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

A BDC-style private credit vehicle reports equity of USD 500 million and total assets of USD 1,250 million. Loans are valued at par by the manager. Credit losses of 8% of assets then occur with no change in liabilities. What is the new debt-to-equity ratio, and what does it imply for covenant risk?

The debt-to-equity ratio rises to about 1.88x. Assets of 1,250 million fall by 100 million, so equity drops from 500 to 400 million while debt stays at 750 million. Losses fall first on equity, so leverage climbs and may approach covenant or asset coverage limits.

  1. A1.50x, unchanged because liabilities are unchanged
  2. B1.88x, as equity falls to 400 million and leverage rises, which may approach covenant limitsCorrect
  3. C2.50x, as the loss is applied to equity only as a percentage of equity
  4. D1.00x, because losses reduce debt first

Explanation

Debt is 1,250 - 500 = 750, so initial D/E is 1.5x. Loss is 8% x 1,250 = 100, so equity becomes 400 and debt remains 750. D/E is 750/400 = 1.875x, about 1.88x. Option A ignores that equity absorbs losses first. Rising leverage raises the risk of breaching asset coverage or financial covenants.

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