FRM Part II · FRM Exam Part II

The Global Drivers of Private Credit: formula sheet

Full chapter guide

Key formulas

Illiquidity premium: Private credit yield ≈ comparable public credit yield + illiquidity premium + complexity premium; A conceptual relationship, not a computed identity. Higher yield compensates for illiquidity, limited transparency and bespoke terms.
Seniority ladder (loss order): Senior secured debt → unitranche → mezzanine → equity; Losses hit equity first, then mezzanine, then senior. Higher in the ladder means lower expected return and lower risk.
Floating-rate all-in coupon: Coupon = reference rate + spread; Direct loans are usually floating. Rising reference rates raise borrower interest burden and default risk.
Interest coverage ratio: ICR = EBITDA ÷ interest expense; Common covenant and stress metric. A lower ICR signals weaker ability to service debt.
Capital ratio: Capital ratio = Regulatory capital ÷ Risk-weighted assets (RWA); Higher risk weights on leveraged loans raise RWA, so the bank needs more capital for the same loan.
Leverage ratio: Leverage ratio = Tier 1 capital ÷ Total exposure measure; Not risk-based. The Basel III minimum is 3%. It limits balance sheet size regardless of loan risk.
Return on regulatory capital: Return on capital = Net income from loan ÷ Capital allocated to loan; Capital allocated = Loan amount × risk weight × required capital ratio. Used to explain why banks retreat.
Liquidity ratios: LCR = High-quality liquid assets ÷ Net cash outflows over 30 days ≥ 100%; NSFR = Available stable funding ÷ Required stable funding ≥ 100%; These raise the funding cost of holding long, illiquid loans.
Comparison rule: private credit vs BSL: Private credit = faster, committed, bespoke, confidential, but higher spread and less liquid; Use this as the standard answer to any advantages question. Always include the cost side.
All-in cost of a floating-rate loan: Interest rate = Base rate + Spread; The spread is the lender's credit and illiquidity compensation. The base rate moves with policy rates.
Interest coverage ratio: ICR = EBITDA ÷ Interest expense; Falls when base rates rise on floating-rate debt. Lenders and sponsors watch it for leveraged borrowers.
Illiquidity premium (concept): Private credit spread ≈ comparable public credit spread + illiquidity premium + complexity premium; A framing rule, not an exact formula. Use it to explain why private loans yield more than similar public bonds.
Floating-rate loan yield: Loan yield = base rate (e.g. SOFR) + credit spread; Most direct loans are floating. When the base rate rises, income rises, which supports investor demand.
Excess yield over safe assets: Yield pickup = private credit yield − government bond yield; Search for yield is strongest when the safe yield is low and the pickup looks large.
Asset-liability match (concept): Long-dated liabilities → capacity to hold illiquid assets; Pensions and insurers with predictable payouts and few redemption risks can hold illiquid loans.
Floating-rate coupon: Coupon = Reference rate + Spread; Reference rate resets; spread is fixed at origination. A floor may stop the reference rate from falling below a set level.
Interest coverage ratio: ICR = EBITDA ÷ Interest expense; A rate rise lifts the denominator, so ICR falls. Lower ICR means higher PD.
Debt service burden: Interest expense = Debt × (Reference rate + Spread); Use for a quick stress on one borrower or a portfolio.
Expected loss: EL = PD × LGD × EAD; Rising rates mainly push PD up. PIK interest also raises EAD.
Net spread after losses: Net yield ≈ Coupon − Expected loss − Fees; Compare the rise in coupon with the rise in expected loss.
Levered fund net return: Equity return ≈ Asset yield + (Debt ÷ Equity) × (Asset yield − Funding cost); Higher funding cost reduces the leverage benefit.
Interest coverage ratio: ICR = EBITDA ÷ interest expense; Falls when floating rates rise on leveraged borrowers. Lower ICR means higher default risk.
Leverage multiplier (fund level): Assets ÷ equity = 1 + (debt ÷ equity); A fund with debt/equity of 1.0 has assets of 2 times equity. A fall of x% in assets cuts equity by about 2x%.
Equity loss from asset loss: Equity loss % = asset loss % × (assets ÷ equity); Ignores financing costs. Use it to show how fund leverage magnifies valuation write-downs.
Liquidity mismatch test: Liquid assets + undrawn committed funding vs. potential redemptions + margin calls + credit line drawdowns; A shortfall means the fund may need forced sales or may draw on bank lines.

Quick revision

Private credit is lending by non-bank lenders outside public markets and bank balance sheets.
Post-crisis rules raised the cost of some bank lending, and non-banks filled part of the gap.
Borrowers value speed, certainty of execution and tailored terms.
Private equity sponsors are major users of private credit for buyouts.
Institutional investors seek yield and diversification and accept lower liquidity.
Floating-rate loans can look attractive when policy rates rise.
Higher rates raise borrowers' interest burden and can strain coverage ratios.
Private loans are held at model-based values, so transparency is limited.
Illiquid assets paired with redemption rights create a liquidity mismatch.
Banks are linked to private credit through lending to funds and other exposures.
Rapid growth with limited data makes risk hard for supervisors to assess.
In scenarios, name the driver first, then trace the effect.

Common mistakes

Treating private credit as the same as syndicated bank loans. Fix: Remember who holds the loan. Private credit is negotiated with a small group of non-bank lenders and held; syndicated loans are arranged by banks and can trade.
Assuming all private credit is senior and safe. Fix: Mezzanine is subordinated and distressed buys stressed debt. Always check seniority.
Saying Basel III banned leveraged lending. Fix: Basel III raised capital and liquidity costs. Banks chose to reduce activity because returns fell.
Treating regulation as the only cause of private credit growth. Fix: Add demand from sponsors and investor search for yield in a low-rate world.
Saying private credit is cheaper than syndicated loans. Fix: Remember borrowers typically pay a higher spread for speed, certainty and flexibility.
Mixing demand-side and supply-side drivers. Fix: Demand side is what borrowers and sponsors want. Supply side is investor capital, search for yield and fundraising.
Calling bank retrenchment a supply-side driver from institutions. Fix: Keep them separate: institutional capital and search for yield are about investors supplying funds; bank retrenchment is about regulation pushing lending out of banks.
Saying higher interest rates always reduce private credit inflows. Fix: Remember loans are mostly floating. Higher rates raise coupon income, so the asset can stay attractive. State the effect on borrowers' debt service as a separate risk.
Treating floating-rate private loans like fixed-rate bonds that lose price when rates rise. Fix: Floating loans reset, so duration is near zero. The risk shifts to borrower credit quality.
Saying rising rates are purely positive for private credit lenders. Fix: Always net the higher coupon against higher PD, restructuring and PIK. Gross yield is not net return.

Exam tips

Expect scenario questions that describe a loan and ask you to name the strategy. Read seniority and borrower health first.
Know the contrast with banks and syndicated loans: holder, liquidity, regulation, and execution speed.
Link growth to post-crisis bank regulation and investor search for yield, not to a single cause.
Watch for absolute words such as always, never or risk-free; they usually signal a wrong option.
If asked about risks, name illiquidity, valuation opacity, credit risk and fund leverage.
Name the exact Basel III element (capital, leverage ratio, LCR, NSFR) rather than writing generic regulation.
Expect case-style questions asking for the best explanation. Choose the answer that combines regulation and investor demand.
Read for risk migration. Correct options usually say risk shifts to non-banks and links back to banks.