Private debt: direct lending, mezzanine, distressed

Learning Outcome Statement

Explain features of private debt and its investment characteristics.

On the exam: The question gives a private-debt structure, capital labels, fee terms, credit and valuation facts, and a return label. It asks you to classify the strategy, calculate net cash income, or choose the right risk and valuation comparison in a table or single-best-answer format.

Private debt means lending through a privately negotiated loan rather than a publicly traded debt security. The borrower owes interest and principal, but the lender bears credit risk and may not have a ready resale market. The exam wants you to connect claim priority and borrower condition to return, risk, and value.

The investor may promise more capital than the fund draws. That promise is committed capital. The drawn amount, invested capital, $I$, funds loans and earns interest.

Seniority changes who is paid first when the borrower fails. It does not remove default risk. A subordinated claim or an impaired borrower can support a higher required return because the lender faces more uncertainty.

Read the claim position together with the borrower's condition. A senior secured loan has a stronger place in the repayment order, while subordination delays payment and distress makes recovery depend on restructuring. These differences explain why the required return can rise as expected recovery becomes less certain.

To calculate the investor's net cash income after fees, use invested capital and the annual rates over the holding period. The loan's annual interest rate is $r$, and the management fee rate is $f$. Both are decimal rates per year. For a holding period of $h$ years, call the result $N$.

$$ N = I \times r \times h - I \times f \times h = I \times h \times (r-f) $$

The first product is gross interest and raises $N$. The second product is the management fee paid by the investor and lowers $N$. A larger $I$ or $h$ increases both terms, while a larger $r$ raises $N$ and a larger $f$ lowers it.

Gross return precedes fees. Net return follows fees. The formula gives net cash income, not a return measure.

The capital path is easier to remember as a sequence. It starts with a promise and ends with principal repayment.

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The timeline shows why committed capital is not current exposure. The fund draws capital, lends it, and waits for interest and principal.

The fund sits between the investor and the borrower. The investor supplies capital to the fund, and the borrower pays interest and principal back through the fund.

🔒Private debt fund and borrower cash flows.

The fee base in this illustration is invested capital, not commitment. If a question uses commitment as the base, change the fee calculation. This illustration is unlevered because it includes no fund borrowing. A levered fund adds borrowing and financing costs before the investor's result, which can increase loss risk.

Private debt is usually illiquid because a lender may have no ready resale market. Credit risk comes from missed payments and uncertain recovery. Borrowing at the fund or deal level adds leverage risk. Manager choices affect underwriting, monitoring, and restructuring.

These risks can increase required return. They do not guarantee a liquidity premium.

Use the map directionally. It compares relative liquidity and credit risk, not measured returns.

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Value can look more stable than the underlying economics. A private loan may be carried at an appraisal-based value, and the appraisal can be stale when borrower risk or market yields move. Traded debt has transaction or market value from observed pricing. Identify the value type before judging a reported gain.

A stale appraisal can smooth reported values without making the loan safer.

Performance labels change with cash-flow patterns. Match each label to its cash-flow treatment.

The labels answer different questions. Money-weighted results reflect when the investor contributes and receives cash. A multiple compares value with capital without a timing adjustment, while time-weighted results remove external cash-flow effects. Choose the label that matches the question's purpose before comparing performance.

Use money-weighted performance when calls and distributions are part of the investor experience. Use time-weighted performance when external cash-flow effects must be removed. A multiple-based return shows relative value without showing when cash arrived.

Worked example

You are handed a direct loan to a middle-market borrower. The fund has a commitment, draws part of it, charges a fee on invested capital, and receives principal at the end. The exam asks for investor net cash income and the end receipt.

The chart separates income from the fee. From left to right, its bars show gross interest, the fee outflow, and net cash income from the investor perspective.

Follow the amounts from the fund's invested base: interest adds cash, and the fee subtracts it. The final bar is the investor's net cash income for the year, while principal is returned separately at the end. This keeps income distinct from the total receipt.

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1. Multiply invested capital by the interest rate and holding period. Only drawn capital earns interest, producing gross interest of USD 800,000.
2. Multiply invested capital by the fee rate and holding period. From the investor perspective, the fee outflow is -USD 160,000.
3. Add the gross interest and fee outflow. Net cash income is USD 640,000.
4. Add net cash income to returned principal. The end receipt is USD 8,640,000.
5. Divide invested capital by commitment. The draw ratio is 0.80, showing that some committed capital remains undrawn.

The result is net cash income of USD 640,000 and an end receipt of USD 8,640,000. Label the income as net and unlevered cash income, not as the gross interest rate.

Changed condition

The only change is a lower draw. Commitment, rates, and holding period stay the same.

Your prediction should be that both income measures fall. A lower draw shrinks both interest and fee because both bases are invested capital, not commitment. Net cash income and end receipt both fall, while the commitment stays unchanged, so the draw ratio also falls. Calculate the lower-draw net cash income before reading on.

Common error

You may treat the commitment as the invested amount and quote gross interest as the investor's return. It feels right because the commitment is the headline amount and the loan rate looks like the return. A fee base or return label tied to committed capital, when only invested capital is earning income, gives you the warning.

Calculator

Use invested capital as the input base. The base draw sequence is below.

Enter the drawn amount first, then apply the annual interest and fee rates for one year. Keep the fee negative from the investor's perspective when combining the two amounts. The displayed result is net cash income; adding returned principal gives the end receipt, not another return measure.

The lower draw changes the invested input and the resulting cash amounts. The fee remains a negative investor cash flow.

Compare the two displays by changing only invested capital. With the lower draw, gross interest falls because less capital earns the loan rate, and the fee outflow also falls because the fee uses that same base. Their difference gives net cash income of USD 480,000. The commitment itself does not enter either multiplication.

Check yourself

Revision snapshot

The formula is $N=I \times h \times (r-f)$. The trap is using committed capital as invested capital or quoting gross interest as net investor return. The exam asks you to classify the strategy, calculate net cash income, or select the matching valuation and risk treatment.