The single most important structural feature in any private credit fund is who absorbs losses first. First-loss capital is the layer that takes the punch before investor capital does. Here is how it works, why it matters, and how to evaluate it.
Is the Investment Manager co-investing in the Fund?
The single most important structural feature in any private credit fund is who absorbs losses first. First-loss capital is the layer that takes the punch before investor capital does. Here is how it works, why it matters, and how to evaluate it.
What first-loss capital is
First-loss capital is a tranche of capital that sits below investor capital in a fund's structure. When the underlying portfolio experiences a loss, that loss is absorbed by the first-loss tranche before it reaches the senior, investor-facing tranche. This is the same tranching logic codified in the Basel II securitisation framework that has governed bank warehouse lending since 20061.
Why it exists
First-loss capital exists for two reasons. The first is structural: it gives the senior investor a buffer against loss. The second is behavioural: a manager who has their own capital in the first-loss tranche has skin in the game. They feel any loss before the investor does. That alignment changes underwriting behaviour, and is the same incentive structure the IMF identifies as a key risk-mitigant in private credit funds3.
What to look for
Not all first-loss capital is created equal. Five questions tell you whether the protection is real:
1. What is the minimum size? A fund that contractually commits to a minimum first-loss percentage (e.g. 10%) is more durable than one that allows it to drift. The Eldium Income Fund commits to a minimum 10% first-loss tranche4.
2. Who provides it? First-loss capital provided by the manager themselves is the strongest form of alignment. First-loss provided by a third party (e.g. another fund) is still protective but less aligned. ASIC's INFO 273 calls out manager alignment as a key disclosure investors should evaluate5.
3. How is it subordinated? Is it true subordination, with no return until the senior tranche is paid? Or is there a waterfall that gives the first-loss tranche participation alongside the senior? True subordination is stronger.
4. How is it sized relative to expected loss? A first-loss buffer should be several times the portfolio's expected loss rate. Under IFRS 96, expected credit losses are calculated automatically per facility. If a portfolio's loss rate has averaged 1-2% per annum across a cycle, a 10%+ first-loss tranche provides multi-year cushion.
5. Is there layered protection? First-loss capital at the fund level is one layer. First-loss capital at the facility level (the originator's own equity in their loan book) is another. Layered protection means losses must pass through both before reaching the investor. See What is Asset-Backed Private Credit? for how this layering is structured.
How it works in a loss scenario
Suppose a $50M asset-backed fund holds a $5M first-loss tranche (10%) and $45M of senior investor capital. The underlying portfolio experiences losses of $100,000 over a year.
In that scenario, the entire $100,000 loss is absorbed by the first-loss tranche. Senior investor capital is unaffected, distributions continue, and the first-loss tranche is reduced from $5M to $4.9M. The fund manager is then typically required to top up the tranche to maintain the minimum.
Now suppose losses are catastrophic, say $5.1M. The first-loss tranche is fully eroded ($5M absorbed), and the remaining $0.1M would flow through to senior investor capital, representing a 0.2% capital impairment.
The job of first-loss capital is to make scenario one common and scenario two extremely rare. Empirically, the Cliffwater Direct Lending Index shows just one negative calendar year for senior secured direct lending in twenty years (2008)7, even before considering fund-level subordination.
What it tells you about a manager
The single strongest signal of a private credit manager's confidence in their own portfolio is the size of the first-loss tranche they are personally committed to. A manager who is willing to put their own money in front of yours, and to keep doing it as the fund grows, is structurally aligned with the investor. A manager who relies entirely on third-party first-loss capital, or whose first-loss commitment shrinks over time, has a weaker alignment.
The bottom line
First-loss capital is the unsung hero of a well-structured private credit fund. Done properly, it is the difference between a strategy that pays regular monthly income across the cycle and one that occasionally hands losses through to investors. When evaluating any private credit allocation, look at the first-loss tranche before you look at the headline yield. The structure protects you, the rate is what pays you. See also Private Credit vs Term Deposits for how the protection compares to bank-guaranteed alternatives.
Sources & references
- Basel Committee on Banking Supervision, Basel II Securitisation Framework. bis.org/publ/bcbs128
- S&P Global Ratings, "Private Credit and Its Evolving Role" (Credit FAQ), March 2024. spglobal.com/ratings
- International Monetary Fund, Global Financial Stability Report, April 2024, Chapter 2: The Rise and Risks of Private Credit. imf.org
- Eldium Income Fund Class A Monthly Report, April 2026.
- ASIC, Information Sheet 273, Warnings on private credit funds. asic.gov.au/info-273
- IFRS Foundation, IFRS 9 Financial Instruments. ifrs.org
- Cliffwater Direct Lending Index (CDLI), 20-year history. cliffwaterdirectlendingindex.com
- Moody's Investors Service, "Default and Loss Rates of Structured Finance Securities" methodology. moodys.com
- Reserve Bank of Australia, Financial Stability Review, non-bank lending sector. rba.gov.au/publications/fsr
This article is general information only. It does not take into account your personal financial situation and is not financial advice. The Eldium Income Fund is open only to wholesale clients under section 761G of the Corporations Act 2001 (Cth).