Private Debt comprises…
Private Credit
Cash Based Strategies
Asset Based Strategies
Insurance Linked Securities
Structuring
Credit Risk
Credit Derivatives
Difference Private Debt and Private Credit
Private Debt = Asset Class
Private Credit = Investment Strategy
Private Credit Types
Leveraged Loans
Direct Lending
Mezzanine Debt
Distressed Debt
Emergence Private Credit
Grew from $200bn in 2007 -> $1.6tr in 2023
Banks reduced lending post GFC due to increased regulations
Private Credit Vehicles
PE Funds
Hedge Funds
BDCs
Private Credit Strategies
Loan-to-own strategy
Fulcrum securities strategy
Private Credit Strategies: Loan-to-own
Loans made expecting default
Goal is asset repossession or control
Used in distress situations
Private Credit Strategies: Fulcrum Securities
Senior debt that is not repaid in cash during bankruptcy
Conversion into equity in reorganized firm
Value from post-reorg ownership
ISDA Agreement
Standardized template for OTC derivatives -> also credit agreements (credit risk in derivatives)
Provides commonly used legal and credit provisions
Reduces negotiation time between market participants
Fixed Income Analysis - Credit Risk e.g. Corporate Bond Yield
Corporate bond yield = risk free rate + credit spread
Credit spread compensates for default risk & illiquidity
Higher credit risk -> higher spread
Private Credit Rating
Typically unrated
Implied credit quality -> B
Falls in speculative (high yield) grade
Credit Ratings
Investment Grade
Lower credit risk
Lower spreads
Speculative Grade
Higher credit risk
Higher spreads
Credit Ratings: Moody’s & S&P/Fitch
Moody’s: Aaa, Aa, A, Baa
S&P/Fitch: AAA, AA, A, BBB
Moody’s: Ba, B, Caa, Ca, C, D
S&P/Fitch: BB, B, CCC, CC, C, D
Fixed Income - Covenant Contract
Indenture -> legal contract between borrower & lender
Includes covenants to protect credit/collateral quality -> no quality decrease
Types of Covenants
Affirmative -> borrower must do
Negative -> borrower must not do
Incurrence -> covenant tested for specific action (new debt-taking)
Maintenance -> must be met regularly
Covenant-Lite Loans
Growth of covenant-lite loans since 2007
Weaker lender protections
Minimal covenants
Covenants: Risk Control
Preserve Collateral (max. LTV)
Control Cash Flow (no dividends)
Limit business risk (limit debt)
Performance requirements (solvency ratios)
Reporting requirements (performance)
FIxed Income Analysis - Capital Stack Hierarchy
Senior debt
High priority
High recovery rates
Low risk/return
Junior debt
Low priority
Low recovery rates
High risk/return
Capital Stack Hierarchy: Senior Debt
Senior Secured First-Lien Debt
Senior Secured Second-Lien Debt
Senior Unsecured Debt
Capital Stack Hierarchy: Junior Debt
Junior / mezzanine / subordinated debt
Preferred Equity
Common Equity
Fixed Income Analysis: Bonds vs. Loans
Bonds offer liquidity but higher credit and interest rate risk
Loans offer seniority and protection but lower liquidity
Fixed Income Analysis: Bonds
Market
Regulation
Liquidity
Default Risk
Interest Rate Risk
Market: Public
Regulation: Higher
Liquidity: Higher
Default Risk: Less senior (riskier)
Interest Rate Risk: Higher (fixed coupon; non-callable)
Fixed Income Analysis: Loans
Market: Private
Regulation: Lower
Liquidity: Lower
Default Risk: More senior (less risky)
Interest Rate Risk: Lower (floating rate; prepayable)
Syndicated (group of) bank loans to non-investment grade
Used for large borrowers -> first or second lien
Coupon: pays 1.25%-2% above market rate (e.g. SOFR)
Growth in Leveraged Loans
Growth boosted by secondary market -> affter credit rating inception 1990
Led to originate-to-distribute model -> bank originate loans and sell to investors to move risk & collect fee
Market relies on CLOs & mutual funds
Lending to mid-sized borrowers
No bank as intermediary
Includes Asset-Based Lending
Direct Lending: Asset-Based Lending
Revolving Loans -> secured by inventory & receivables
Term Loans -> secured by PPE (Property, Plant, Equipment)
Direct Lending: Investor Skills
Credit Analysis
Legal Expertise (restructuring)
Strong access to deal flow
Sits between Senior Debt and Equity in capital stack
Hybrid instrument -> debt & equity features
Mezzanine Debt: Common Structures
Convertible Bonds
Subordinated Bonds + Warrants
Convertible Preferred Shares
Mezzanine Debt: Exit Strategy
IPO or large equity issuance
J-curve no issue -> regular, immediate cash returns
Characteristics: Leveraged Loans
Borrower Size
Seniority
Asset Claim
Credit Rating
Covenants
Term
Principal Repayment
Coupon Form
Coupon Rate
Prepayment Penalty
Equity Kicker
Recovery Rate
Borrower Size: Large
Seniority: First / Second Seniority
Asset Claim: First Second Lien
Credit Rating: Required
Covenants: Extensive
Term: 5 years
Principal Repayment: Install Payments
Coupon Form: Cash / Floating
Coupon Rate: Floating + Spread
Prepayment Penalty: None
Equity Kicker: No
Recovery Rate: 60%-100%
Liquidity: High
Characteristics: High-Yield Bonds
Seniority: Subordinated Seniority
Asset Claim: Unsecured
Covenants: Moderate
Term: 7-10 years
Principal Repayment: Bullet Payments (only interest during loan; principal at maturity)
Coupon Form: Cash / Fixed
Coupon Rate: 5%-8%
Prepayment Penalty: Large
Equity Kicker: Potentially
Recovery Rate: 40%-50%
Liquidity: Low
Characteristics: Mezzanine Debt
Borrower Size: Medium
Seniority: Lowest Seniority
Credit Rating: Not Required
Covenants: Limited
Term: 4-6 years
Principal Repayment: Bullet Payments
Coupon Form: Cash / PIK / Fixed
Coupon Rate: 8%-11%
Prepayment Penalty: Moderate
Equity Kicker: Always
Recovery Rate: 20%-30%
Liquidity: Minimal
Payment In Kind (PIK)
Interest is not paid in cash during loan
Interest is capitalized -> added to principal
Principal + accrued interest repaid at maturity
Mezzanine Financing: Uses
MBOs
Growth
Acquisitions
Recapitalizations
Real Estate
LBOs
Bridge Financing
Mezzanine Financing: Investors
Mezzanine Funds
Insurance Companies
Banks -> stretch financing (senior lenders lend more than usual; higher leverage)
Mezzanine Financing: Characteristics
Board representation
Borrower restrictions
Flexibility -> Acceleration
Assignment -> cannot be sold without consent
Takeout provisions -> option to repay
Advanced Mezzanine Features
Subordinated Debt with Step-Up Rates
Subordinated Debt with PIK Interest
Subordinated Debt with Profit Participation
Advanced Mezzanine Features: Subordinated Debt with Step-Up Rates
Interest rate increases over time
Lower cash burden in early years
Step-up may depend on meeting financial targets
Advanced Mezzanine Features: Subordinated Debt with PIK Interest
No cash interest paid until maturity or refinance
Interest capitalized into principal
PIK toggle lets borrower choose cash vs. PIK -> each interest period
Advanced Mezzanine Features: Subordinated Debt with Warrants
Used for higher-risk borrowers
Provides equity upside to investors
Warrants give right to buy shares in the future
Mezzanine Finance: Project Finance
Capital raised for a specific project
Secured by project assets and cash flows
Common in real estate and infrastructure
Project Finance: PPP
Public-private partnerships use mezzanine
Public sector defines required service
Private partner finances, builds, and operates project
Project revenues or government payments repay debt and generate returns
Venture Debt
Debt financing for VC-backed companies
Provided by specialized banks and venture debt funds
Target IRR: 12%–18%
Venture Debt: Key Terms
Volume
Duration
Interest rate
Fees
Dilutions
Repayment
Volume: $1M-$20M
Duration: 1-3 years
Interest rate: 9%-15%
Fees: 1%-2%
Dilutions: warrants covering 5%-15% loan amount -> <2% equity dilution
Covenants: minimal / none
Repayment: at next financing round
Venture Debt: Reasons for Issuance -> Founder Perspective
Reduces Equity Dilution
Cheaper than equity financing
Faster / simpler than equity raise
Capital to reach milestones
Venture Debt: Risks
Focus on loss prevention -> not warrant upside and receive startup shares
Low default rates (3%)
Defualts limited by VC follow-on financing -> pay debt
Issuer in or near default
Distressed Debt: Criteria
Meet one of following:
Credit rating equal/lower CCC/Caa
Market price < 50% less than of par (face value)
Yield > 10% above risk-free rate
Face Value
Amount printed on bond & issuer to repay at maturity
Usually 100 per bond
Face value = principal owed
U.S. Bankruptcy Processes
Chapter 7
Chapter 11
U.S. Bankruptcy Processes: Chapter 7
Liquidation
Liquidation of assets
Business ceases operations
U.S. Bankruptcy Processes: Chapter 11
Reorganization
WIthin 120 days: debtor files plan
Next 60 days: debtor negotiates with creditors
After 180 days: no plan accepted -> any claimant may file a plan
U.S. Bankruptcy Terms: Prepacked filing
Reorganization plan agreed with creditors before court filing
U.S. Bankruptcy Terms: Classification of Claims
Similar debt claims grouped into classes
U.S. Bankruptcy Terms: Acceptance Level
Plan approved by >50% of claimants and ≥66% of claim value in each class
U.S. Bankruptcy Terms: Blocking Position
Holding ≥33⅓% of a class can block approval
U.S. Bankruptcy Terms: Absolute Priority
Claims paid in strict order of seniority
U.S. Bankruptcy Terms: Cramdown
Court confirms plan despite creditor objections
U.S. Bankruptcy Terms: Debtor-in-possession (DIP) financing
New, super-priority secured funding during bankruptcy
Distressed Debt: Investment Approaches
Debt-to-equity swap for control
Debt or debt-to-equity without control
Undervalued distressed securities
DIstressed Debt: Debt-to-Equity Swap for Control
Investor buys distressed debt at discount
In bankruptcy/restructuring -> debt converted to equity
Investor controlling shareholder -> leads operations
DIstressed Debt: Debt or Debt-to-Equity Without Control
Investor holds debt or converts to minority equity stake
No intention to control management
Goal is to benefit from company recovery -> sell when credit quality improves
DIstressed Debt: Undervalued Distressed Securities
Investor buys debt or equity priced below intrinsic value
Market overly pessimistic about default or recovery
No need for restructuring -> profit from market re-rating
Expected Credit Loss Rate
Measures expected loss from defaults
Minimum loss compensation a credit spread must cover -> then add risk premium
Default Rate * (1 - Recovery Rate)
Expected Credit Loss Rate: Investor Outperformance
Investor outperforms when:
Credit spread > Credit loss rate + required risk premium
Expected Credit Loss Rate: Example Required Credit Spread
Default Rate: 10%
Loss given default: 70%
Risk premium: 5%
Credit loss rate: 10% * (1 - 0.7) = 7%
Minimum required credit spread: 7% + 5% = 12%
Vulture Investors
Distressed debt investors
Invest in companies in or near bankruptcy
Seek profit from restructuring, recovery / control
Vulture Investors: Observation
Active / positive role in restructuring -> resolve bad debt
Credit cycles are driven by monetary policy -> not investors
Key skill: identify fulcrum security -> rising leverage; up in capital stack
Negative perception -> negative connotation of loan-to-own (buy low; sell high)
Private Credit: Performance
Volatility -> low (exacerbated by smoothing)
Correlations -> High for all types except DL
Returns -> Distressed debt & DL highest returns
Timing -> deployment in crisis outperformed
Unitranche Debt
Single loan combining senior and junior debt in one instrument
Haircut
Reduction of claims accepted by creditors in bankruptcy
PIK Toggle
Option to pay interest in cash or by adding to principal each interest period
Sponsored Lending
Mezzanine lending backed by PE sponsor
Stretch Financing
Lender lends amount above traditional limits
Higher interest & possible equity kicker
Ticking Fee
Fee paid by borrower between commitment and funding
Compensates for capital being reserved
Accrues until loan is drawn
Distressed Debt: Instruments
Asset-Based Loans
Asset-Backed Securities (ABS)
Distressed Debt: Asset-Based Loans
Loan to distressed borrowers
Loan secured by specific assets
Revolving loans -> short-term, liquid assets (inventory, receivables)
Term loans -> long-term, fixed assets (PPE)
Distressed Debt: Asset-Backed Securities
RMBS (Residential Mortgage-Backed Securities)
CMBS (Commercial Mortgage-Backed Securities)
Auto-Loan ABS
Credit-Card ABS
Asset-Backed Securities: RMBS & CMBS
RMBS
Securities backed by home mortgages -> monthly mortgage payments
CPR (Conditional Prepayment Rate) -> measures how fast borrowers repay early
CMBS
Securities backed by commercial property mortgages
Cash flows from rental -> less frequent prepayment than RMBS
Asset-Based Lending
Loan secured by specific collateral
Typical collateral
Receivables, inventory, real estate
Loan size: $10M - $50M
Asset-Based Lending: Borrowers
SMIDs
Non-investment grade firms
High working capital needs
Asset-Based Lending: Investor Protection
SPVs
Lockbox
Asset-Based Lending: Investor Protection - SPV
Use SPV to hold collateral
Protects assets from borrowers bankruptcy
Gives lender direct control over collateral
Asset-Based Lending: Investor Protection - Lockbox
Customer payments go into a lender-controlled account
Borrower cannot divert cash flows
Ensures debt service is paid first
Reduces cash flow diversion risk
Collateral Amount
Total value of assets supporting the loan
Assets are pledged to lender if default
Borrowing Base
Maximum loan amount lender willing to lend after reducing collateral to reflect senior claim
Amount is calculated from value of eligible collateral -> deselect ineligible values
Advance Rate
% lent per dollar of collateral
Seasonal Overadvance
Temporary higher advance rate for seasonality
Used to fund seasonal working capital needs
Traditional Overadvance
Higher advance rate in acquisition or LBO
ABL: Use by Larger/Smaller/Distressed Companies
Larger companies -> fund working capital
Smaller companies -> component of capital structure
Distressed companies -> bridge loan for restructuring
ABL: Typical Loan Structure
Revolving + Term Loan
Revolving -> like credit card
Preapproved limit drawable by borrower; used for working capital
Term -> long-term loan; borrow once
Repayment is gradual (amortizing) or at end (bullet)
Secured against fixed assets
ABL: Lender Protection and Covenants
Key Ratio
Fixed Charge (FC) coverage
(EBIT/FC) / (interest+FC)
Covenant Flexibility
often springing covenants -> activated only in distress
ABL: Risks
Valuation Risk (Change in collateral value)
People & Process Risk (Lender controls borrower)
Hedging Risk (Difficult to hedge as private & illiquid; basis risk)
Legal Risk (Ensure security interest)
Timing/Exit Risk (Default & collateral lose value)
ABS: Mortgage-backed Security (MBS)
Security backed by a pool of mortgages
Investors receive cash flows from mortgage payments
MBS: Types
Pass-through MBS -> investor receive pro-rata share of interest & principal repayment of pooled mortgage
Collaterized Mortgage Obligation (CMO) -> Cash flows are restructured into tranches (maturity, risk) with different priorities
Low credit risk -> supported by U.S. government
Prepaymenr risk -> borrower’s right to repay early -> affect size & timing of returns
Prepayment Risk: Characteristics
Lower interest rates
Path Dependence
Other drivers of prepayment
regional economic activity, maturity
Prepayment Risk: Lower Interest Rates
Hiher prepayment due to:
borrower refinancing when rates fall (low opportunity costs)
Home sales increase -> mortgages repaid early
Investor -> reinvestment risk: early repayment, reinvest at lower rate -> income declines
Prepayment Risk: Path Dependence
Prepayment depend on past interest rate moves
Refinancing burnout:
Borrower refinance once -> after many refinancings -> further rate cuts don’t increase prepayments
Estimating Prepayment Speed: Public Securities Association - PSA Model
PSA Benchmark
Standard for modeling mortgage prepayments
Expressed as CPR -> Conditional Prepayment Rate
PSA Model: Assumptions
Standard: 100(%) PSA
CPR = 0.2% Month 1
CPR increase = 0.2% per Month until Month 30
CPR = 6% capped after Month 30
200 PSA -> twice speed / 50 PSA -> half speed
MBS and Default Risk
Models focus on forecasting cash flow & mortgage pools
Agency RMBS -> government-backed, low credit risk -> prepayment & interest rate risk
Non-Agency RMBS & CMBS -> no guarantee, higher credit risk -> focus on defaults & loss correlation
Alternative Mortgage Structures
Graduated payment mortgages
Option ARMs
Balloon payment loans
Alternative Mortgage Structures: Graduated Payment Mortgages
Low payments at start
Payments increase over time
Risk -> payments become unaffordable
Alternative Mortgage Structures: Option ARMs (Adjustable-Rate Mortgages)
Flexible payments in early years
Borrower may pay less than full interest -> negative amortization
full payment
interest-only payment
minimum payment (less than interest -> outstanding interwest added to balance)
Risk -> loan balance grow over time
Alternative Mortgage Structures: Balloon Payment Loans
Small regular payments
Large final payment at maturity
Risk of default -> often requires refinancing
Historically -> investors focused on in inrest rate & prepayment risk
Post-GFC -> default risk matters (especially subprime mort)
Default Risk KPIs Considerations
Debt-to-income ratio (low prio)
Loan-to-value ratio (low prio)
Credit score (high prio)
Subprime Mortgages
Home loans to borrowers with weak credit quality
Characteristics: low credit score -> high DTI / LTV
Carry higher interest rate to compensate default risk
Mortgage REIT Returns - Oberservations
Avg. Return -> rel. high (above equities)
Volatility -> very high (highly levered / unstable returns)
Sharpe -> low (poor risk-adj. perf.)
Skewness -> strongly negative (large downside risk)
Kurtosis -> very high (extreme tail events)
Mortgage REIT Returns - Interpretation
Mortgage REITs offer high returns but severe downside risk (max. DD of 70%)
Not equity substitutes -> behave like leveraged credit strategies
Auto-Loan Backed Securities (ALBS)
Car loan backed by the car
ABS backed by a pool of auto loans -> CF from car loan payments
ALBS: Risks
Prepayment Risk
Driven by vehicle sales, trade-ins, accidents, repo
No government backing & recourse loan
Loans may be prime, near-prime or subprime
Classfication Prime, Near-Prime, Subprime
Prime -> strong credit quality
Near-Prime -> avg / weaker credit quality
Subprime -> poor credit quality
Subprime Credit Enhancements
Overcollaterization
Collateral principal > securities (loan sum) issued
Reserve accounts
Excess interest retained -> part of interet goes to res. ac. for bad times
Protects senior tranches from losses
Credit Card Receivables (CCR)
Amounts (receivables) owed by consumers on credit cards
Receivables generate interest and fee payments
Receivables are pooled and securitized into one credit-card ABS for investor
CCR: Characteristics
Short-lived collateral -> receivables are repaid / reborrowed frequently
Master trust structure —> multiple ABS series
Interest-only (lockout) period -> after: principal amortization period
Recourse loans -> lender can pursue borrower’s other assets
CCR: Credit Enhancements
External credit enhancements
Cash collateral account
3. party guarantor
Collatal invested amounts (CIA)
Internal credit enhancements
Subordination
Spread accounts (cash for losses at exit)
Overcollateralization
Attachment of Security Interest
Legal process -> lender gets right to seize collateral
Applies if default
Net Leverage Covenant
Covenant that limits how much net debt borrower can have
Common in cash-based loans
Protects lender from excessive borrowing
Perfecting the Security Interest
Borrower legally assures that no other party can make a claim on the respective collateral
Critical in default event
Shadow Banking System
Non-bank lenders (e.g., private credit funds)
Provide loans when banks reduces credit due to regulation
Funds operating outside traditional banking rules
Negative Amortization
Interest owed is greater than interest paid
Unpaid interest is added to the loan balance
Common in option ARMs
Basis Risk
Risk that hedge does not perfectly offset actual losses
Occurs when payout is based on different reference than exposure
Cat Bond: Definition
Risk-transfer security -> convert insurance risk into tradable securities with high yield and event-driven downside
Insurance hedge event risk -> investor receives coupon payments
Event -> investor loses (part of) principal -> used to pay insurance claim
Cat Bond: Parties involved
Insurance company -> wants protection against losses
SPV -> to issue the bond
Investors -> provide capital and earn risk premium
Cat Bond: Setup
Investors buy cat bond issued by SPV
Investor principal -> collateral trust
Collateral invested in safe assets (e.g., Treasuries)
Cat Bond: No Catastrophe
Insurance company pays insurance premiums to SPV
Investor receives
risk-free rate (from collateral)
Risk premium (insurance premium passed through)
Cat Bond: Catastrophe
Defined insured event happens
Investors loses (part of) principal
Principal used to pay insurance company’s claims
Cat Bond: 4 Triggers
Indemnity
Industry loss
Parametric
Modeled
Cat Bond Trigger: Indemnity
Payout based in issuer’s actual insurance losses
Losses are between attachment (loss start) & exhaustion point (max. loss)
Pro -> payout amounts actual loss (no basis risk)
Con -> moral hazard (insurer incentive to adjust losses) & time to settle (no knowledge of losses quickly)
Cat Bond Trigger: Industry Loss
Payout based on total industry losses
Losses estimated by idnependent 3. Party
Trade-off -> issuer bears basis risk
Cat Bond Trigger: Parametric
Payout triggered by exceeding set natural parameters (Richter scale)
Payout is fast and objective
High basis risk -> parameter doesn’t capture losses
Trigger occurs but insurer has low losses or vice versa
Cat Bond Trigger: Modeled
Payout based on modeled loss estimates
Uses independent catastrophe model
Trade-off -> faster than indemnity / less basis risk than parametric
Cat Bond: Coupon
Total Coupon rate = SOFR + Spread
Spread = constant + (loss multiple * exp. loss)
Exp. loss = (porb. of event * annual monetary loss) / principal
SOFR
Secured Overnight Financing Rate
Risk-free reference interest rate
Base rate for floating-rate instrument
Replaced LIBOR
SOFR Methodology
SOFR based on overnight repo transactions
Repo transaction = one party borrows cash overnight and returns next day
Borrower gives U.S. Treasury securities as collateral
U.S. Treasury Types
Treasury bills -> short-term
Treasury notes -> medium-term
Treasury bonds -> long-term
-> all securities are highly liquid & safe -> near risk-free rate
Cat Bond: Risks
Low liquidity (infrequent rading, wide spreads)
Negative skew (rare but large losses)
Issuer credit risk (non-catastrophe-related loss risk; SPV failure)
Cat Bond: Risk Premium
Alternative Beta (comp for event not market risk)
Alpha Opportunities
Security selection (choosing risk/return cat bonds)
Market timing (after event)
Complexity arbitrage (exploit opportunities others avoid)
Life ILS (Life Insurance-Linked Securities): Longevity Risk
Policyholder living longer than expected -> prolonging payouts
Faced by insurers, pension plans, social security programs
Hedged through longevity swaps
Index-based
Indemnity-based
Longevity Swap: Parties
Pension fund -> wants to hedge longevity risk
Counterparty -> takes longevity risk
Longevity Swap: Cash Flow Structure
Pension fund pays fixed payments
Based on assumed mortality rates + margin
Counterparty pays floating payments
Based on actual mortality experience of the pension plan
Longevity increase -> payment increase
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