Private Equity & Private Debt — Private Credit and Asset-Based Strategies

Private Equity & Private Debt — Private Credit and Asset-Based Strategies

CAIA Level I Study Guide

What Is It?

1. Private credit is non-bank lending to private companies, secured by assets or cash flows, offering higher yields than public debt.
2. Tested via valuation methods, risk assessment, and structuring in exams; applied in direct lending, distressed debt, and asset-based finance; audited for compliance with covenants and collateral quality.

Why Does the Exam Ask This?

CAIA tests this to assess: - Valuation judgment (discount rates, recovery assumptions) - Risk differentiation (senior vs. mezzanine, secured vs. unsecured) - Structuring logic (covenants, collateral priority, waterfall payments) - Regulatory awareness (shadow banking risks, Basel III capital rules) - Operational due diligence (loan servicing, workout scenarios)

What Do I Need to Know First?

1. Capital structure (senior debt, subordinated debt, equity)
2. Time value of money (IRR, NPV, discount rates)
3. Credit risk fundamentals (default probability, loss given default)
4. Collateral types (real estate, inventory, receivables, IP)
5. Covenant basics (maintenance vs. incurrence, EBITDA adjustments)

Topic Snapshot

Private credit sits at the intersection of alternative debt and private markets in CAIA. It matters because: - Yield premium: Illiquidity and complexity command higher returns than public bonds. - Diversification: Low correlation to public markets (but higher idiosyncratic risk). - Structural flexibility: Tailored terms (e.g., PIK toggles, equity kickers) absent in public debt. - Regulatory arbitrage: Non-bank lenders fill gaps left by Basel III’s bank capital constraints.

Exam / Job / Audit Weighting

• Frequency: 8–12% of Level I (10–15 questions)
• Difficulty Rating: Intermediate (blends credit analysis, structuring, and valuation)
• Question Type:
• Exam: MCQs (single-best-answer), short-answer calculations (IRR, recovery rates), scenario-based covenant analysis.
• Job: Due diligence on loan terms, collateral stress-testing, workout negotiations.
• Audit: Covenant compliance checks, collateral valuation reviews, risk-weighting under Basel.

Difficulty Level

Intermediate

Must-Know Rules, Formulas, Standards, or Principles

1. Priority of Claims (Waterfall)
2. Senior secured → Senior unsecured → Subordinated → Mezzanine → Equity.

3. Formula: Recovery Rate = (Collateral Value – Senior Claims) / Junior Claims.

4. Covenant Triggers

5. Maintenance covenants (e.g., Debt/EBITDA ≤ 4.0) require ongoing compliance.

6. Incurrence covenants (e.g., no new debt unless Debt/EBITDA ≤ 3.5) apply only to specific actions.

7. Discount Rate for Private Credit

8. Base rate = Risk-free rate + credit spread (public bond proxy) + illiquidity premium (200–500 bps).
9. Adjustment: Add 100–300 bps for structural subordination or weak covenants.

Misconceptions

1. "Private credit is just high-yield bonds."
2. Reality: Private credit is illiquid, bespoke, and often secured (vs. public bonds’ liquidity and unsecured nature).
3. "All private debt is senior secured."
4. Reality: Mezzanine and unitranche debt blend senior and subordinated features.
5. "Covenants don’t matter if the loan is secured."
6. Reality: Covenants trigger early warnings (e.g., cash sweep) before collateral value erodes.
7. "Asset-based lending (ABL) is risk-free."
8. Reality: ABL depends on collateral quality (e.g., receivables aging, inventory obsolescence).
9. "Private credit IRRs are always higher than equity."
10. Reality: IRRs vary by strategy (e.g., direct lending: 8–12%, distressed: 15–25%).

Common Mistakes

1. Ignoring covenant headroom in stress tests (e.g., assuming EBITDA won’t drop).
2. Overestimating recovery rates (e.g., assuming 80% recovery on senior secured when collateral is specialized machinery).
3. Misclassifying debt (e.g., calling mezzanine "senior" because it’s secured).
4. Using public bond spreads for private credit without adding illiquidity premiums.
5. Forgetting structural subordination (e.g., holding company debt vs. operating company debt).

The Common Trap

Assuming collateral value = recovery value. - Why it’s tempting: Collateral (e.g., real estate) seems "safe." - Reality: Recovery depends on forced sale discounts (30–50% haircuts), legal costs, and priority of claims. - Example: A $100M office building might secure a $70M loan, but in default, it sells for $60M after fees—senior lenders recover 86%, subordinated lenders get $0.

Terms to Remember

1. Unitranche: Single loan blending senior and mezzanine terms (simpler but riskier for lenders).
2. PIK Toggle: Option to pay interest "in kind" (adding to principal) instead of cash.
3. Borrowing Base: Collateral value (e.g., 80% of eligible receivables) determining loan size in ABL.
4. Cash Sweep: Mandatory prepayment of debt from excess cash flow (triggered by covenants).
5. First-Out/Last-Out (FOLO): Tranched unitranche where "first-out" lenders get repaid first but earn lower spreads.

Step-by-Step Process

1. Assessing a Private Credit Investment

1. Identify the debt type (senior secured, mezzanine, unitranche, ABL).
2. Review collateral (type, liquidation value, priority).
3. Analyze covenants (maintenance vs. incurrence, headroom).
4. Stress-test cash flows (EBITDA downside, interest coverage).
5. Estimate recovery (collateral haircuts, legal costs, priority).
6. Calculate IRR (cash flows + exit assumptions; use XIRR for irregular payments).

2. Valuing a Private Credit Loan

1. Benchmark public bonds (same credit rating, maturity).
2. Add illiquidity premium (200–500 bps).
3. Adjust for structure (e.g., +100 bps for subordinated, +200 bps for weak covenants).
4. Discount cash flows (coupons + principal) at adjusted rate.
5. Compare to market yields (e.g., direct lending funds target 8–12% IRR).

3. Auditing a Private Credit Portfolio

1. Verify collateral (appraisals, aging reports for receivables).
2. Check covenant compliance (Debt/EBITDA, interest coverage).
3. Review loan documents (waterfall, PIK toggles, cash sweeps).
4. Test recovery assumptions (forced sale values, legal costs).
5. Document exceptions (e.g., covenant breaches, collateral shortfalls).

Exam Answer Builder

1-Mark Question (MCQ)

What it tests: Recognition of debt priority. Example: In a bankruptcy, which creditor is repaid first? A) Senior unsecured bondholders B) Mezzanine lenders C) Senior secured lenders D) Preferred equity holders Correct Answer: C Key Tip: Memorize the waterfall order (senior secured → senior unsecured → subordinated → equity).

2-Mark Question (Short Answer)

What it tests: Covenant interpretation. Example: A private credit loan has a Debt/EBITDA covenant of 4.0x. The borrower’s EBITDA drops from $50M to $40M, and debt remains at $160M. What is the covenant breach, and what is the likely lender response? Model Answer: - Breach: Debt/EBITDA = 160/40 = 4.0x (technical breach if covenant is ≤ 4.0x). - Lender response: Cash sweep, amendment fees, or acceleration if not cured. Key Tip: Always calculate the ratio and compare to the covenant threshold.

3-Mark Question (Calculation)

What it tests: Recovery rate estimation. Example: A senior secured lender holds a $100M loan secured by machinery valued at $120M. In default, the machinery sells for $80M after 6 months. Legal costs are $5M. What is the recovery rate? Model Answer: - Recovery = (Collateral Proceeds – Legal Costs) / Loan Amount - = ($80M – $5M) / $100M = 75%. Key Tip: Subtract legal costs and apply forced sale discounts (here, 33% haircut from $120M to $80M).

5-Mark Question (Scenario)

What it tests: Structuring and risk assessment. Example: A private credit fund is considering a $50M unitranche loan to a mid-market company. The loan has a 10% coupon, 5-year term, and is secured by all assets. The company’s EBITDA is $20M, and total debt is $100M. The fund’s target IRR is 12%. 1. What is the Debt/EBITDA ratio, and what risk does this pose? 2. How might the fund structure the loan to mitigate risk? 3. What covenants would you recommend? Model Answer: 1. Debt/EBITDA = 100/20 = 5.0x (high leverage → default risk). 2. Mitigation:
- First-out/last-out tranching (senior portion gets repaid first).
- Cash sweep (e.g., 50% of excess cash flow to repay debt).
- PIK toggle (reduce cash interest burden). 3. Covenants:
- Maintenance: Debt/EBITDA ≤ 4.5x, Interest Coverage ≥ 2.0x.
- Incurrence: No new debt unless Debt/EBITDA ≤ 4.0x.
- Collateral: Minimum borrowing base (e.g., 80% of receivables). Key Tip: Link covenants to risks (e.g., high leverage → tighter Debt/EBITDA covenant).

This vs That

Time-Saver Hack

Eliminate wrong IRR answers by checking: - Direct lending: 8–12% (low risk, senior secured). - Mezzanine: 12–18% (higher risk, equity kickers). - Distressed: 15–25% (high risk, workout scenarios). If an MCQ offers 20% for a senior secured loan, it’s likely wrong.

Mini Scenarios

1. Basic

A private credit fund lends $10M to a retailer secured by inventory. The retailer files for bankruptcy. What’s the first question the lender should ask? What to notice: Collateral quality (inventory may be obsolete or hard to liquidate).

2. Applied

A unitranche loan has a 10% coupon and a PIK toggle. The borrower elects PIK for 2 years. How does this affect the lender’s IRR? What to notice: PIK increases principal (e.g., $10M → $12.1M after 2 years), boosting IRR but increasing risk.

3. Tricky

A private credit fund holds a $50M senior secured loan to a company with $60M of real estate collateral. The company breaches its Debt/EBITDA covenant. The lender waives the breach but adds a cash sweep. Why? What to notice: Waiver preserves relationship, but cash sweep accelerates repayment to reduce risk.

Diagnostic MCQ Bank

Easy

Question: Which private credit strategy typically offers the lowest IRR? A) Direct lending B) Mezzanine C) Distressed debt D) Asset-based lending Correct Answer: A Explanation: Direct lending is senior secured with lower risk → 8–12% IRR. Trap Option: C (distressed debt is riskier → higher IRR).

Medium

Question: A private credit loan has a 12% coupon and a 3-year term. The borrower prepays $1M in Year 1 and $2M in Year 2. What is the IRR if the loan was $10M? A) 10.5% B) 12.0% C) 13.2% D) 14.0% Correct Answer: C Explanation: - Cash flows: Year 0: -$10M; Year 1: +$1M + $1.2M (interest) = $2.2M; Year 2: +$2M + $1.08M = $3.08M; Year 3: +$7M + $0.84M = $7.84M. - XIRR = 13.2%. Trap Option: B (ignores prepayments).

Hard

Question: A mezzanine lender holds a $20M loan with a 15% coupon and 5% equity kicker. The company is sold for $100M after 3 years. The senior debt is $50M. What is the mezzanine lender’s IRR? A) 15.0% B) 18.3% C) 22.1% D) 25.0% Correct Answer: C Explanation: - Repayment: Senior debt ($50M) → Mezzanine ($20M) → Equity ($30M). - Equity kicker: 5% of $30M = $1.5M. - Cash flows: Year 0: -$20M; Year 3: +$20M (principal) + $9M (interest) + $1.5M (kicker) = $30.5M. - IRR = 22.1%. Trap Option: A (ignores equity kicker).

Real-World Patterns

1. Covenant Breaches in Downturns
2. Example: 2022–2023 saw Debt/EBITDA covenant breaches in retail and healthcare.

3. What to watch: Cash sweeps and amendment fees (lenders charge 0.5–1.0% of loan size).

4. Collateral Shortfalls in ABL

5. Example: A lender advances 80% of receivables, but aging reports show 30% over 90 days past due.

6. What to watch: Borrowing base reductions (lender cuts loan size, triggering liquidity crises).

7. Workout Negotiations
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