A direct lending fund at zero, one and two turns of leverage, worked from asset yield to net return, with the loss tolerance each turn gives up.
On loans yielding an illustrative 11.00 per cent, with leverage costing 6.50 per cent, one turn of fund leverage lifts the net return from 7.10 to 9.01 per cent after fees, losses and carry. The same turn cuts the annual loss rate the fund can absorb before its return reaches zero from 9.35 to 6.30 per cent: 1.6 points of safety given up for each point of return gained.
Worked in full in The Private Credit Investor by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
A direct lending fund holds senior loans to mid-market borrowers. The question an investor asks at the first meeting is how the manager gets from an 11 per cent loan book to the net return in the deck, and how much of that comes from borrowing at the fund level. The assumptions below are illustrative, chosen to be plausible for a senior direct lending strategy, not market data.
| Input | Value |
|---|---|
| All-in yield on the loans | 11.00% |
| Cost of the fund's leverage facility | 6.50% |
| Management fee, on gross assets | 1.25% |
| Fund expenses, on equity | 0.40% |
| Credit losses, on assets | 1.00% |
| Preferred return (hurdle) | 7.00% |
| Carried interest, full catch-up | 15% |
Work per 100 of investor equity. With leverage of L turns the fund holds 100 × (1 + L) of loans and owes 100 × L to the facility. Every line that scales with assets, the income, the fee and the losses, is multiplied by (1 + L); the interest scales with L; the expenses do not scale at all.
Pre-carry return = (1 + L) × (yield − fee − loss) − L × cost of debt − expenses
At one turn: 2 × (11.00 − 1.25 − 1.00) − 6.50 − 0.40 = 10.60%
Carry: 10.60% clears the full catch-up threshold of 7.00 / (1 − 15%) = 8.24%, so carry is 15% of the whole: 1.59. Net = 9.01%
Excel, with the inputs named: =(1+L)*(Yield-Fee-Loss)-L*Cost-Exp
| Leverage | 0.0x | 0.5x | 1.0x | 1.5x | 2.0x |
|---|---|---|---|---|---|
| Loans held | 100.0 | 150.0 | 200.0 | 250.0 | 300.0 |
| Interest income | 11.00 | 16.50 | 22.00 | 27.50 | 33.00 |
| Facility interest | 0.00 | −3.25 | −6.50 | −9.75 | −13.00 |
| Management fee | −1.25 | −1.88 | −2.50 | −3.12 | −3.75 |
| Expenses | −0.40 | −0.40 | −0.40 | −0.40 | −0.40 |
| Credit losses | −1.00 | −1.50 | −2.00 | −2.50 | −3.00 |
| Pre-carry return | 8.35 | 9.47 | 10.60 | 11.73 | 12.85 |
| Carry | −1.25 | −1.42 | −1.59 | −1.76 | −1.93 |
| Net return | 7.10% | 8.05% | 9.01% | 9.97% | 10.92% |
| Loss rate that takes pre-carry return to zero | 9.35% | 7.32% | 6.30% | 5.69% | 5.28% |
Each turn adds the same 1.91 points of net return, because each extra 100 of loans earns 11.00, costs 6.50 to fund, 1.25 in fee and 1.00 in losses: a levered spread of 2.25, less 15 per cent carry. The return line is straight. The safety line is not. The loss rate the fund can absorb is the pre-loss return divided by the assets that can lose, and the assets grow with every turn. Going from zero to one turn costs 3.05 points of loss tolerance; going from one to two costs another 1.02. At two turns, 3.82 points of extra return have cost 4.07 points of tolerance.
The other way to see it: at one turn every 1.00 per cent of loans lost costs the equity 2.00 per cent. A credit fund's investors are buying the manager's loss rate twice over.
| Annual losses on assets | 0.0x | 1.0x | 2.0x |
|---|---|---|---|
| 0.00% | 7.95% | 10.71% | 13.47% |
| 1.00% | 7.10% | 9.01% | 10.92% |
| 2.00% | 7.00% | 7.31% | 8.37% |
| 3.00% | 6.35% | 6.60% | 6.85% |
| 5.00% | 4.35% | 2.60% | 0.85% |
Before carry, leverage helps only while the loans, net of fee and losses, out-earn the facility: 11.00 less 1.25 less the loss rate must exceed 6.50, so the break-even is a loss rate of 3.25 per cent a year. At 3.00 per cent the three columns are within half a point of each other; at 5.00 per cent two turns of leverage turn a 4.35 per cent fund into one that returns 0.85. At 2.00 per cent losses the carry compresses the gap: the unlevered fund sits in the catch-up zone and pays less carry than the levered ones, so 1.25 points of pre-carry advantage at one turn shrink to 0.31 of net.
The first is to compare a gross asset yield with a net return and call the gap the cost of the manager. At one turn the 11.00 per cent yield and the 9.01 per cent net are not measured on the same base: the gross return on equity before fees, expenses, losses and carry is 15.50 per cent, and the erosion from that figure is much larger than two points.
The second is to ignore what the fee is charged on. A 1.25 per cent fee on gross assets costs the equity 2.50 points at one turn. Charged on equity, it costs 1.25, the net return rises to 10.07 per cent, and the loss tolerance to 6.92. The basis of the fee is worth 1.06 points, more than half of what the leverage adds, and at one turn the manager's fee and carry together take 4.09 points, against 2.50 unlevered. Leverage pays the manager before it pays the investor.
The book's Ridgeline bridge, from gross yield to net return line by line, is worked in the free workbook for this case, including the leverage sensitivity and the fee-basis question. For the listed version of the same arithmetic, see how to calculate a BDC's dividend coverage ratio.
Because loans yielding more than the facility costs earn a positive spread on borrowed money. With loans at 11.00 per cent and leverage at 6.50 per cent, after a 1.25 per cent fee and 1.00 per cent of losses, each turn adds about 1.91 points of net return in the worked case, taking it from 7.10 to 9.01 per cent at one turn.
When the loan yield, less the management fee and losses, falls to the cost of the leverage. With an 11.00 per cent yield, a 1.25 per cent fee on assets and 6.50 per cent debt, the break-even is a loss rate of 3.25 per cent a year. Above it each extra turn lowers the return; at 5.00 per cent losses the net falls from 4.35 unlevered to 0.85 at two turns.
Yes. A fee of 1.25 per cent charged on gross assets costs the equity 2.50 points at one turn of leverage, against 1.25 if charged on equity. In the worked case moving the fee base from assets to equity lifts the net return from 9.01 to 10.07 per cent, 1.06 points, more than half of what the leverage itself added.
This article is one calculation from The Private Credit Investor. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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