GF500 Unit 10 Private Credit Sector Appraisal Example

Lending to the Lenders on Conditions: A Unit 10 Market Sector Appraisal of Private Credit for a Bank Credit Committee

[Student Name]

Purdue University Global

GF500: Financial Institutions and Markets

Unit 10 Market Sector Appraisal

[Instructor Name]

[Date]

The bank, the three funds and every facility figure are composite; the sector estimates, reports and articles cited are real, with figures rounded.

Summary for the Committee

Private credit is large, growing and so far performing, but its losses are hard to see quickly because most loans float with short rates and are valued by models rather than by trades. The bank can lend to the three funds safely only if its facilities are protected against those two features. The recommendation is to approve $300 million in total on four conditions: advance rates no higher than 55 percent of eligible loan value, an independent quarterly valuation of a sample of the collateral, borrower interest coverage tests applied loan by loan, and a single-borrower concentration limit of 5 percent of the pledged pool.

How Large the Sector Is and Why It Grew

The International Monetary Fund estimated that private credit funds held about $2.1 trillion in assets and committed capital worldwide by 2023, with roughly three quarters of that in the United States (International Monetary Fund, 2024). Growth began after 2010. Tighter bank capital and supervisory guidance made banks less willing to hold loans to highly indebted mid-sized companies, and funds raised from pensions and insurers stepped in. Research comparing firms that borrow from banks with firms that borrow from nonbank lenders finds that the nonbank borrowers are more often unprofitable or heavily indebted, the kind of firm bank rules discourage, and that they pay noticeably higher interest for the access (Chernenko et al., 2022). The sector, in other words, did not take the banks' customers so much as the customers banks had stopped serving.

Who Stands Behind the Funds

A direct lending fund raises equity commitments from long-term investors, chiefly pension plans, insurers, endowments and wealthy individuals, and draws them down as it makes loans. It then borrows against those loans to raise its returns, and that borrowing is where this bank would enter. A survey of private debt fund managers found that most lend senior and secured, focus on a borrower's cash earnings when sizing a loan and hold loans to maturity rather than trading them (Block et al., 2024). Business development companies, a public form of the same lender, add equity raised from retail investors.

The three applicants follow this pattern. Fund A holds $900 million of senior loans to 48 companies and seeks $120 million. Fund B holds $700 million across 35 companies, mostly in software and health care services, and seeks $100 million. Fund C, a newer fund, holds $450 million across 22 companies and seeks $80 million.

Borrower Quality and Rate Sensitivity

Loans in the three pools carry an average of about 5.2 times debt to EBITDA, with coupons set about 5.75 percentage points over the Secured Overnight Financing Rate, so with short rates near 5.3 percent the typical borrower pays roughly 11 percent. A representative borrower with $40 million of EBITDA and $208 million of debt therefore pays about $22.9 million of interest a year, covering it about 1.75 times.

Because the loans float, a 200-basis-point rise in short rates would lift that borrower's interest to about $27.0 million, cutting coverage to about 1.48 times, before any fall in earnings. If EBITDA fell 15 percent at the same time, as it might in a recession that arrived alongside high rates, coverage would drop to about 1.26 times. The Federal Reserve has flagged the same pattern, noting that the share of private credit borrowers with interest coverage below one rose as rates climbed, though defaults remained moderate (Board of Governors of the Federal Reserve System, 2024).

The sector's main weakness for a lender to the funds is not that its borrowers are risky, which is priced, but that rising rates and falling earnings hit the same borrowers at the same time while the funds' valuations may take several quarters to show it.

The Valuation Lag

Private loans rarely trade, so funds value them with models, usually discounting expected payments at a rate drawn from comparable loans. Marks move slowly, and a fund's managers have reason to keep them steady. The IMF noted that reported values in private credit fell far less than traded leveraged loans in 2022, which may reflect either genuine stability or slow recognition (International Monetary Fund, 2024). For the bank, the lag matters because its advance rate is applied to those same marks. If a pool's true value has fallen 10 percent and the marks have not, a 55 percent advance is really closer to 61 percent of what the collateral would fetch.

Comparing the Three Applicants

Fund A is the strongest. Its pool is diversified, its largest single loan is 3.8 percent of the total, and its manager has run three earlier funds through the 2020 shock without a loss to lenders. Fund B is concentrated in two sectors that have held up well but have similar exposure to rate rises, since many of its borrowers were bought by private equity firms at high prices. Its largest loan is 6.4 percent of the pool, above the proposed limit. Fund C has the shortest record, the fewest loans and two loans already on its watch list, and it values the pool through the manager alone, with no outside firm involved.

Conditions for Approval

First, advance rates should be set no higher than 55 percent of eligible loan value, falling to 45 percent for any loan with coverage below 1.5 times. Second, an outside valuation firm, chosen by the bank, should value a quarter of each pool every quarter, so that the whole pool is reviewed each year and stale marks surface. Third, eligibility should depend on each borrower's own coverage and debt ratio, tested quarterly, rather than on the pool's average, because averages hide the weakest loans. Fourth, no single borrower should exceed 5 percent of a pledged pool; Fund B would need to remove or partly exclude its largest loan.

With these conditions, the recommendation is to approve Fund A for $120 million and Fund B for $100 million now, and to defer Fund C for two quarters until its watch-list loans resolve and it engages an outside valuation firm.

Limits of the Appraisal

The sector is young enough that it has not been tested by a long recession at high rates. Published size estimates differ by source, and data on defaults are reported by managers themselves. The bank's protections reduce, but do not remove, the risk that losses appear in the collateral before they appear in the marks.

References

Block, J., Jang, Y. S., Kaplan, S. N., & Schulze, A. (2024). A survey of private debt funds. The Review of Corporate Finance Studies, 13(2), 335-383. https://doi.org/10.1093/rcfs/cfae001

Board of Governors of the Federal Reserve System. (2024). Financial stability report (May 2024). https://www.federalreserve.gov/publications/financial-stability-report.htm

Chernenko, S., Erel, I., & Prilmeier, R. (2022). Why do firms borrow directly from nonbanks? The Review of Financial Studies, 35(11), 4902-4947. https://doi.org/10.1093/rfs/hhac016

International Monetary Fund. (2024). Global financial stability report: The last mile: Financial vulnerabilities and risks (April 2024). https://www.imf.org/en/Publications/GFSR/Issues/2024/04/16/global-financial-stability-report-april-2024