Skip to content

FRM Exam Part II · Private Markets Investing

Private Credit and Direct Lending for FRM Part II

Updated 11 October 2026 · Fact-checked

Private credit is debt lent by non-bank funds directly to borrowers, not traded in public markets. Strategies include direct lending (senior, floating rate), mezzanine (subordinated, higher yield) and distressed debt (stressed issuers, recovery-driven). To solve questions, identify the seniority, return source, then judge the illiquidity, credit and valuation risks against public credit.

Understand Private Credit and Direct Lending

Private credit is lending by non-bank investors, such as funds, insurers and pension plans, to companies through negotiated loans. The loans are not issued on public markets and usually trade rarely or not at all. The lender holds them, often to maturity.

Direct lending is the core strategy. A fund lends straight to a mid-sized company, often one owned by a private equity sponsor. Loans are usually senior secured and floating rate, priced as a reference rate plus a spread. Terms are negotiated with a small group of lenders, so covenants can be tighter and the lender can monitor closely. Institutional investors usually access it through closed-end funds, separate accounts or business development vehicles.

Mezzanine debt sits below senior debt and above equity in the capital structure. It pays a higher coupon, often partly paid-in-kind (PIK), and may carry equity warrants. It offers more return because it has lower recovery if the borrower fails. Distressed debt is different. You buy the debt of a stressed or defaulted issuer, usually at a deep discount. Return depends on recovery, restructuring outcome and timing, not on coupon income.

Compared with public bonds, private credit typically offers an illiquidity premium and a possible complexity premium. You are paid extra for being unable to sell quickly and for doing hard analysis. The costs are real. Valuations are model-based and infrequent, so reported volatility looks lower than true risk. Borrowers are often smaller and more leveraged. Fund leverage can magnify losses. Links to banks, through credit lines to funds, can spread stress.

The exam asks you to link strategy to position in the capital structure, return driver and main risk. Do not claim private credit is always safer or always higher returning. Higher yield is compensation for risks, not free return.

Key formulas to remember

Floating-rate loan yield
Loan yield ≈ reference rate + credit spread
Direct loans reprice with the reference rate, so interest rate risk is low but borrower payment burden rises when rates rise.
Excess return over public credit
Illiquidity premium ≈ private credit spread − comparable public credit spread (same rating and seniority)
Only an approximation. Part of the gap may be compensation for credit risk, not illiquidity.
Expected loss
EL = PD × LGD × EAD
Use it to compare senior loans (low LGD) with mezzanine (high LGD).
Net credit return (approx.)
Net return ≈ yield − expected loss − fees
Fund fees and defaults reduce the headline spread.
Distressed debt return on a position
Return = (recovery value + interim cash − purchase price) ÷ purchase price
Driven by recovery and timing, so annualise if the holding period differs.
Leverage effect on equity return
Return on equity = asset return + (debt ÷ equity) × (asset return − cost of debt)
Fund-level leverage magnifies gains and losses.

How to solve Private Credit and Direct Lending questions

Use this order for any question on private credit strategies, returns or risks.

  1. 1Identify the strategy: direct lending, mezzanine, distressed debt, or a comparison with public bonds.
  2. 2Place the instrument in the capital structure: senior secured, subordinated or near equity.
  3. 3Name the main return driver: spread plus floating rate, high coupon with PIK or warrants, or recovery on a discounted purchase.
  4. 4Name the main risk: default and recovery, illiquidity, valuation opacity, leverage, or concentration.
  5. 5If numbers are given, compute yield, expected loss or return step by step, using the exact formula.
  6. 6Compare with public credit on liquidity, pricing transparency, covenants and premium earned.
  7. 7Check wording such as 'most likely', 'primary' or 'least consistent', and pick the option that fits the strategy exactly.

Quickest way: Strategy-to-risk matching

When to use it: For conceptual MCQs that ask which strategy or risk fits a description.

  1. Senior, floating, covenants, sponsor-backed: direct lending.
  2. Subordinated, high coupon, PIK or warrants: mezzanine.
  3. Discounted stressed or defaulted debt, recovery and restructuring: distressed.
  4. Smooth reported returns or quarterly marks: think stale valuation and understated volatility.
  5. Eliminate any option claiming a free premium or no liquidity cost.

Common mistakes in Private Credit and Direct Lending

  • Treating mezzanine and distressed debt as the same thing.

    Both are risky and both are junior to senior debt in many cases.

    Fix: Mezzanine is a performing, subordinated financing with high coupon. Distressed debt is bought at a discount from a troubled issuer, with return from recovery.

  • Saying direct loans have high interest rate risk.

    Students link all debt to duration.

    Fix: Floating-rate loans have low duration. The rate risk shows up as higher borrower debt service and default risk.

  • Believing low reported volatility means low risk.

    Private loans are marked infrequently, which smooths returns.

    Fix: Treat smoothed volatility as understated. Unsmooth returns or stress test to see the true risk.

  • Calling the whole yield spread an illiquidity premium.

    The spread is higher than for public bonds, so students assume it is all for illiquidity.

    Fix: Compare against public credit of the same seniority and rating. Part of the spread pays for credit risk and complexity.

  • Ignoring fund-level leverage and bank links.

    Focus stays on the borrower loan only.

    Fix: Check for subscription lines, credit facilities and bank funding, which amplify losses and create interconnectedness.

Worked examples

Example 1

A fund buys a defaulted bond at 40 per 100 face. Over two years it receives no interest and then recovers 55 per 100 face in the restructuring. What is the total return on the investment and the approximate annualised return?

Show the solution
  1. Total return = (55 − 40) ÷ 40 = 15 ÷ 40 = 0.375, or 37.5%.
  2. Annualised return = (55 ÷ 40)^(1/2) − 1.
  3. 55 ÷ 40 = 1.375. The square root of 1.375 is about 1.1726.
  4. Annualised return ≈ 0.1726, or about 17.3%.

Answer: Total return 37.5%; annualised about 17.3%. The return comes from recovery and timing, not coupons.

Example 2

A direct loan pays the reference rate plus 6.0% spread. A comparable public bond of the same rating and seniority yields a spread of 4.5%. The private loan's expected loss is 1.0% a year and the public bond's is 0.8%. Estimate the extra spread net of expected loss, as compensation for illiquidity and complexity.

Show the solution
  1. Spread difference = 6.0% − 4.5% = 1.5%.
  2. Expected loss difference = 1.0% − 0.8% = 0.2%.
  3. Extra compensation net of expected loss = 1.5% − 0.2% = 1.3%.

Answer: About 1.3% a year is left to compensate for illiquidity and complexity, before fees and unexpected loss.

Exam tips

  • Always locate the instrument in the capital structure first. Most answers follow from seniority.
  • Read for the keyword that signals the strategy: PIK and warrants mean mezzanine; discount and recovery mean distressed.
  • When asked about risk versus public bonds, expect illiquidity, valuation lag, leverage and concentration as correct choices.
  • Reject options that say private credit removes risk or that higher yield is guaranteed.
  • For numbers, write expected loss and return formulas out and compute carefully; options often include the mistake of using price instead of face.

Practice questions from Private Markets Investing

Private Credit and Direct Lending in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Private Credit and Direct Lending: frequently asked questions

How does direct lending work for institutional investors?

An institution commits capital to a fund or account that lends straight to mid-sized companies. Loans are usually senior secured and floating rate, with negotiated covenants. The investor earns spread income, pays fees and accepts limited liquidity.

What is the difference between mezzanine and distressed debt?

Mezzanine is subordinated financing to a going concern, paying a high coupon, often with PIK interest or warrants. Distressed debt is the debt of a troubled or defaulted issuer bought at a discount. Mezzanine earns from income; distressed earns mainly from recovery.

Private credit vs public bonds: how do risk and return compare?

Private credit usually offers a higher spread for illiquidity and complexity, and often stronger covenants. It has weaker price transparency, infrequent valuations and often smaller, more leveraged borrowers. The extra yield is compensation for these risks, not a guarantee.

Is private credit covered in the FRM Part II exam?

Yes. It sits within Risk Management and Investment Management and also connects to the current issues readings, including the BIS paper on private credit. Expect applied questions on strategies, risks and financial stability links.