4.2 Other risks

Lesson 4.1 covered credit risk: the chance that borrowers don't repay. It is the biggest risk in private credit, but not the only one. A portfolio of loans that all repay can still cause problems for investors if they need their money back early, if interest rates move sharply, if too much rides on one name, or if reported values turn out to be wrong.

These risks matter to everyone in this course's audience. Investor relations teams have to explain them. Fund accounting and valuation staff deal with them every quarter. LP-side analysts need to judge whether a fund's structure matches their own needs. This lesson covers four: liquidity, interest rates, concentration and valuation.

Liquidity risk

Liquidity is how quickly and cheaply you can turn an asset into cash. Private loans are illiquid: they are privately negotiated, held by a small group of lenders, and rarely traded. There is no exchange and often no regular buyer. Selling a loan can take weeks and may mean accepting a discount.

For investors, liquidity risk depends on the fund structure:

The key idea is a liquidity mismatch: when a vehicle promises more liquidity than its assets can provide. Redemption limits are there to protect remaining investors. Without them, a fund facing heavy redemptions might have to sell loans cheaply, hurting everyone who stays. The trade-off is that investors may not be able to get out when they most want to.

Interest-rate risk

Interest-rate risk is the risk that changes in interest rates hurt an investment. For a fixed-rate bond, the main effect is on price: when rates rise, the bond's fixed coupon looks less attractive and its price falls.

Most private loans are floating rate. They pay a base rate such as SOFR plus a spread (lesson 3.2), and the base rate resets every few months. This means:

• Price sensitivity to rates is low. When rates rise, the loan's coupon rises too, so its value doesn't need to fall much.
• Income moves with rates. Investors earn more when rates are high and less when rates fall. Rate floors limit how low the base rate can go.
• Borrowers carry the rate risk. When rates rise, the borrower pays more interest. That is good for lender income, until it isn't.

That last point is where interest-rate risk turns into credit risk. A standard measure is interest coverage: the borrower's earnings divided by its interest bill. Here is an illustrative borrower, Northfield Components, with $50 million of floating-rate debt and $10 million of annual earnings (EBITDA):

Nothing changed in Northfield's business, yet its cushion shrank. If earnings also dip, it may struggle to pay. Some borrowers use interest-rate hedges to limit this, and some lenders require them.

Concentration risk

Concentration risk is having too much exposure to one source of risk, so a single problem causes outsized losses. In private credit it comes in three main forms:

• Borrower concentration. A fund with 20 loans loses much more from one default than a fund with 150 loans of similar size. Funds often set limits on the largest single position.
• Sector concentration. Many direct lenders favor sectors like software, healthcare services and business services. If several borrowers share the same exposure, such as a change in regulation or a shift in technology, losses can arrive together.
• Sponsor concentration. In sponsor-backed lending, the private equity firm that owns the borrower matters. If many loans are to companies owned by one sponsor, the fund depends heavily on that sponsor's judgement and willingness to support struggling companies.

Concentration isn't always bad. A focused lender may know a sector deeply. But investors should understand where the portfolio's risks overlap.

Valuation risk

Listed shares have a price every second. Private loans don't. So how does a fund know what its loans are worth when it reports its net asset value (NAV)?

Under fair value accounting rules, funds must estimate what a loan would sell for in an orderly transaction. With no market price, they use models: typically a yield-based analysis comparing the loan's yield with current market yields for similar risk, and checks of whether the company's value comfortably covers its debt. Many managers also hire third-party valuation firms to review or prepare these marks.

Under US GAAP, assets valued mainly with unobservable inputs such as model assumptions are classified as Level 3. Most private loans fall into this category. (PC302 covers the rules in detail.)

Valuation risk is the risk that reported values are wrong or out of date. Common concerns:

• Lag. Models rely on quarterly financials that arrive weeks after quarter-end, so marks may trail reality.
• Smoothing. Because marks move gradually, private credit returns can look steadier than the underlying risk. Low reported volatility is partly an accounting effect.
• Judgement. Different reasonable assumptions give different values, and the manager has an interest in the outcome, since fees are often based on NAV.

Valuation risk matters in practice. Investors who redeem from or buy into an evergreen fund do so at the reported NAV. If NAV is too high, leaving investors are overpaid at the expense of those who stay.

Key terms

• Liquidity: how quickly and cheaply an asset can be turned into cash.
• Liquidity mismatch: when a vehicle offers investors more liquidity than its underlying assets can provide.
• Gate: a limit on how much investors can redeem from a fund in a period.
• Floating rate: an interest rate that resets periodically to a base rate plus a fixed spread.
• Interest coverage: a borrower's earnings divided by its interest expense; a measure of its ability to pay interest.
• Concentration risk: the risk of large losses from heavy exposure to one borrower, sector or sponsor.
• Fair value: the price that would be received to sell an asset in an orderly transaction between market participants.
• Level 3: the US GAAP fair value category for assets valued mainly with unobservable inputs, such as model assumptions.

Key takeaways

• Private loans are illiquid. Fund structure determines how that illiquidity reaches investors: lock-ups, redemption limits or discounted share prices.
• Floating rates protect loan prices from rate moves but push rate risk onto borrowers, where it can become credit risk.
• Diversification is about overlapping exposures, not just the number of loans: watch borrower, sector and sponsor concentration.
• Private loans are valued by models and judgement, not market prices, so reported values can lag reality and understate volatility.