The spread gap between a direct loan and a syndicated loan is a gross number; the premium an investor keeps is about half of it.
The illiquidity premium in private credit is the difference between the yield of a direct loan and the yield of a comparable syndicated loan, measured to the same expected life and after expected loss and fees. On illustrative terms, a direct loan at S+575 issued at 98 against a syndicated loan at S+325 at 99.5 shows a 312 basis point gap in yield, but the premium the investor keeps is 162 basis points, about half of the headline.
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 →
Every private credit pitch book shows a spread premium over broadly syndicated loans. The number is real, but it is gross: it includes the original issue discount, it ignores that smaller, more levered borrowers default more and recover less, and it compares an asset that costs 45 basis points a year to hold in a loan fund with one that costs almost four times as much in a direct lending fund. The calculation below strips each of those layers off in turn.
| Input | Direct loan | Syndicated loan |
|---|---|---|
| Spread over SOFR | 575 bp | 325 bp |
| Issue price | 98.0 | 99.5 |
| Annual default rate | 2.25% | 2.00% |
| Recovery | 60% | 65% |
| Fee and expense load, % of assets a year | 1.75% | 0.45% |
| SOFR, flat | 4.00% | 4.00% |
The fee load is everything that stands between the loan and the investor, expressed per unit of assets: management fee, incentive fee and fund expenses for the direct lending fund, the management fee of a loan fund for the syndicated side. Both loans are held unlevered so that fund leverage does not blur the comparison.
Yield to expected life = IRR of (−price, coupon, coupon, coupon + 100)
Expected loss = default rate × (1 − recovery)
Net yield = yield to expected life − expected loss − fee load
Illiquidity premium = net yielddirect − net yieldsyndicated
In Excel, for a three-year bullet: =RATE(3,Coupon*100,-Price,100), then subtract PD*(1-Recovery) and the fee load.
| Layer | Direct | Syndicated | Premium, bp |
|---|---|---|---|
| Coupon | 9.75 | 7.25 | 250 |
| Yield to three-year life | 10.56 | 7.44 | 312 |
| Less expected loss | 0.90 | 0.70 | −20 |
| Yield after loss | 9.66 | 6.74 | 292 |
| Less fee load | 1.75 | 0.45 | −130 |
| Net yield | 7.91 | 6.29 | 162 |
The investor keeps 162 basis points a year for giving up daily liquidity, or 52 per cent of the headline yield gap. That is still a meaningful premium: on a $100 million allocation it is $1.62 million a year. But it is the right number to set against what illiquidity costs the investor, which is the inability to sell in a drawdown and the need to hold more cash elsewhere, and it is a number a committee can challenge line by line.
Part of the 162 basis points is not about liquidity at all. Direct borrowers are smaller, documents are bespoke and the lender does more work. The calculation measures the total excess return of the asset class after loss and fees; how much of it rewards illiquidity rather than size and complexity is a judgement, not an output.
The two inputs that move the answer are the direct loan's default rate and the fee load. Base rates barely matter: both loans float, so moving SOFR from 3.00 to 5.00 per cent changes the net premium only from 161 to 163 basis points.
| Direct default rate | Fees 1.00% | Fees 1.75% | Fees 2.50% |
|---|---|---|---|
| 1.50% | 267 | 192 | 117 |
| 2.25% | 237 | 162 | 87 |
| 3.00% | 207 | 132 | 57 |
| 4.00% | 167 | 92 | 17 |
Each 0.75 point of extra annual defaults costs 30 basis points of premium at a 60 per cent recovery; each 0.75 point of extra fees costs 75. A manager's fee terms move the premium more than a plausible range of credit outcomes. With fees held at 1.75 per cent, the premium reaches zero only at a direct default rate of 6.30 per cent a year, a loss rate of 2.52 per cent: the asset class has a wide margin against credit losses and a narrow one against fees.
The common mistake is to compare spreads. S+575 against S+325 looks like 250 basis points, but it ignores the OID, which is worth more on a direct loan because it is larger and the expected life is short; the conversion is the same one used to turn a point of OID into basis points. The opposite mistake is to stop at the yield gap of 312 and call it the premium: it is a gross number, and the 150 basis points that separate it from the net figure are the fees and the extra loss rate. A third is to compare a levered private credit fund's net return with an unlevered loan index; leverage changes the return and the risk, and it has to come out before the premium is measured.
Measure the illiquidity premium in four layers: coupon, yield to expected life, after expected loss, after fees. On these illustrative terms the gap shrinks from 312 to 162 basis points, and fees take more of it than defaults do. The free workbooks for this book include the Ridgeline fund bridge, which walks the same kind of gap from asset yield to the investor's net return.
It depends on how it is measured. On the illustrative terms here the headline gap in yield is 312 basis points, but only 162 survive a 0.20 point difference in expected loss and a 1.30 point difference in fees. Quoted premiums are usually spread comparisons before either deduction, so they overstate what the investor keeps.
Very little, because both loans float. Moving SOFR from 3.00 to 5.00 per cent lifts the direct loan's yield from 9.55 to 11.58 per cent and the syndicated loan's from 6.44 to 8.45, but the net premium only moves from 161 to 163 basis points. Base rates change the level of returns, not the reward for illiquidity.
Solve for the default rate at which the direct loan's yield, less fees and expected loss, equals the syndicated loan's net yield. With a 10.56 per cent yield, 1.75 per cent of fees and 60 cent recoveries, the premium reaches zero at a default rate of 6.30 per cent a year, a loss rate of 2.52 per cent, against 2.25 per cent assumed.
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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