Private credit and direct lending: floating rates, covenants, default and recovery assumptions and private credit funds

What you will learn

• What private credit and direct lending are and how they differ from bonds and bank loans
• How a floating-rate loan's yield is built and why it has little duration but full credit risk
• How maintenance covenants work and what "covenant-lite" removes
• How to move from gross loan yield to a fund investor's net return after defaults and fees

Explanation

Private credit is lending done by funds rather than banks or bond markets. The largest segment is direct lending: a fund lends to a mid-sized company, often one owned by a private equity sponsor, with a single loan that is not traded. Credit ratings, spreads and seniority were introduced in the course "Bonds & Fixed Income in Depth"; here the focus is on what changes when the loan is private.

How the yield is built

Most private loans are floating rate: interest = base rate + fixed spread. In the euro area the base is usually 3-month Euribor (Euro Interbank Offered Rate); in the US it is SOFR (Secured Overnight Financing Rate). Many loans have a floor on the base rate, so the lender's coupon cannot fall below a minimum. On top of the coupon come an original issue discount (OID) or arrangement fee of typically 1 to 3% paid up front, and sometimes prepayment fees. Because the coupon resets every three months, the loan has almost no interest-rate duration, but every point of credit risk remains.

A unitranche loan blends senior and junior debt into one instrument; PIK (payment-in-kind) interest is added to principal instead of paid in cash, which defers the lender's risk rather than removing it.

Covenants

A covenant is a promise in the loan agreement. Maintenance covenants are tested every quarter, typically a maximum leverage ratio (net debt / EBITDA) and a minimum interest coverage ratio (ICR) (EBITDA / interest expense). A breach gives the lender the right to renegotiate early, charge a fee, raise the spread or take control, long before the company runs out of cash. Covenant-lite loans have only incurrence covenants, tested only when the borrower takes a specific action such as new debt. This delays the lender's warning and is one reason recoveries on covenant-lite loans can be lower.

Default and recovery assumptions

Expected credit loss per year = annual default rate × (1 − recovery rate). Senior secured loans have historically recovered more than unsecured bonds, but recovery depends on the cycle, the covenants and how early the lender acted. If a fund's target return does not state its default and recovery assumptions, assume it is gross of losses.

Private credit funds

Private investors in Europe reach this market through closed-end or semi-liquid funds (see the lesson on ELTIF 2.0) or listed US business development companies. Typical terms: 1 to 1.5% management fee on invested capital, 10 to 20% incentive fee above a hurdle, and often fund-level leverage that raises both yield and loss.

Worked example

Hypothetical example, part 1 – one loan. A fund lends €100 million to a company at 3-month Euribor + 600 basis points (6.0%) with a 2% OID, four-year maturity. Assume Euribor averages 2.5%.

• Coupon: 2.5% + 6.0% = 8.5% per year.
• OID spread over four years: 2% / 4 = 0.5% per year.
• Gross yield: about 9.0% per year.

Part 2 – covenant test. The company has EBITDA of €20 million and net debt of €100 million; covenants: leverage ≤ 5.5×, ICR ≥ 2.0×. At signing: leverage 100 / 20 = 5.0×; ICR 20 / 8.5 = 2.35×. Both pass. A year later EBITDA falls 10% to €18 million: leverage 100 / 18 = 5.56× (breach); ICR 18 / 8.5 = 2.12× (still passes). The leverage covenant triggers a renegotiation while the company can still pay its interest; a covenant-lite loan would have given no signal.

Part 3 – the fund investor's net return. Assume the fund's portfolio earns 9.0% gross, an annual default rate of 3% with 60% recovery, a 1.25% management fee and a 15% incentive fee above a 6% hurdle (no fund leverage).

1. Expected loss: 3% × (1 − 0.60) = 1.2% per year. Yield after losses: 9.0 − 1.2 = 7.8%.
2. After management fee: 7.8 − 1.25 = 6.55%.
3. Incentive fee: 15% × (6.55 − 6.0) = 0.08%. Net to investor: about 6.5% per year.

Sensitivity: if Euribor falls to 1.0%, gross yield drops to 7.5%, after losses 6.3%, after management fee 5.05%, below the hurdle so no incentive fee, net 5.05%. If instead defaults double to 6%, expected loss becomes 2.4% and net return falls to roughly 5.3%. Taxes, fund expenses, cash drag and currency hedging costs are excluded.

Common mistake

Practice activity

On paper: a direct lending fund targets 10% gross yield. Its historical default rate is 4% per year with 50% recovery, management fee 1.0%, incentive fee 10% above a 5% hurdle. Calculate the expected net return to the investor.

Key takeaways

• Private loan yield = base rate + spread + amortised fees; floating rates remove duration but not credit risk.
• Maintenance covenants give lenders an early warning; covenant-lite removes it.
• Always deduct expected loss (default rate × loss given default) and both fee layers before comparing a private credit target with a bond yield.
• Stable reported values reflect infrequent pricing; losses arrive in steps when defaults are recognised.

Next step

In the next lesson you will scale the same credit logic down to the retail level: P2P lending and crowdinvesting platforms in Europe, buyback guarantees and the real net return after defaults.