a typical capital structure.
Step 3: Choose allocations to asset-based lending
The asset-based lending market is expanding rapidly, driven by a need for working capital and alternative financing solutions, as banks reduce their footprint in this market. Asset-based lending allows firms to borrow based on their assets, like accounts receivable, real estate, and intellectual property, rather than cash flow. It is well suited for asset-rich companies experiencing seasonal or cyclical sales fluctuations, commodity price changes, or earnings volatility. Borrowers in this market often include manufacturers, distributors, and retailers needing capital to manage operations and growth.
Since the debt is often securitized by physical assets, asset-based lending tends to be less correlated to corporate earnings and can diversify a private credit portfolio that has a large allocation to corporate direct lending. In the example shown below in Figure C, we ran four hypothetical portfolios featuring various exposures to corporate credit, asset-based lending, and niche strategies. These hypothetical models suggest that a 30% allotment to asset-based lending, depending on an allocator’s risk/return, liquidity, and diversification requirements, may provide higher total returns and risk-adjusted return than a portfolio without an allocation to asset-based lending. It is important to keep in mind that within an asset-based lending allocation, it is recommended to diversify across consumer credit, mortgage-backed, and commercial mortgage-backed exposures to ensure adequate diversification both by manager and by market sub-segment.
Step 4: Choose niche strategy allocations
Strong borrower demand for nonbank financing has also expanded the market universe for niche financing options such as music royalties and litigation finance. These assets are generally uncorrelated to the economic environment and potentially provide an opportunistic means for allocators to maximize yield within a well-balanced portfolio. However, given the specialized nature of these assets and the industry-specific risk they represent, investing in this sub-strategy requires sophisticated knowledge and a focused level of attention. Based on our analyses, we see that a 10% allocation to niche strategies in a diversified private credit portfolio may provide the most attractive risk-adjusted returns compared to the other hypothetical portfolios. Allocators are likely to be best served by diversifying this allocation across sub-strategy type, which would include the likes of music and/or pharmaceutical royalties as well as even narrower sectors like litigation finance to ensure adequate diversification by manager and strategy.
Allocation in action: Hypothetical portfolio models
In Figure C below, we evaluate the risk and return profile of four hypothetical model portfolios, with varying allocations to the three market segments.
Figure C
Credit segment allocation has a significant effect on performance
For illustrative purposes only. Each hypothetical model portfolio’s construction targets allocations discussed in the text above. Model portfolios were constructed based on custom sub-composites of funds in Preqin’s private credit universe. Sub-composites were created in Preqin for each fund that fit into the three private credit segments delineated above (corporate credit, asset-based lending, and niche strategies). The total return (net IRR) for each sub-composite was calculated based on quarterly returns from 6/30/2020 to 12/31/2024. The historical risk-adjusted return is calculated using risk/standard deviation to reflect return per unit of risk. Returns shown are gross of portfolio level management fees and carried interest, but net of underlying management fees and carried interest. If portfolio level management fees and carried interest were applied returns would be lower. Hypothetical model performance results are inherently limited and should not be considered a reliable indicator of future results. One of the limitations of hypothetical performance results is that they are prepared with the benefit of hindsight. No representation is being made that any private credit allocation will or is likely to achieve profits or losses similar to those shown. This information should be used solely as a guide and should not be relied upon to manage your investments or make investment decisions. Investments in private funds involve significant risks, including loss of the entire investment. See Disclosures at the end of the paper for important information on this hypothetical illustration.
Depending on one’s return target and risk tolerance, one can size the relative allocations to these market segments. We believe for most allocators, the 60/30/10 portfolio strikes a nice risk/return balance, after incorporating the different risk/return profiles of the underlying credit segments.
Implementation: Primary or secondary
After a private credit LP has mapped out its private credit allocations, it must then consider the best way to implement that allocation. Historically, many allocators have relied on making primary commitments to private credit GPs to obtain their desired exposure. These are investments in a private credit fund at the time it is being raised. Historically, allocators have largely relied on making these commitments to private credit GPs in closed-end funds or drawdown funds that raise and invest capital over discrete time periods. Today, allocators have more tools at their disposal to manage these exposures, including a wide array of semi-liquid vehicles, which offer LPs flexibility to moderate their deployment over time.
In addition to committing capital to private credit GPs on a primary basis, allocators now also have the option to consider a range of strategies in the credit secondaries market. Secondary investments occur when a buyer purchases existing private assets, which we believe offer several key advantages. Credit secondaries funds can mitigate blind-pool risk by investing in seasoned assets, which also leads to quicker deployment, accelerated cash distributions, and enhanced returns. A credit secondaries portfolio is substantially more diversified than investing in a credit portfolio managed by a single GP, as a secondaries portfolio will have exposure to thousands of underlying loans, which minimizes the impact of a default/impairment in any underlying position. Finally, by purchasing positions in existing LP portfolios at discounts to par, there is an opportunity to generate a return premium relative to relying exclusively on primary commitments.
The last decision that newer allocators to the space need to consider is the decision to build a private credit portfolio sequentially or concurrently. In other words, allocators can either make a pro-rata allocation to the corporate, asset-based lending, and niche strategies at the outset, or they can start with corporate credit and incrementally add exposures to higher-risk segments of the market as they grow more familiar with these market segments over time. Recognizing the diversification benefit that we quantified above from having exposure outside of just the corporate credit segment of the market, we believe allocators are best served by building out allocations to all three segments of the market simultaneously, recognizing that it might take time to properly diligence each segment of the market and the respective managers in each segment. One way to mitigate this challenge is to use the credit secondaries market as a tool to get broad-based, immediate diversification across market segments and managers by leveraging the secondary manager’s intimate familiarity with the market and its underlying managers in each market segment.
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Key takeaways
The private credit market today bears little resemblance to the humble stature of the asset class 20 years ago. Private debt’s rapid growth and expanding universe of financing structures has set forth yield and diversification opportunities like never before for investors and allocators alike. But as it has grown, private credit has become increasingly complex and more challenging for allocators to navigate. Taking a thoughtful approach to portfolio construction can help mitigate this risk by helping to ensure that allocators are properly diversified and do not have disproportionate exposure to any segment of the market.
Footnotes
- https://www.federalreserve.gov/econres/notes/feds-notes/private-credit-characteristics-and-risks-20240223.html
- https://www.greenwich.com/press-release/institutional-investors-north-america-raise-long-term-allocation-targets-private
- https://www.moodys.com/web/en/us/insights/credit-risk/outlooks/private-credit-2025.html
- Diversification does not ensure a profit or protect against a loss.
Disclosure
Diversification does not ensure a profit or protect against a loss.
HarbourVest Partners, LLC is a registered investment adviser under the Investment Advisers Act of 1940. This material is solely for informational purposes and should not be viewed as a current or past recommendation or an offer to sell or the solicitation to buy securities or adopt any investment strategy. The opinions expressed herein represent the current, good faith views of the author(s) at the time of publication, are not definitive investment advice, and should not be relied upon as such. This material has been developed internally and/or obtained from sources believed to be reliable; however, HarbourVest does not guarantee the accuracy, adequacy, or completeness of such information. There is no assurance that any events or projections will occur, and outcomes may be significantly different than the opinions shown here. This information, including any projections concerning financial market performance, is based on current market conditions, which will fluctuate and may be superseded by subsequent market events or for other reasons. The information contained herein must be kept strictly confidential and may not be reproduced or redistributed in any format without the express written approval of HarbourVest.
Nothing herein should be construed as a solicitation, offer, recommendation, representation of suitability, legal advice, tax advice, or endorsement of any security or investment and should not be relied upon by you in evaluating the merits of investing in HarbourVest funds or in any other investment decision.
Credit Strategy Risks: A fundamental risk associated with credit investments is credit risk, which is the risk that a borrower will be unable or unwilling to make principal and interest payments on its outstanding debt obligations when due. Investments in subordinated or junior debt investments, should an issuer trigger an event of default, depending on the capital structure and the issuer’s financial situation, a loss of the entire value of the investment is possible. Adverse changes in the financial condition of an issuer or in general economic conditions (or both) could impair the ability of such issuer to make payments on its debt and result in defaults on, and declines in, the value of its subordinated debt more quickly than in the case of the senior debt obligations of such issuer. Adverse changes in the financial condition of an issuer or in general economic conditions (or both) could impair the ability of such issuer to make payments on its debt and result in defaults on, and declines in, the value of its subordinated debt more quickly than in the case of the senior debt obligations of such issuer.
Hypothetical Models: Model results are hypothetical and inherently limited. They should not be relied upon as indicators of future performance. Individual fund and strategy performance can be better or worse than the model. No investor received the indicated hypothetical model performance. Certain assumptions have been made for modeling purposes. No representation or warrant is made as to the reasonableness of the assumptions made. Changes in the assumptions may have a material impact on the hypothetical returns presented. Different hypothetical model scenarios will provide different results. While the model portfolio may consist of investments made by HarbourVest during the relevant period(s), it does not reflect an actual portfolio managed by HarbourVest during the relevant period(s) and does not represent the impact that material economic and market factors might have had on HarbourVest’s decision making if HarbourVest had been managing a fund that incorporated the investment strategy shown during the specified period(s).
In addition, investment results may be materially different from the results portrayed in the model portfolio during the relevant period(s). Actual investments may have substantially different terms than those reflected in the model portfolio. No representation is made that any investment will or is likely to achieve returns similar to those presented, and there can be no assurance that an investment will achieve profits or avoid incurring substantial losses. Other periods selected for the model portfolios may have different results, including losses. Current model results may differ from those shown.
Hypothetical Model Methodology: The model portfolios were constructed based on custom sub-composites of funds in Preqin’s private credit universe. Fund inclusion in each composite was determined by the stated strategy or objective of the fund. The corporate direct lending composite includes direct loans to primarily private equity backed companies. The Asset-Based Lending composite includes funds involved in aviation finance, consumer credit, residential mortgage-backed securities, and/or credit related strategies secured by hard assets. The Specialty Finance composite includes funds that provide financing based on royalty income streams, litigation claims, and/or insurance linked income. The period under review covers June 30, 2020, through December 31, 2024, which represents the total combined time period in which performance data was available for all three sub-composites. The Corporate Direct Lending sub-composite includes 90 funds, the Asset-Based Lending sub-composite includes 35 funds, and the Niche/Specialty Finance sub-composite includes 7 funds. Each sub-composite contains all representative funds with performance data available through Preqin for the time period covered. Performance and risk metrics were calculated based on past results and no projections or forecasts are included in the analysis.
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