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Judge how private credit lending stacks up against bank lending, and how movements in equity costs, debt costs and leverage have reshaped rivalry between them.

FRM® Part II · Current Issues in Financial Markets · The Global Drivers of Private Credit · FRM2.CI.3.c

The idea

Banks and private credit funds compete for the same borrowers on funding cost and leverage. In a simplified before-tax model, a lender's break-even loan yield must cover its weighted average cost of capital plus expected credit losses and operating costs, all as percentages of the same loan balance and period. WACC = (E ÷ V) × cost of equity + (D ÷ V) × cost of debt. Here E is equity, D is debt and V is their total, in a before-tax WACC. Banks fund mostly with cheap deposits and debt but face capital requirements, so a higher risk weight raises risk-weighted assets and, all else equal, required capital. More equity changes the funding mix, not the cost of equity. Many funds use longer-dated, locked-up capital under different regulation, which can support lending that banks find less attractive. They usually carry a higher cost of equity and often higher borrowing costs. Cheaper fund debt or more leverage helps funds, and heavier capital charges hurt banks. Leverage raises the cost of equity, so ignoring that overstates the gain. Exam point: use the right weights and let equity costs move with leverage.

Formulas

Before-tax weighted average cost of funding a loan

WACC = (E ÷ V) × rE + (D ÷ V) × rD

E
equity funding
D
debt funding
V
equity plus debt
rE
the cost of equity
rD
the cost of debt

A simplified before-tax model. When leverage rises, the cost of equity rises too, so recompute the weights and let rE move.

Break-even loan yield for a lender

break-even yield = WACC + expected loss + operating cost

WACC
the lender's weighted average cost of funding
expected loss
expected credit losses as a percentage of the loan
operating cost
operating costs as a percentage of the loan

All three must be on the same loan balance and period. Comparing a bank and a fund on funding cost alone ignores losses and costs.

A practice question

From the question bank, with the reason each wrong option is wrong.

Which feature best explains why private credit funds can lend to riskier borrowers than banks typically can?

  1. They fund loans with insured retail deposits that are cheap and stableWhy not: Describes banks; funds have no deposits.
  2. They are required to hold more risk-weighted capital than banks, which lets them take on more riskWhy not: Reverses the regulation: banks, not funds, face the binding risk-weighted capital rules.
  3. They have access to central bank liquidity facilities that banks lackWhy not: Reverses the access; central bank facilities are available to banks, not to funds.
  4. Longer-dated, locked-up committed capital with no deposit run risk, and in many structures different prudential regulation, so asset-liability mismatch and risk-weight charges bind less - correct

Funds often draw on committed, locked-up capital and, in many structures, face different prudential rules from banks, so they can hold illiquid, riskier loans without runs or heavy capital charges. This is a common structural difference, not a universal rule. Banks have deposits, regulation and central bank access.

A harder one

A private credit fund is financed with 40% equity costing 14% and 60% debt costing 7.5%. Ignoring credit losses and operating costs, the minimum loan yield needed to cover its funding cost is closest to:

  1. 10.1% - correct
  2. 10.75%Why not: Takes the simple average of 14% and 7.5% instead of weighting by funding shares.
  3. 11.4%Why not: Applies the weights the wrong way round, 60% to equity and 40% to debt.
  4. 13.1%Why not: Weights equity at 40% (5.6%) but adds the full 7.5% debt cost without weighting by 60%.

WACC = 0.40 x 14% + 0.60 x 7.5% = 5.6% + 4.5% = 10.1%. The weights are each source's share of total funding.

The hardest tier

A private credit fund is financed 50% by equity at 13% and 50% by debt at 8%. It raises leverage to a debt-to-equity ratio of 2, its debt cost falls to 6.5% and, because of the extra leverage, its cost of equity rises to 15%. The new weighted cost of funding and its change are closest to:

  1. 8.7%, a fall of about 1.8 percentage pointsWhy not: Keeps the cost of equity at 13% and so ignores that more leverage raises the cost of equity.
  2. 9.3%, a fall of about 1.2 percentage points - correct
  3. 10.75%, a rise of about 0.25 percentage pointsWhy not: Takes the simple average of 15% and 6.5% and ignores the new funding weights.
  4. 12.2%, a rise of about 1.7 percentage pointsWhy not: Reverses the weights, using 2/3 for equity and 1/3 for debt, when debt-to-equity of 2 means debt is 2/3.

Before: 0.5 x 13 + 0.5 x 8 = 10.5%. After, D/E = 2 gives equity 1/3 and debt 2/3: (1/3) x 15 + (2/3) x 6.5 = 5.0 + 4.33 = 9.33%. A fall of about 1.2 points, smaller than if equity cost had stayed at 13%.

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