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Characterise and judge the risks and weak points of private credit, and show how it can threaten financial stability.

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

The idea

The main weak points of private credit are opacity, valuation, liquidity mismatch, leverage and interconnection. Loans are valued by managers using models, so losses can be recognised late. Borrowers are highly levered and pay floating rates, so a rise in the base rate cuts interest coverage and raises defaults. Payment-in-kind interest and amendments can hide distress, so low reported non-accruals may overstate health. Funds add leverage through credit lines and NAV loans. Semi-liquid vehicles sold to retail investors promise periodic redemptions against illiquid loans. Banks lend to the funds and insurers hold the assets, so losses can spread to regulated institutions. For fund leverage, let A be assets, E equity and D debt, so that assets equal equity plus debt. Fund leverage amplifies returns both ways. ROE = (A ÷ E) × asset return − (D ÷ E) × borrowing cost. Stability threats come from linkages and hidden leverage, not just size.

Formulas

Return on equity of a leveraged fund

equity return = (A ÷ E) × asset return − (D ÷ E) × borrowing cost

A
the fund's assets
E
the fund's equity
D
the fund's debt
asset return
the return on the loan portfolio
borrowing cost
the interest rate on the fund's debt

Scale the asset return by assets over equity, not debt over equity, and still deduct interest when assets lose value.

Interest coverage ratio

coverage = EBITDA ÷ interest

EBITDA
earnings before interest, tax, depreciation and amortisation
interest
the annual interest cost, debt times base rate plus spread

On a floating-rate loan a higher base rate raises interest straight away, so coverage falls with EBITDA unchanged.

A practice question

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

Which channel most directly links private credit to the stability of the banking system?

  1. Banks lend to private credit funds, so fund stress can return to bank balance sheets - correct
  2. Private credit funds take insured deposits from retail savers and lend them onWhy not: Funds raise capital from investors, not deposits.
  3. Banks are forbidden from having any exposure to private credit funds or their borrowersWhy not: Banks do lend to these funds; the exposure is the concern.
  4. Private credit loans are guaranteed by central banks in a crisisWhy not: There is no such guarantee, which is part of the stability concern.

Bank lending to non-bank financial institutions, including private credit vehicles, creates a transmission route: losses or drawdowns on credit lines can hit banks and amplify stress.

A harder one

A semi-liquid private credit fund allows redemptions of up to 5% of net asset value per quarter, pro rata. Redemption requests total 12% of NAV. What fraction of each investor's request is met, closest to?

  1. 100%Why not: Ignores the redemption limit and assumes all requests are met.
  2. 58.3%Why not: Reports the unmet fraction rather than the fraction paid.
  3. 41.7% - correct
  4. 5.0%Why not: Reports the limit as a percentage of NAV rather than as a fraction of each request.

Paid fraction = 5%/12% = 41.7%. Each investor receives about 42% of the request. The mismatch between promised liquidity and illiquid loans is the weak point, and gates only delay the problem.

The hardest tier

A fund holds assets of 250 financed by equity of 100 and debt of 150 at 6% interest. If the loan portfolio loses 4% over the year, the return on equity is closest to:

  1. -10.0%Why not: Scales the asset loss by A/E but ignores interest on the borrowing.
  2. -19.0% - correct
  3. -15.0%Why not: Uses the debt-to-equity ratio instead of assets-to-equity ratio on the asset loss.
  4. -13.0%Why not: Adds the interest cost to the unlevered loss without scaling the asset loss by A/E.

Equity return = (250/100) x (-4%) - (150/100) x 6% = -10% - 9% = -19%. Leverage multiplies losses, which is how fund-level borrowing amplifies stress.

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