The Rise and Risks of Private Credit: formula sheet

Key formulas

Strategy risk ladder (senior to junior)

Direct lending (senior) → Mezzanine (junior debt) → Distressed / Special situations (event or recovery driven)

Higher position in the loss queue means lower expected loss and lower expected return. Mezzanine ranks below senior debt and above equity.

Growth drivers

Growth = Bank retrenchment (supply gap) + Borrower and sponsor demand + Investor search for yield

A memory aid, not a numerical formula. Name all three when asked for causes.

Private credit vs syndicated loan

Private credit: bilateral or small club, held to maturity, bespoke terms. Syndicated: bank-arranged, many lenders, tradable.

The key distinction is who holds the loan and whether it can easily trade.

Illiquidity compensation

Expected spread ≈ credit spread + illiquidity premium + complexity premium

A conceptual decomposition. It is not a precise pricing formula.

Borrower trade-off

Private credit: higher spread + speed + flexibility + tailored terms vs Public markets: lower spread + liquidity + scale

A qualitative rule. Use it to justify why a borrower picks one route; it is not a pricing formula.

Covenant types

Maintenance covenant = tested on a schedule; Incurrence covenant = tested only when an action is taken

Covenant-lite loans have no maintenance financial covenants, typically only incurrence tests.

Funding comparison

Bank: deposits + wholesale funding; Private credit fund: investor commitments (plus possible fund leverage); BSL/bond: capital-market investors

Run risk is a bigger concern for deposit-funded banks than for closed-end funds with locked capital.

Spread decomposition

Spread ≈ expected credit loss + liquidity premium + complexity premium + risk premium

Illustrative decomposition. Private loans usually carry a larger illiquidity and complexity premium.

Fund leverage ratio

Debt-to-equity = Fund borrowings ÷ Net asset value (equity)

Gross assets = equity + debt. Regulators and funds may also quote debt ÷ total assets, so check the definition.

Return on equity with leverage

ROE = r_A + (D ÷ E) × (r_A − r_D)

r_A is return on assets, r_D is cost of debt, D ÷ E is debt-to-equity. Ignores fees and taxes.

Loss impact on equity

Equity loss % = Asset loss % × (1 + D ÷ E)

Applies to a fall in asset value with debt cost ignored. The leverage multiplier is assets ÷ equity.

Borrower interest cover

Interest cover = EBITDA ÷ Interest expense

Lower cover means higher borrower-level default risk, especially with floating rates.

Incentive fee with hurdle (no catch-up)

Fee = Rate × max(0, Return − Hurdle) × Capital

With a full catch-up, the manager gets the rate on all profit once the hurdle is passed.

Expected loss

EL = PD × LGD × EAD

Use for borrower default risk. LGD = 1 − recovery rate.

Recovery and loss given default

LGD = 1 − recovery rate

Weak covenants and weak documentation tend to lower recovery, so raise LGD.

Cash-pay interest coverage

Cash interest coverage = EBITDA ÷ cash interest expense

Exclude PIK interest from cash interest. Compare with total coverage including PIK to see hidden stress.

PIK share of interest

PIK share = PIK interest ÷ total interest

A rising share signals borrowers conserving cash. It is a warning sign, not proof of default.

Discounted cash flow value of a loan

Value = Σ CFt ÷ (1 + r)^t

Higher discount rate or spread lowers value. Small input changes can move the mark materially.

Unsmoothed return

rt(true) = [rt(reported) − α × rt−1(reported)] ÷ (1 − α)

Use for first-order smoothing, where α is the smoothing weight between 0 and 1. Unsmoothing raises measured volatility.

Redemption coverage

Liquid assets ÷ expected redemption requests

Below 1 means the fund must sell illiquid assets, gate or borrow.

Interest coverage ratio

Interest coverage = EBITDA ÷ Interest expense

Falls when floating rates rise. Lower coverage signals borrower stress and higher default probability.

Debt service burden after a rate rise

New interest = Debt × (Base rate + Spread)

For floating-rate loans the base rate resets, so the rise passes to the borrower almost fully.

Leverage (fund level)

Leverage = Total assets ÷ Equity

Higher leverage magnifies NAV falls: a fall in assets of x% cuts equity by about x% × leverage.

Bank exposure to a fund after drawdown

Exposure = Drawn amount + (Undrawn commitment × expected draw rate)

Credit lines can be drawn in stress, so use stressed draw rates, not current usage.

Expected loss

EL = PD × LGD × EAD

Use it to turn a higher default rate into a bank loss estimate.

Interest coverage ratio

Interest coverage = EBITDA ÷ Interest expense

Core stress-test metric for borrowers. Falls when rates rise on floating-rate debt or earnings drop.

Leverage multiple

Debt ÷ EBITDA

Borrower-level leverage. Compare against covenant limits and under stressed EBITDA.

Loan-to-value

LTV = Loan amount ÷ Value of the borrower's enterprise or collateral

Higher LTV means less cushion before lenders take losses.

Expected loss

EL = PD × LGD × EAD

Stress tests raise PD and LGD together because recoveries tend to fall when defaults rise.

Fund leverage

Fund leverage = Total assets ÷ Fund equity

Fund-level borrowing magnifies losses on the underlying loans.

Stressed loss on equity

Loss on equity (%) = Asset loss (%) × Fund leverage

Simple approximation that ignores financing costs. Shows why leverage matters.

Quick revision

• Private credit is non-bank lending to firms, mostly negotiated directly, outside public bond markets.
• Growth was helped by tighter bank regulation, investor demand for yield and borrower demand for tailored financing.
• Loans are usually bespoke, held to maturity and rarely traded, so market prices are scarce.
• Compared with banks, private credit funds do not take deposits, but they may use leverage and bank credit lines.
• Compared with public bonds, private loans have less disclosure and less liquidity.
• Leverage at fund level magnifies both returns and losses.
• Valuation often relies on models and manager judgement, so marks can lag true conditions.
• Illiquidity risk grows when investors can redeem faster than assets can be sold.
• Credit risk can be hidden by weak covenants and by borrowers that refinance or defer interest.
• Bank links include lending to funds and to private credit vehicles, which can transmit stress.
• Limited data on exposures makes system-wide risk hard to measure.
• Controls include stress testing, independent valuation, liquidity management, covenant monitoring and better data reporting.

Common mistakes

• Treating private credit as the same as syndicated bank lending. Fix: Remember who holds the loan. Private credit is held by non-bank funds, often bilaterally, and is far less tradable.
• Saying mezzanine is senior debt. Fix: Mezzanine sits below senior debt and above equity, which is why it earns a higher return.
• Saying private credit is unregulated. Fix: Say funds face different regulation, often without bank-style capital or liquidity rules, but are still subject to securities and investor-protection oversight.
• Treating all private credit loans as having tight covenants. Fix: Say private loans tend to have tighter maintenance covenants and easier renegotiation, but terms vary and some large deals loosen protections.
• Treating interval funds and BDCs as the same as closed-end drawdown funds for liquidity. Fix: Separate asset liquidity from investor liquidity. Interval funds offer periodic repurchases, so they carry a liquidity mismatch that drawdown funds do not.
• Using debt ÷ total assets as debt-to-equity. Fix: Read the definition. Debt-to-equity divides by equity. With debt ₹60 and equity ₹40, D/E is 1.5, not 0.6.
• Treating low reported volatility as low risk Fix: Remember marks are model-based and smoothed. Unsmoothing raises volatility and lowers the apparent Sharpe ratio.
• Counting PIK loans as performing without caution Fix: Check cash coverage. PIK means no cash was paid. A growing PIK share points to hidden stress.
• Treating private credit as fully separate from banks. Fix: Remember that banks fund and service these funds through credit lines, leverage facilities and prime services.
• Assuming rising rates help floating-rate lenders without risk. Fix: Also consider borrower stress: higher interest burden lowers coverage and raises defaults.

Exam tips

• Expect scenario questions that describe a loan and ask you to name the strategy. Locate the loan in the capital structure first.
• Always pair a feature with its risk: illiquidity, opaque valuation, leverage, or bank linkages.
• Watch for absolute words such as 'always' or 'never' in options; they are usually wrong.
• For growth questions, name regulation-driven bank retrenchment plus demand and investor yield search to be safe.
• This topic is part of Current Issues, so be ready to connect it to financial stability concerns.
• Expect case-style questions asking you to match a borrower profile to a funding route; read size, speed and confidentiality cues first.
• Know the difference between maintenance, incurrence and covenant-lite terms; options often mix them up.
• Watch for absolute words in options; the correct answer usually states a tendency.