Characterise how private credit funds are built and what defines them, along with how the asset class has expanded worldwide.
The idea
A private credit fund is a non-bank pool of capital that originates and holds loans directly to companies. These are most often mid-sized, sponsor-backed firms that find public bond markets or bank syndicates less suitable. The usual structure is a closed-end limited partnership. A general partner manages the fund, and institutional limited partners such as pension funds, insurers and endowments commit capital that is drawn down over an investment period. The life is fixed at roughly seven to ten years. Fees are normally charged on committed capital during the investment period and on invested capital afterwards. Loans are mostly senior secured and floating rate. Some funds add fund-level borrowing, so return on equity is amplified by leverage. Locked-up capital means no deposit-style runs. The asset class began mainly in the United States and has since spread to Europe and other regions, though the US remains the largest market. Exam point: define the fund by its structure, not by the borrowers it serves.
Formulas
Return on equity of a leveraged private credit fund
ROE = y + (D ÷ E) × (y − rD)
- y
- the gross yield on the fund's loans
- D
- fund-level borrowing
- E
- the fund's equity
- rD
- the interest rate on the fund's borrowing
No losses or fees, and loans equal to equity plus borrowing. Leverage helps only while the loan yield exceeds the borrowing rate; the same formula amplifies losses when it does not.
A practice question
Which description best characterises a typical private credit fund?
- A deposit-funded institution that lends out insured retail deposits and is subject to Basel capital and liquidity rulesWhy not: Describes a bank, which is the competitor of a private credit fund rather than the fund itself.
- A non-bank, usually closed-end vehicle that pools committed institutional capital and lends directly to firms, mostly holding loans to maturity - correct
- An open-end vehicle offering daily redemption that invests mainly in tradable investment-grade bondsWhy not: Describes a mutual bond fund; private credit loans are illiquid and investor capital is locked up.
- A securitisation conduit that buys loans from banks and funds them with short-term commercial paperWhy not: Confuses the fund with an ABCP conduit; private credit funds originate loans directly and use committed equity.
Private credit funds are typically closed-end partnerships funded by committed institutional capital that originate and hold loans directly. Banks use deposits, bond funds offer liquidity and conduits buy loans from others.
A harder one
A private credit fund charges a management fee of 1.25% per year on committed capital during its investment period. Commitments are USD 800 million, 55% has been drawn, and the fund also borrows an amount equal to 50% of drawn capital. What is the management fee for the year?
- USD 10 million - correct
- USD 5.5 millionWhy not: Charges the fee on drawn (invested) capital of 440; during the investment period the fee base is committed capital.
- USD 4.5 millionWhy not: Charges the fee on uncalled commitments of 360, which is neither the committed nor the invested base.
- USD 8.25 millionWhy not: Charges the fee on gross assets of 660 (drawn capital plus fund-level borrowing); leverage does not enter a fee on commitments.
The fee base is committed capital: 800 x 1.25% = USD 10.0 million. Drawn capital (440), uncalled capital (360) and gross assets with borrowing (660) are all the wrong base.
The hardest tier
A private credit fund has equity of USD 400 million and fund-level borrowing of USD 200 million at 6%. Its USD 600 million of loans earn a gross yield of 9% and there are no losses or fees. What is the return on equity?
- 10.0%Why not: Weights the 3% spread by debt over assets (200/600) instead of debt over equity (200/400).
- 7.0%Why not: Divides net income (54 - 12 = 42) by total assets of 600 instead of by equity of 400.
- 9.0%Why not: Reports the unlevered asset yield and ignores the effect of fund-level leverage.
- 10.5% - correct
Income = 600 x 9% = 54; interest = 200 x 6% = 12; net = 42; ROE = 42 / 400 = 10.5%. Equivalent: 9% + (D/E)(9% - 6%) = 9% + 0.5 x 3%.
In the app: 6 practice questions on this outcome, spaced review that brings it back before you forget it.
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