How to Start a Direct Lending Fund

A real estate lender's downside case is the collateral. A direct lender's downside case is a business — repayment comes from operating cash flow, and recovery in a default comes from enterprise value, not a foreclosure sale. That changes what underwriting means: customer concentration, margin durability, management quality, and industry cyclicality are the credit file, and the loan is sized against debt-service coverage and leverage multiples (total debt to EBITDA), not loan-to-value.

Your PPM should state the credit box in those terms: EBITDA range, leverage limits through your tranche, minimum coverage ratios, industries you avoid, and check size relative to fund size. LPs read a tight box the same way they read one in any credit strategy — as the discipline that will be tested in month eighteen.

The first structural question allocators ask a direct lending manager is sponsor coverage, because the two lanes are different businesses:

The lower middle market is the last place in credit where full covenant packages are standard, and that's a core part of the LP pitch. Your term-sheet standards belong in the PPM: financial maintenance covenants (leverage, fixed-charge coverage) tested quarterly, EBITDA definitions that resist adjustment inflation, limits on debt incurrence and asset sales, and board observation rights where you can get them.

Structure is the other half. Senior secured first-lien is the emerging-manager default. Unitranche — one blended facility replacing separate senior and mezzanine tranches — is the product that built the direct lending market: borrowers get one document set and one lender to negotiate with, and the fund earns a blended rate for holding what would have been two tranches of risk. If you'll write unitranche, say what through-leverage you'll hold and whether you'll sell first-out pieces to a bank partner.

Across a 5–7 year fund life some borrowers will breach covenants, and a few will need restructuring. Allocators ask directly: who on your team has run a workout, and what happened? The strong answer is a named person with a specific story — amendment negotiated, sponsor injected equity, exit at par plus fees; or the harder version, loan-to-own and a sale two years later with a recovery number.

This is also why covenant discipline matters more than yield at the margin: maintenance covenants exist to put you at the table while enterprise value still covers your tranche. A first-time team with no restructuring scar tissue should fill the gap visibly — an operating partner, a board member, or a standing relationship with a restructuring advisor named in the deck.

Multi-year illiquid loans make direct lending a closed-end strategy for first-time managers: capital commitments drawn as deals close, a 2–3 year investment period (often with recycling of repaid principal inside it), and a 5–7 year fund term with extensions. Evergreen direct lending vehicles exist at scale, but they demand liquidity management a first fund shouldn't promise.

Economics follow the credit pattern: management fee of 1.5–2%, increasingly charged on invested capital rather than commitments — LPs push hard on this in credit, where undrawn commitments earning fees is a sore point — and an incentive of 10–20% over a 6–8% hurdle, with income distributed quarterly as interest is collected. A European-style structure (return capital plus preferred before incentive) is the LP-friendly norm in credit and worth conceding early.

The Fund Builder models the fund — target raise, credit box parameters, investment period and recycling policy, fee basis, hurdle and incentive, distribution mechanics — so the leverage limits in your pitch are the ones in your documents. Scroll Deck presents the origination lane and covenant discipline with the fund's actual economics; Legal Canvas prepares the formation and offering documents for independent counsel review. The fund formation package is $6,000, documents prepared in days rather than months — leaving the calendar for the part that's genuinely slow, which is the raise and the pipeline.