WHAT IS PRIVATE CREDIT? CORE STRUCTURE

Private credit refers to non-bank credit extended by specialized investment vehicles to small and medium-sized non-financial firms. Understanding fund structure is foundational for the exam.

KEY STRUCTURAL FEATURES

• Deals are directly negotiated between borrower and lender
• Loans held on originator’s balance sheet until maturity
• Most funds are closed-end, locking in capital for 5 to 8 years
• Not traded on exchanges; not available to retail investors
• Illiquid and subject to lighter regulation than banks
• Fund life cycle matches loan maturity, reducing liquidity risk

BUSINESS DEVELOPMENT COMPANIES (BDCs)

BDCs are a critical exception. Many list shares on stock exchanges, allowing access by retail investors. They are federally regulated with mutual-fund-like disclosure. BDCs hold over $300 billion in AUM (~20% of US private credit). Must invest 70%+ in small companies and pay out 90% of income as dividends.

BDCs are the primary vehicle used to analyze cost of capital comparisons with banks in this reading.

LENDING STRATEGIES AND INVESTOR BASE

FUNDRAISING BY STRATEGY TYPE

Direct lending (floating rate, covenant-heavy loans based on cash flow) is the dominant strategy and has grown sharply since 2015. Other strategies include mezzanine, asset-based lending, and distressed debt.

COMPOSITION OF INVESTOR BASE

Capital base dominated by institutional investors: pension funds (30.7%), sovereign wealth funds (23.5%), and private funds (13.6%). Insurance companies have notably increased allocations. Retail investors remain a small but growing share.

GLOBAL GROWTH: SCALE AND SCOPE

GEOGRAPHIC CONCENTRATION

• Global outstanding: ~$100B (2010) to over $1.2 trillion (2024)
• United States: over 87% of total volume
• Europe (ex-UK): ~6%; UK: ~3-4%
• Total AUM now exceeds $2.5 trillion

INDUSTRY DIVERSIFICATION OVER TIME

Manufacturing, TMT, and industrials once accounted for over two thirds of deals. Their share has since fallen below 40%. Newer sectors such as cleantech, life sciences, and financial technology now make up a growing share.

PORTFOLIO CONCENTRATION: BENEFITS AND RISKS

Individual fund portfolios remain highly concentrated. The HHI (Herfindahl-Hirschman index) measures concentration on a 0-to-1 scale. Average HHI: US funds 0.74; non-US funds 0.81 vs. banks at only 0.2 in the syndicated loan market.

WHY SPECIALIZATION CAN BE BENEFICIAL

• Deeper knowledge of borrower characteristics within a narrow sector
• Superior screening and monitoring of riskier, opaque borrowers
• Ability to offer larger loans, lower risk-adjusted rates, and longer maturities
• Willingness to lend to smaller firms with limited tangible collateral

WHY CONCENTRATION ENTAILS RISK

• Elevated sector-specific or regional downturn exposure
• Investors must diversify across multiple funds
• Retail investors may not understand concentration risks
• Greater diversification could erode local expertise
• Larger funds are more diversified: HHI falls as size increases

THE FOUR HYPOTHESES: DRIVERS OF PRIVATE CREDIT GROWTH

The cross-country regression framework tests four hypotheses explaining why private credit is larger in some countries than others. These are core exam concepts.

H1: LOWER POLICY RATES

Low rates compress bank profitability via narrow deposit spreads. Private credit funds gain market share. Low rates also induce yield-seeking, lowering funds’ cost of capital.

H2: UNMET CREDIT DEMAND

About 10% of SMEs in advanced economies and over 20% in EMEs report being credit constrained. Private credit fills this gap with uncollateralized, covenant-tailored loans.

H3: STRICTER BANK REGULATION

Post-GFC capital requirements raised the cost of bank credit to risky firms. Riskier borrowers migrated toward private credit funds, which face no equivalent regulatory constraints.

H4: RISING CORPORATE LEVERAGE

Non-financial corporations have increased leverage substantially. Private credit funds are more willing to lend to highly leveraged firms, so rising NFC debt levels expand the addressable borrower pool.

THE REGRESSION MODEL: EQUATION AND SETUP

ln(P_c,t) = βX_c,t + controls_c,t + θ_c + ε_c,t

SPECIFICATION

Estimated on a panel of 45 countries, Q1 2010 to Q4 2019.

Dependent variable (ln(Pc,t)): log of newly originated private credit loan volume per country per quarter.

KEY EXPLANATORY VARIABLES

The set of explanatory variables Xc,t captures variables related to the four hypotheses laid out earlier.

• Policy rate: Set by national central bank (or ECB for eurozone)
• FI Index: IMF measure of banking system depth, access, efficiency
• Bank stringency: World Bank index of regulatory capital requirements (0-1)
• NFC debt-to-GDP: Leverage of non-financial corporations

Country fixed effects θ_c capture time-invariant factors such as country size, institutional features, and level of economic development.

Controls include GDP, population, and inflation.

REGRESSION RESULTS: INTERPRETING THE EVIDENCE

Key Exam Insight: Banking sector efficiency (FI index) has the largest economic impact, followed by the policy rate. Regulatory stringency and NFC leverage have smaller but statistically meaningful effects.

WHAT THE FI INDEX MEASURES

The Financial Institutions (FI) Index is constructed by the IMF and captures three dimensions of banking sector development. A lower FI index implies banks are less capable of satisfying loan demand, creating space for private credit to expand.

DEPTH (FID)

Measures bank credit to the private sector as % of GDP, pension fund and mutual fund assets to GDP, and insurance premiums to GDP. Captures the overall size of the financial sector relative to the economy.

ACCESS (FIA)

Measures bank branches per 100,000 adults and ATMs per 100,000 adults. Captures the physical and geographical reach of the banking system to potential borrowers.

EFFICIENCY (FIE)

Measures banking sector profitability and cost indicators, including return on equity and net interest margin. Captures how productively the banking system converts inputs into financial services for firms.

Median FI index: 0.79 for advanced economies vs. 0.43 for EMEs. A 0.17 difference (~1 SD) corresponds to a 33% increase in private credit activity.

DEMAND VS. SUPPLY DECOMPOSITION (SVAR EVIDENCE)

A structural vector autoregression (SVAR) model applied to US data (Q1 2004 to Q3 2024) decomposes private credit growth into demand shocks and supply shocks.

PRE-GFC PERIOD: DEMAND DOMINATED

From roughly 2005 to 2012, demand factors drove private credit growth. A growing number of riskier, asset-light firms underserved by traditional banks turned to private credit for more flexible, tailored financing.

POST-GFC (2010–2019): SUPPLY DOMINATED

From 2010 onwards, supply factors became the primary driver. Tighter banking regulation, low policy rates, and attractive yields drew institutional investors into private markets, lowering funds’ cost of capital and expanding credit supply capacity significantly.

COST OF CAPITAL FRAMEWORK: BANKS VS. BDCs

A lower cost of capital allows any lender to offer more competitive loan rates, attract more borrowers, and grow market share. Understanding cost of capital composition is essential for the BDC vs. bank comparison.

COST OF EQUITY (CoE)

The return shareholders require for investing in the firm. Computed using CAPM: risk-free rate plus a risk premium based on market exposure (beta). Higher for firms perceived as riskier by equity markets.

COST OF DEBT (CoD)

The effective after-tax interest rate paid on borrowed funds. BDCs are wholesale-financed at market rates; banks benefit from “sticky” deposit rates that lag policy rate increases.

Exam focus: The WACC spread between BDCs and banks narrowed by approximately 200 basis points between the GFC and 2019.

WACC

Weighted Average Cost of Capital. Combines CoE and CoD by their share in the capital structure:

WACC = [CoD × ^D⁄_V] + [CoP × ^P⁄_V] + [CoE × ^E⁄_V]

where D is total debt, V is total capital, P is preferred equity and E is equity capital

A declining WACC relative to competitors is a funding advantage.

COST OF EQUITY, DEBT, AND CAPITAL: THE CHARTS

COST OF EQUITY (CHART A)

• Banks/BDCs similar pre-2009; banks surged during GFC
• Post-GFC: banks’ CoE remained higher (leverage + systemic risk)

COST OF DEBT (CHART B)

• BDCs’ CoD slightly higher throughout the sample
• Gap widens during Fed tightening → BDCs pay wholesale rates; banks benefit from deposit stickiness

WACC CONVERGENCE (CHART C)

• Pre-GFC: BDC WACC ~200 bps higher
• Spread declined ~250 bps by late 2010s
• Banks’ earlier funding edge effectively eliminated

Key takeaway: CoE drove convergence (banks’ CoE rose post-GFC), while CoD differences were relatively stable. The net effect: banks lost their WACC advantage.

WHAT DROVE THE WACC CONVERGENCE?

Three counterfactual exercises isolate the contribution of each component to the narrowing WACC spread between BDCs and banks.

FACTOR 1: RELATIVE DECLINE IN BDCs’ COST OF EQUITY

• Banks’ CoE rose more than BDCs’ after GFC
• Contributed ~100 bps to spread narrowing (2009–2011)
• Driven by bank solvency concerns, regulatory capital burdens, “low-risk anomaly”

FACTOR 2: STEADY INCREASE IN BDC LEVERAGE

• Contributed ~150 bps to spread reduction after 2010
• D/E ratio: 0.4 (2011) → 1.0+ (2020s)
• Cheap debt during low-rate era reduced WACC even as equity risk rose

FACTOR 3: COST OF DEBT (MINIMAL IMPACT)

• CoD contributed little to convergence
• BDCs’ CoD trended slightly upward relative to banks
• Actually slightly widened the spread (banks’ deposit advantage)

CoE (~100 bps) + Leverage (~150 bps) = ~250 bps of WACC spread reduction. CoD was a minor offset.

BDC LEVERAGE: THE RISING ROLE OF DEBT FINANCING

KEY TREND

• D/E ratio: 0.4 (2011) → 1.0+ (recent years)
• Debt weight in WACC climbed from ~30% to ~50%
• Deliberate strategy to exploit low borrowing costs post-GFC

WHY LEVERAGE LOWERED COST OF CAPITAL

• Substituting cheap debt for expensive equity → lower WACC
• Falling defaults allowed leverage without commensurate CoD/CoE increase
• Regulatory D/E cap of 2:1 limits further expansion

WACC convergence implies banks’ historical funding advantage has substantially eroded, supporting supply-driven private credit growth post-2010

KEY TAKEAWAYS AND EXAM SUMMARY

PRIVATE CREDIT STRUCTURE

• Closed-end funds, hold-to-maturity, not open to retail
• BDCs: listed, regulated, retail-accessible exception
• Direct lending is the dominant strategy

GLOBAL DRIVERS (REGRESSION)

• Lower policy rates → larger private credit
• FI index: largest effect (33%)
• Stricter bank regulation → positive (significant)

COST OF CAPITAL CONVERGENCE

• WACC spread fell ~200 bps (GFC to 2019)
• CoE: ~100 bps + Leverage: ~150 bps = convergence
• CoD changes had minimal net impact

SUPPLY VS. DEMAND

• Pre-GFC: demand factors drove growth
• Post-2010: supply factors dominated (low rates, tighter bank reg)
• Consistent with declining funding costs for PC funds