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

Private Credit Risk Management and Regulatory Considerations

Updated 11 October 2026 · Fact-checked

Private credit risk management combines due diligence before investing, stress testing of portfolios and leverage, and ongoing monitoring of valuations and covenants. Regulators debate how far to extend disclosure and oversight because data on loans, leverage and bank links are patchy. For exam questions, match each tool to the risk it addresses.

Understand Risk Management and Regulatory Considerations

Private credit is lending by non-bank funds directly to companies. The loans are usually illiquid, bespoke, floating-rate and held to maturity. They are not traded, so there is no daily market price. Risk managers must therefore rely on models, manager reports and their own checks.

The main risks are credit risk (borrower default, often mid-sized and leveraged firms), valuation risk (marks come from models or the manager, and can lag reality), illiquidity risk (investors may not be able to exit when they want), leverage risk (fund-level borrowing amplifies losses) and interconnectedness (banks lend to private credit funds and share exposures).

The management toolkit follows these risks. Due diligence tests the manager before you commit: strategy, track record, underwriting standards, valuation policy, governance and operations. Stress testing asks what happens to defaults, recoveries, interest coverage, fund leverage and liquidity under a severe scenario such as higher rates plus a recession. Monitoring tracks covenants, watch-list loans, payment-in-kind use, amendments and valuation changes over time. Transparency means investors and supervisors get enough loan-level and fund-level information to see concentrations and leverage.

The regulatory debate is about gaps. Private credit funds are lightly regulated compared with banks, and data on total size, borrower leverage, fund borrowing and bank links are incomplete. Supporters of more oversight point to possible build-up of hidden risk and contagion to banks and insurers. Critics note that funds often use long-term capital and limited redemption rights, which can make them less run-prone than banks. Both views agree that better data come first. Policy responses include more reporting, system-wide stress tests, and closer supervision of bank exposures to funds.

In the exam, expect short case-style questions. You will choose the best tool, spot a weakness in a manager's process, or identify the gap that blocks risk assessment.

Key formulas to remember

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.

How to solve Risk Management and Regulatory Considerations questions

Use this method for any question on managing or regulating private credit.

1Identify the risk in the case: credit, valuation, illiquidity, leverage or interconnectedness.
2Identify the stage: before investing (due diligence), during holding (monitoring), or forward-looking (stress testing).
3Pick the tool that matches the risk and stage. Valuation concerns point to valuation policy review and independent pricing. Hidden leverage points to look-through and fund-level stress tests.
4If numbers are given, compute the relevant metric first (coverage, leverage, EL, equity loss) under both base and stressed inputs.
5Interpret the result against a limit, covenant or buffer, and say what it means for the investor or bank.
6For regulation questions, state the gap (data, disclosure, leverage visibility, bank links) and the policy response that closes it.
7Eliminate options that overstate: private credit is not proven to cause a crisis, and it is not risk-free either.

Quickest way: Match risk to tool

When to use it: Use when a multiple-choice question asks which action or tool is most appropriate.

Underline the risk word in the stem: valuation, leverage, liquidity, concentration or data.
Valuation: independent valuation and challenge of marks.
Leverage or contagion: look-through exposure data and system-wide stress tests.
Manager quality or fraud: operational due diligence and references.
Deteriorating borrowers: covenant monitoring and watch-lists.
Choose the option that acts directly on that risk, not a generic one.

Common mistakes in Risk Management and Regulatory Considerations

Treating manager-reported valuations as market prices.
Public bond habits carry over to loans that never trade.
Fix: Remember marks are model-based and can lag. Ask about independent valuation and how stale marks are.
Stress testing only default rates.
PD is the most familiar input.
Fix: Stress PD, LGD, interest coverage, fund leverage and investor liquidity together.
Ignoring floating rates in stress tests.
Candidates think of rate rises as a market-risk issue only.
Fix: Higher base rates raise borrower interest cost and cut coverage, turning rate risk into credit risk.
Saying private credit funds are as run-prone as banks.
Overlap with bank-run language.
Fix: Closed-end funds with limited redemptions are less run-prone, but fund leverage and bank credit lines can still transmit stress.
Confusing due diligence with ongoing monitoring.
Both involve reviewing the manager.
Fix: Due diligence is the pre-investment assessment. Monitoring is continuous review after commitment.
Claiming regulators have complete data on private credit.
Assuming all funds report like banks.
Fix: The core debate is incomplete data on size, leverage and bank links, so better reporting is the first step.

Worked examples

Example 1

A private credit borrower has EBITDA of $40 million and floating-rate debt of $250 million at an all-in rate of 8%. Rates rise so the all-in rate becomes 11%, and EBITDA falls 25%. What is the interest coverage before and after, and what does it signal?

Show the solution

Before: interest = 250 × 8% = $20 million.
Coverage before = 40 ÷ 20 = 2.0x.
After: interest = 250 × 11% = $27.5 million.
Stressed EBITDA = 40 × 0.75 = $30 million.
Coverage after = 30 ÷ 27.5 ≈ 1.09x.
Interpretation: earnings barely cover interest, so default risk and covenant breach risk rise sharply.

Answer: Coverage falls from 2.0x to about 1.09x. The loan would likely sit on a watch-list and a stress test should raise its PD.

Example 2

A fund holds loans worth $300 million financed by $100 million equity and $200 million borrowing. In a stress scenario the loans lose 8% of value. Ignoring financing costs, what is the loss on equity, and which risk does it show?

Show the solution

Fund leverage = 300 ÷ 100 = 3.0x.
Asset loss = 300 × 8% = $24 million.
Loss on equity = 24 ÷ 100 = 24%.
Check: 8% × 3 = 24%.
This shows leverage risk: borrowing magnifies a modest asset loss into a large equity loss and may trigger lender margin or covenant action.

Answer: Equity loses 24% ($24 million). It illustrates leverage amplification, so stress tests should be run at fund level, not only loan level.

Exam tips

Questions are usually short cases: name the risk, then the best tool. Do that before reading the options.
Know the regulatory theme: data gaps and opacity, not a proven crisis. Choose balanced wording.
Do quick arithmetic on coverage and leverage under stress; the numbers are simple but the interpretation earns the mark.
Link private credit to banks through credit lines to funds and shared borrowers when asked about systemic risk.
Distinguish due diligence (before), monitoring (during) and stress testing (forward-looking).

Practice questions from The Rise and Risks of Private Credit

Risk Management and Regulatory Considerations: frequently asked questions

What are the best practices for managing private credit risk?

Run thorough due diligence on managers, stress test portfolios and fund leverage, and monitor covenants and valuations continuously. Add independent valuation and concentration limits. Together these address credit, valuation, liquidity and leverage risk.

How do you stress test a private credit portfolio?

Define a severe but plausible scenario, such as higher rates and a recession. Apply it to defaults, recoveries, interest coverage and fund leverage. Then check liquidity needs and losses against buffers and limits.

What are the data gaps in private credit?

Information on total market size, loan-level terms, borrower leverage, fund borrowing and links with banks is incomplete. Valuations are also not market-observed. This limits supervisors' and investors' ability to see risk build-up.

How do you do due diligence on a private credit manager?

Review strategy, track record through a cycle, underwriting standards, valuation policy, governance, conflicts of interest and operations. Check how the manager handles distressed loans and what leverage it uses. Seek independent verification of key claims.