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FRM Exam Part II · The Rise and Risks of Private Credit

Private Credit: Credit, Valuation and Illiquidity Risks

Updated 11 October 2026 · Fact-checked

Private credit risk has four linked parts: borrower default risk, weak underwriting with covenant-lite terms, opaque mark-to-model valuation, and illiquidity from redemption mismatches. To solve a question, find which risk is tested, check what the reported number hides, then judge how losses or outflows could arrive together under stress.

Understand Credit, Valuation and Illiquidity Risks

Private credit is lending by non-bank funds directly to firms, usually mid-sized and often owned by private equity sponsors. There is no public market price. The loan is held, not traded. That one fact drives most of the risks in this topic.

Borrower default risk is the first layer. Borrowers are often highly leveraged and floating-rate. When policy rates rise, interest costs rise and coverage ratios fall. Expected loss is still PD × LGD × EAD. The exam asks you to see why PD may be understated: short track records, no full credit cycle, and recoveries that depend on how strong the loan documents are.

Weak underwriting and covenant-lite terms make it worse. Covenants are early-warning triggers, for example a maximum leverage ratio. If they are loose or absent, lenders cannot step in until a payment is missed. Default then comes later, but recovery can be lower because the borrower has had longer to erode value. Competition for deals pushes terms looser. Be careful with headline default rates: PIK (payment-in-kind) interest lets a borrower add interest to principal instead of paying cash. A loan can look performing while it is under stress. Rising PIK share, amendments and extensions are signs of hidden stress.

Valuation is mark-to-model. The manager estimates fair value using discounted cash flows, comparable spreads or recent deal terms. Inputs are judgemental and updated slowly, so reported returns look smooth and volatility looks low. This is stale or smoothed pricing. It hides drawdowns, understates risk and can delay recognition of losses. Independent valuation, governance and back-testing against actual sale prices are the controls.

Illiquidity risk is a mismatch. Loans are long-dated and hard to sell. Some vehicles offer investors periodic redemptions. If many investors ask out at once, the fund must sell the best assets, gate redemptions or borrow. Fund leverage, credit lines and bank links can amplify this. Selling at a discount shows that the model value was too high. Remember that the key idea is correlation: weak credit, marked-up values and redemption pressure tend to arrive together.

Key formulas to remember

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.

How to solve Credit, Valuation and Illiquidity Risks questions

Use this order for any question on private credit credit, valuation or illiquidity risk.

  1. 1Identify which risk the question tests: default, underwriting and covenants, valuation, or liquidity mismatch.
  2. 2Read what the reported figure measures. Ask whether it is cash-based or model-based, and whether PIK or amendments are included.
  3. 3Name the mechanism: for example covenant-lite terms delay the trigger, or smoothing hides volatility.
  4. 4Do any needed calculation: EL, cash coverage, PIK share, unsmoothed return or redemption coverage.
  5. 5Interpret the number. State whether true risk is higher or lower than shown, and why.
  6. 6Link to other risks. Ask if defaults, valuation marks and redemptions could move together under stress.
  7. 7Pick the control or answer that addresses the root cause, such as independent valuation, covenants, liquidity buffers or gates.

Quickest way: Spot the hidden-risk clue

When to use it: Use when you have about two minutes and the options look similar.

  1. Scan the stem for a keyword: PIK, covenant-lite, mark-to-model, smooth returns, redemptions, gate.
  2. Match it: PIK means hidden credit stress; mark-to-model means understated volatility; redemptions mean liquidity mismatch.
  3. Eliminate options that treat reported numbers as fully reliable.
  4. If a calculation is needed, do only the one formula that fits and check direction: does the risk go up or down?

Common mistakes in Credit, Valuation and Illiquidity Risks

  • Treating low reported volatility as low risk

    Private credit marks look stable, so the numbers seem safe.

    Fix: Remember marks are model-based and smoothed. Unsmoothing raises volatility and lowers the apparent Sharpe ratio.

  • Counting PIK loans as performing without caution

    Interest is still accrued, so income looks intact.

    Fix: Check cash coverage. PIK means no cash was paid. A growing PIK share points to hidden stress.

  • Saying covenant-lite means higher default probability immediately

    Students link weak terms directly to more defaults.

    Fix: Covenant-lite mainly delays lender intervention. Defaults may arrive later and recoveries may be lower.

  • Using a default rate without checking the cycle

    Low observed defaults are read as a stable long-run PD.

    Fix: Ask whether the sample includes a full downturn. Short, benign history understates through-the-cycle PD.

  • Ignoring the liability side of the fund

    Focus stays on loan quality.

    Fix: Compare redemption terms with asset liquidity. Long loans with frequent redemptions create a run risk.

  • Setting LGD as 1 + recovery rate or confusing recovery with LGD

    Rushing under time pressure.

    Fix: LGD = 1 − recovery rate. A 60% recovery means 40% LGD.

Worked examples

Example 1

A private credit loan has EAD of USD 50 million, PD of 4% and a recovery rate of 55%. Compute expected loss. If weak covenants cut recovery to 40%, what is the new expected loss?

Show the solution
  1. Original LGD = 1 − 0.55 = 0.45.
  2. Original EL = 0.04 × 0.45 × 50 million = 0.018 × 50 million = USD 0.9 million.
  3. New LGD = 1 − 0.40 = 0.60.
  4. New EL = 0.04 × 0.60 × 50 million = 0.024 × 50 million = USD 1.2 million.
  5. Increase = 1.2 − 0.9 = USD 0.3 million.

Answer: Expected loss rises from USD 0.9 million to USD 1.2 million, an increase of one third, purely from lower recovery.

Example 2

A borrower has EBITDA of USD 30 million. Total interest is USD 20 million, of which USD 8 million is PIK. Compute the total interest coverage, cash interest coverage and PIK share, then interpret.

Show the solution
  1. Total coverage = 30 ÷ 20 = 1.5x.
  2. Cash interest = 20 − 8 = USD 12 million.
  3. Cash coverage = 30 ÷ 12 = 2.5x.
  4. PIK share = 8 ÷ 20 = 40%.
  5. Interpretation: cash coverage looks comfortable, but the borrower is deferring 40% of interest. Total coverage of 1.5x is thin, and the unpaid interest adds to debt.

Answer: Total coverage 1.5x, cash coverage 2.5x, PIK share 40%. The cash figure hides stress, so total coverage is the better guide to credit quality.

Exam tips

  • When a stem mentions PIK, amendments or extensions, the answer is usually hidden credit stress, not strong performance.
  • For mark-to-model questions, the correct option nearly always says volatility and drawdowns are understated and independent valuation is the control.
  • Liquidity questions test the asset-liability mismatch. Look for redemption terms, leverage and gates.
  • Do the one calculation asked and state direction. Many options differ only by sign or by a recovery versus LGD swap.

Practice questions from The Rise and Risks of Private Credit

Credit, Valuation and Illiquidity Risks: frequently asked questions

Why is mark-to-model a risk in private credit?

There is no market price, so the manager estimates value with models and judgemental inputs. Marks are updated slowly, which smooths returns and hides losses until late. Independent valuation and comparison with actual sale prices reduce the risk.

Why can PIK interest signal hidden stress?

PIK interest is added to principal rather than paid in cash. The loan appears to perform while the borrower is not paying. A rising PIK share means debt grows and cash coverage is weak.

How do you measure illiquidity risk in private credit?

Compare liquid assets with likely redemption requests, review redemption terms and fund leverage, and run stress scenarios. You can also unsmooth returns to see true volatility. A coverage ratio below 1 shows the fund may need to sell, gate or borrow.

Does covenant-lite lending always raise default rates?

Not always. It removes early triggers, so lenders act later. Defaults may be delayed, but recoveries are often lower because value has eroded further.