Private loans are priced by building up from a risk-free rate, adding compensation for defaults, for being unable to sell, and for the intermediary. Values between lending and repayment are mostly estimates.
11 min read · Level 3
I think the illiquidity premium is the most overstated part of private credit's pitch. In theory investors are paid extra for tying money up. In practice, when a lot of money chases private lending, competition compresses the premium while the illiquidity stays exactly the same. Before accepting a lock-up, it is worth asking whether you are actually being paid for it today.
A loan's interest rate can be built up like this:
Base rate (e.g. government or reference rate) 4% Expected annual loss 3% Illiquidity and uncertainty premium 2% Platform or manager fees 1% Rate charged to the borrower 10%
The part above the base rate is the credit spread: here 6%, or 600 basis points. An investor who receives all of it after fees and losses earns the base rate plus the illiquidity premium - about 6% in this stack.
Many private loans, especially to companies, pay a floating rate: a reference rate plus a fixed margin. When reference rates rise, interest income rises, but so does the borrower's burden, which can increase defaults.
Between lending and repayment, private loans have no trading price. Funds usually value them at cost unless there is evidence of impairment, or estimate value using models. As with private equity, this makes reported values smoother than those of listed high-yield bonds, which fall immediately when credit conditions worsen.
Because it shows what the extra yield is for. If a loan pays 6 percentage points over the base rate, most of that is meant to cover losses and the cost of being unable to sell. It is not surplus.
It also warns about smooth valuations. A credit fund reporting stable values while listed high-yield bonds fall 15% may not be safer - its values may simply not have been updated yet.
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Educational, not personalised financial advice. Nothing in the Investor Academy is a recommendation to buy, sell or hold anything — what is right for you depends on your own circumstances and the rules where you live.
Sources: U.S. SEC - Investor.gov; IOSCO - global securities regulators; CFA Institute
Floating rate cuts both ways. A company borrows 5,000,000 at the reference rate plus 6%.
Reference rate Loan rate Annual interest Company EBITDA Interest coverage 1% 7% 350,000 1,000,000 2.9x 5% 11% 550,000 1,000,000 1.8x
The lender's income rose from 350,000 to 550,000. The company's ability to cover interest fell from about 2.9 times to about 1.8 times. If EBITDA then falls to 700,000, coverage drops to about 1.3 times, and the risk of default rises sharply.
Assuming rising interest rates are purely good for a private lender. Higher rates raise income and also raise the chance that borrowers cannot pay.
Estimate how much of the rate covers the base rate, expected losses, illiquidity and fees.
For floating loans, test borrowers' interest coverage at higher reference rates.
Look at how a credit fund's reported value moved when listed high-yield bond prices fell.
When judging whether a loan's rate is fair compensation or reading a private credit fund's valuations.
Do not treat the illustrative stack as a formula used by every lender. Actual pricing depends on the borrower, market conditions and competition.
The International Monetary Fund, in its Global Financial Stability Report, and several central banks have published analysis noting the rapid growth of private credit, the opacity of its valuations and the potential for losses to surface slowly in a downturn.
When official bodies flag valuation opacity as a system-level concern, an individual investor should not assume a fund's reported stability reflects its true risk.
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