Structure as the Secret Sauce: Evolving Beyond Traditional Fund Structures in Direct Lending

Executive Summary

Private credit, especially direct lending, has experienced rapid growth and transformation in recent years. As the asset class becomes a mainstream allocation, investors are shifting their attention to optimizing portfolio construction, risk management, and value creation. At the same time, rising interest rates and market volatility have further broadened the appeal of direct lending, attracting a diverse investor base ranging from individuals to large capital allocators and sophisticated issuers.

Amidst this growth and precarious backdrop, market participants will need to continue to refine their approach to underwriting and portfolio construction. Disciplined risk management and thoughtful diversification are essential for navigating today’s evolving landscape. Managers must maintain vigilance in underwriting, employing dynamic, bottom-up due diligence that evolves as markets shift. Specifically, managers need a strong understanding of complex geopolitical developments (such as tariff and trade policy) and new transformative technologies (such as Generative AI) to anticipate and avoid credit mistakes. In addition, a disciplined, top-down approach to portfolio construction remains just as crucial. Diversification across industries and issuers and limiting exposure to sectors prone to cycles or regulatory risk helps reduce overall portfolio risk.

An often-overlooked consideration is the importance of structure in direct lending transactions. Given current market dynamics, maintaining a risk-first mindset is essential, and thoughtful structuring can be a powerful driver of value in direct lending. Features such as faster capital calls, more efficient deployment, and potentially lower fees can enhance net returns while reinforcing the robust risk management highlighted above.

Investor Challenges with Traditional Drawdown Structures

Historically, direct lending was only offered via traditional drawdown structures. However, the rise of business development companies and other liquid vehicles in recent years has provided credit investors with additional options. While each of these structures has pros and cons, we believe a hybrid solution, the Institutional Open-Ended Structure, can provide investors with the best of both worlds.

Key Considerations for Investors When Evaluating Direct Lending Structures:

• Familiarity:
  For investors accustomed to traditional drawdown structures, vehicles with defined investment and harvest periods offer a familiar experience.
• Simplicity:
  A well-designed structure can provide pure-play direct lending exposure. This approach avoids accelerated liquidity options (reducing cash drag), gates, and the need to hold liquid, non-direct lending investments.
• Optionality:
  Investors should be able to retain control over key decisions, including: (i) whether to receive distributions or recycle income, and (ii) whether to remain invested or begin harvesting exposures. Each investor's choices should operate independently without affecting others.

Addressing the Challenges Investors Face with Traditional Closed-End Structures

Challenge 1: Slower deployment and the J-Curve
In traditional drawdown structures, capital is called in a pro-rata fashion, whether it was committed months ago or the day before the final close. As a result, it can often take an investor 3-4 years to reach specific deployment targets. While this has been the industry standard for locked-up capital, many investors today are looking for faster ways to put capital to work to generate income and manage asset allocation targets.

• Potential Solution:
  We believe it is preferable to use a structure where capital is called from next quarter's tranche only after the previous quarter's tranche is fully called. By calling capital in this fashion, investors who committed earlier get their capital called first and deployed faster. Importantly, new investors enter the existing portfolio at the latest quarterly NAV and avoid blind pool risk by underwriting an existing portfolio during their diligence process.

EXHIBIT 1: Visual Representation of Tranche and Queue System

Challenge 2: Incomplete deployment and not reaching 100% utilization
At the end of a traditional drawdown fund investment period, investors are typically ~85-90% deployed. In many cases, 10–15% of commitments are held in reserve for both unfunded commitments and future defensive follow-on investments. When paired with Challenge 1, this means an investor’s effective funded exposure over the life of their investment rarely reaches >50%, which is a suboptimal outcome when trying to stay invested in the asset class and generate current income.

• Potential Solution
  With a queue structure, managers have visibility into the remaining uncalled capital and can call 100% of a single tranche while still adequately reserving for unfunded commitments and defensive follow-ons. By combining a faster initial ramp period and a 100% capital call experience, investors benefit from a more fulsome yield profile for their investment and from potentially higher returns compared to a drawdown structure. The exhibit below highlights the positive impacts of faster and more fulsome deployment on investor returns.

EXHIBIT 2: Structure Has the Ability to Deliver Faster and More Fulsome Deployment, Leading to Higher Returns Over Time¹

Institutional Open-Ended Structure Has the Potential to Deliver Faster Deployment...

... and When Paired with Attractive Fees, Translates to Higher Returns

Challenge 3: End of investment period treadmill
In traditional draw-down vehicles, once the investment period concludes, investors begin receiving paydowns and distributions with no option to remain invested. This dynamic introduces reinvestment risk and perpetuates a costly cycle—requiring investors to repeatedly commit time, resources, and fees to underwrite each successive vintage. The ongoing need to re-underwrite new commitments every few years diverts focus from higher-value investment activities.

• Potential Solution
  Following a lock-up period, investors in an institutional open-ended structure may be given the option at predetermined times to begin harvesting their exposure or stay invested. This optionality helps mitigate reinvestment risk without locking up capital in perpetuity. This aligns with the above: that investors are in control of how to manage their exposure.

Enhancing Performance Through Structural Efficiency

In a market that is constantly evolving, much of the recent attention has focused on compressing yields and managing risk and return in the current environment. Despite the market backdrop, there are only a finite number of ways to help investors maximize gross and net returns. Gross returns can be improved by either (a) increasing asset level yields, which comes with a commensurate increase in risk profile, or (b) optimizing for faster, and more complete deployment with consistent, diversified exposure to the asset class. We believe the latter is a far better answer for investors, particularly when net returns can be enhanced through more efficient investment structures and improved fee schedules.

We believe that a successful approach to direct lending involves having a steady hand on the wheel for risk, across all market environments and cycles. By employing innovative structures to access direct lending, we believe managers can maintain this risk-first approach and enhance gross and net returns.

EXHIBIT 3: Comparison of Institutional Open-Ended Structures vs. Traditional Closed-Ended Structures

REFERENCES

¹ Institutional Open-Ended returns are illustrative and based on assumptions over time using model fee rates and assumes income is distributed. Return assumptions include current expectations of forward curve base rates, current market spread levels, and average OID/Fees. Model assumes that evergreen funds get 100% called in 12-18 months vs. 90% called in closed-ended funds in 36 months.