Explain how private credit has grown and what it returns, and compare its track record of returns against that of other asset classes.

FRM® Part II · Risk Management and Investment Management · The Rise and Risks of Private Credit · FRM2.IM.10.b

The idea

Private credit grew from a small niche after the 2008 crisis to a market usually estimated at well over one trillion US dollars. Banks pulled back from leveraged lending under tighter capital and supervisory rules, while institutional investors searched for yield, floating-rate income and diversification. Returns come from the base rate plus a wide spread, upfront fees and original issue discount, less credit losses and fund fees. Reported returns look strong and smooth. But valuations are model-based and infrequent, which creates appraisal smoothing. Reported volatility is understated, so Sharpe ratios look too good against marked-to-market bonds or equities. Let φ be the first-order autocorrelation of reported returns. Then true volatility is roughly the reported volatility times an adjustment factor. Adjustment = √((1 + φ) ÷ (1 − φ)). Also remember that the track record covers mostly benign credit conditions and low defaults.

Formulas

Unsmoothed volatility of appraisal-based returns

σ true = σ reported × √[(1 + φ) ÷ (1 − φ)]

σ reported: the reported volatility
φ: the first-order autocorrelation of reported returns

For positive φ the true figure is higher. Take the square root of the factor, and adjust upwards, not downwards.

Expected annual net return on a direct loan

net return = base rate + spread + OID ÷ life − PD × LGD − fees

base rate: the floating reference rate, such as SOFR
spread: the loan's spread
OID: the original issue discount
life: the loan's expected life in years
PD: the annual default probability
LGD: the loss given default
fees: annual fund fees

Expected loss is probability times severity, not the default probability alone. Do not leave out the base rate.

Compound annual growth rate

CAGR = (end ÷ start)^(1 ÷ n) − 1

end: the final size
start: the initial size
n: the number of years

Compound, not simple: dividing total growth by n overstates the rate. Count periods, not observations.

A practice question

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

Which factor most directly explains the rapid growth of private credit after the 2008 financial crisis?

Regulators forced insurers to sell all of their bonds and to buy private loans insteadWhy not: No such mandate existed; the growth reflected investor demand for yield, not forced purchases.
Banks retrenched from leveraged lending under tighter rules while investors sought yield - correct
A rise in bank deposit insurance limits that made loans cheaper for banks to fundWhy not: Confuses bank funding with the non-bank lending channel; deposit insurance is unrelated to private credit growth.
A collapse in demand for loans from sponsor-owned companies after the crisisWhy not: Demand for sponsor-backed financing was strong; the shift was in who supplied it.

Post-crisis capital and supervisory rules made banks less willing to hold riskier middle-market loans. Non-bank managers stepped in, helped by investors seeking floating-rate income and higher yields in a low-rate environment.

A harder one

A private credit market grows from USD 400 billion to USD 1,600 billion over 8 years. The compound annual growth rate is closest to:

37.5%Why not: Divides total growth of 300% by 8 years, which is a simple rate, not a compound rate.
21.9%Why not: Uses 7 periods instead of 8 in the compounding exponent.
18.9% - correct
17.3%Why not: Gives the continuously compounded rate, ln(4)/8, rather than the annual compound rate asked for.

Growth multiple = 1,600/400 = 4. CAGR = 4^(1/8) - 1 = 18.9%. Simple averaging overstates growth, and counting the wrong number of periods changes the answer.

The hardest tier

A direct loan pays SOFR (4.0%) plus 5.5%, with a 2.4% original issue discount over a four-year life, spread evenly. Annual default probability is 3%, loss given default is 40%, and fund fees are 1.0% a year. The expected annual net return is closest to:

6.1%Why not: Deducts the full 3% default probability as the loss, ignoring that only 40% of exposure is lost.
7.9% - correct
7.3%Why not: Omits the original issue discount of 0.6% a year.
3.9%Why not: Leaves out the base rate and counts only the spread, discount, loss and fees.

Gross yield = 4.0 + 5.5 + 2.4/4 = 10.1%. Expected loss = 3% x 40% = 1.2%. Net = 10.1 - 1.2 - 1.0 = 7.9%. Loss rate is probability times severity.

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