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

Private Credit Fund Structures, Investors and Leverage

Updated 11 October 2026 · Fact-checked

Private credit funds pool investor money to lend directly to companies. They are closed-end, open-end, BDCs or interval funds. Investors include pensions, insurers and BDC shareholders. Risk is amplified by fund-level leverage (borrowing against the portfolio) and borrower-level leverage. To solve questions, link liquidity terms, leverage layers and investor type to the risk.

Understand Fund Structures, Investors and Leverage

A private credit fund raises money from investors and lends it to companies, usually mid-sized firms owned by private equity sponsors. Loans are mostly senior, floating-rate and not traded. A manager runs the fund and earns fees.

Structure matters because it sets how liquid the fund is. A closed-end drawdown fund calls capital from investors over time, holds loans to maturity and returns cash over a fixed life, often around 7 to 10 years. Investors cannot withdraw early, so liquidity risk for the fund is low. An open-end or evergreen fund accepts new money and allows redemptions, often quarterly with limits. A BDC (business development company) is a US-regulated vehicle that lends to private firms. It can be publicly traded or non-traded. An interval fund is a registered fund that repurchases a stated percentage of shares at set intervals. Both hold illiquid loans but offer investors some liquidity, which creates a liquidity mismatch.

Investors differ in what they need. Pension funds have long liabilities and can accept illiquidity for extra yield. Insurers match long-dated liabilities and may hold private credit directly or through funds, so credit quality and capital treatment matter. Retail and wealth clients reach the asset class through BDCs and interval funds, where redemption pressure is the main concern.

Fees usually have two parts. A management fee is charged on committed or invested capital. A performance (incentive) fee is charged on income or profits above a hurdle rate, often with a catch-up. Fees on invested assets, including borrowed money, can push managers to add leverage.

Leverage works at two levels. Fund-level leverage is borrowing by the fund, such as subscription lines, credit facilities or securitised financing. It raises returns and losses for investors. Borrower-level leverage is the debt of the companies the fund lends to. Higher borrower debt means thinner interest cover and higher default risk. The two stack: losses at borrowers hit a fund that is itself geared, and lenders to the fund, often banks, are then exposed. This links private credit to banks and to systemic risk.

Key formulas to remember

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.

How to solve Fund Structures, Investors and Leverage questions

Use this order for any question on private credit fund structure, investors or leverage.

  1. 1Identify the vehicle: closed-end drawdown, open-end evergreen, BDC or interval fund.
  2. 2Compare asset liquidity (illiquid loans) with investor liquidity (redemption terms) and name any mismatch.
  3. 3Identify the investor type and what constrains it: pension long horizon, insurer liability matching and capital, retail redemption behaviour.
  4. 4Locate leverage at fund level and at borrower level, and note whether lenders to the fund are banks.
  5. 5If numbers are given, compute the leverage multiplier first (assets ÷ equity), then apply it to returns or losses.
  6. 6Check fee terms: base, hurdle and catch-up, and whether fees on assets reward more leverage.
  7. 7State the risk in precise terms: liquidity mismatch, amplified losses, valuation opacity, or bank interconnectedness.
  8. 8Match the answer to what was asked and check the numbers and units.

Quickest way: Multiplier-first shortcut

When to use it: Use for numerical questions on leveraged returns or losses, and for quick conceptual elimination.

  1. Compute multiplier = (E + D) ÷ E.
  2. Multiply the asset loss by the multiplier to get the equity loss; for gains, use the ROE formula.
  3. For concept questions, eliminate options that claim closed-end funds face redemption runs or that leverage lowers risk.
  4. Pick the option that links structure, liquidity and leverage together.

Common mistakes in Fund Structures, Investors and Leverage

  • Treating interval funds and BDCs as the same as closed-end drawdown funds for liquidity.

    All three hold the same illiquid loans.

    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.

    Both are called leverage.

    Fix: Read the definition. Debt-to-equity divides by equity. With debt ₹60 and equity ₹40, D/E is 1.5, not 0.6.

  • Applying the multiplier as D ÷ E instead of 1 + D ÷ E.

    Forgetting the equity base is also exposed to the loss.

    Fix: Equity loss = asset loss × assets ÷ equity.

  • Looking at only fund-level or only borrower-level leverage.

    Questions often name just one.

    Fix: Ask where the other layer sits. Stacked leverage is the core amplification point.

  • Assuming insurers and pensions face the same constraints.

    Both are long-term investors.

    Fix: Insurers face liability matching and capital charges. Pensions focus on funding ratio and long horizons.

  • Applying a hurdle fee to total return rather than excess return.

    Skipping the catch-up condition.

    Fix: Without catch-up, fee applies only above the hurdle. With full catch-up, the manager receives the rate on all profit once the hurdle is cleared.

Worked examples

Example 1

A private credit fund has equity of $400 million and borrows $600 million through a credit facility. Its loans lose 5% of value. Ignoring financing costs, what is the loss on equity?

Show the solution
  1. Assets = 400 + 600 = $1,000 million.
  2. Asset loss = 5% × 1,000 = $50 million.
  3. Equity loss % = 50 ÷ 400 = 12.5%.
  4. Check: multiplier = 1,000 ÷ 400 = 2.5; 5% × 2.5 = 12.5%.

Answer: The equity loses 12.5% ($50 million).

Example 2

A fund earns 9% on assets, borrows at 6%, and has debt-to-equity of 1.5. Ignoring fees and taxes, what is the return on equity?

Show the solution
  1. Use ROE = r_A + (D ÷ E) × (r_A − r_D).
  2. Spread = 9% − 6% = 3%.
  3. Leverage effect = 1.5 × 3% = 4.5%.
  4. ROE = 9% + 4.5% = 13.5%.

Answer: Return on equity is 13.5%.

Exam tips

  • Always separate asset liquidity from investor liquidity; many questions test the mismatch in interval funds and non-traded BDCs.
  • Compute the multiplier as assets ÷ equity before anything else.
  • Watch for stacked leverage: a geared fund lending to geared borrowers, financed by banks.
  • Name the investor and its constraint: insurer capital and matching, pension long horizon, retail redemptions.
  • Do not claim leverage only raises returns; it widens losses by the same multiplier.

Practice questions from The Rise and Risks of Private Credit

Fund Structures, Investors and Leverage in other exams

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

Fund Structures, Investors and Leverage: frequently asked questions

What is the difference between a BDC and an interval fund?

A BDC is a US-regulated vehicle that lends to private companies and can be listed or non-traded. An interval fund is a registered fund that repurchases a stated share of its units at set intervals. Both hold illiquid loans and offer investors some liquidity.

How do private credit funds use leverage?

They borrow through subscription lines, credit facilities or securitised financing to hold more loans than their equity allows. This raises returns when loans perform and magnifies losses when they do not. The borrowers also carry their own debt.

Why do insurers and pension funds invest in private credit?

They have long-dated liabilities and can accept illiquidity in exchange for extra yield. Insurers must also consider capital treatment and credit quality of the holdings.

Closed-end or open-end: which has more liquidity risk?

Open-end and evergreen structures carry more, because investors can redeem while the loans cannot be sold quickly. Closed-end drawdown funds lock capital for a fixed life, so redemption runs are not an issue.