The distribution rate is a payout. The return is gross income on levered assets, less borrowing, three layers of fees and credit losses, and half of the gross never reaches the investor.
Build the fee stack on one unit of NAV: gross income on the levered loan book, less interest on the borrowing, the management fee, expenses, the incentive fee and credit losses. An illustrative private credit interval fund paying a 9.00 per cent distribution on loans yielding 10.25 per cent is expected to earn 7.19 per cent. Fees and interest take 50.18 per cent of the gross income, and the 1.81 point shortfall against the distribution comes out of NAV, which falls from 25.00 to 23.50 in three years.
Worked in full in The Credit Investor by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
Interval funds and non-traded BDCs advertise a distribution rate: the quarterly payout, annualised, over NAV. It is a real cash figure and a board decision. The return is what is left after a long chain of costs, and the only way to see it is to write the chain down.
| Input | Value |
|---|---|
| SOFR | 4.00% |
| Loan spread over SOFR | 5.75% |
| Fees and discount earned on the loans | 0.50% |
| Leverage, debt to NAV | 0.75x |
| Borrowing cost | SOFR + 2.25% |
| Management fee, on gross assets | 1.25% |
| Other expenses and servicing fee, on NAV | 0.60% + 0.25% |
| Incentive fee, above a 5.00% hurdle | 12.5% |
| Annual default rate, loss given default | 2.50%, 40% |
| NAV per share, distribution per quarter | 25.00, 0.5625 |
The 0.75x leverage is the case's illustrative assumption. A US interval fund registered under the Investment Company Act must keep 300 per cent asset coverage on its borrowings, which caps debt at 0.50x NAV; a BDC, at 150 per cent coverage, can borrow up to 2.00x. Read the 0.75x and 1.00x rows below as the economics of leverage, not as what a registered interval fund may carry.
Gross income = asset yield × (1 + leverage)
NII = gross − interest − management fee − expenses − incentive fee
Expected return = NII − default rate × LGD × (1 + leverage)
Everything is per 1 of NAV, a year. The management fee and the credit losses scale with gross assets, 1.75 per unit of NAV; the expenses scale with NAV. In Excel, with named inputs: =Yield*(1+Lev)-(SOFR+BorrowSpread)*Lev-Mgmt*(1+Lev)-Other-Incentive-PD*LGD*(1+Lev).
| Line | Working | % of NAV |
|---|---|---|
| Asset yield | 4.00 + 5.75 + 0.50 | 10.25 |
| Gross income | 10.25 × 1.75 | 17.94 |
| Interest on borrowing | 6.25 × 0.75 | −4.69 |
| Management fee | 1.25 × 1.75 | −2.19 |
| Other expenses and servicing | 0.60 + 0.25 | −0.85 |
| Pre-incentive net investment income | 10.21 | |
| Incentive fee | 12.5% × 10.21 | −1.28 |
| Net investment income | 8.94 | |
| Credit losses | 2.50 × 40% × 1.75 | −1.75 |
| Expected total return | 7.19 |
The pre-incentive income of 10.21 per cent clears the 5.00 per cent hurdle comfortably, so the incentive fee is charged on all of it. The incentive fee is charged before credit losses, so the manager is paid on income the defaults will later take back.
On 100,000 invested, 4,000 shares at 25.00, year one looks like this: 9,000 of distributions received, against 8,935.94 of net investment income. Coverage in the first quarter is 99.3 per cent, which looks almost exactly covered. It is not, because the 1,750 of expected credit losses do not pass through net investment income at all. They come straight off NAV.
| Item | Amount |
|---|---|
| Management fee | 2,187.5 |
| Other expenses and servicing | 850 |
| Incentive fee | 1,276.56 |
| Fees, total | 4,314.06 |
| Interest on the fund's borrowing | 4,687.5 |
| Expected credit losses | 1,750 |
| Distributions received | 9,000 |
Fees alone take 4.31 points, 24.05 per cent of gross income. With the interest, 9.00 points of the 17.94 go to the lender and the manager, 50.18 per cent. Run the quarters forward with the distribution held at 0.5625 and NAV falls to 24.53 after one year, 24.03 after two and 23.50 after three, down 6.0 per cent. The investor received 27,000 of cash over three years and holds shares worth 93,987.
| Default rate | Credit losses | Expected return | Shortfall to the distribution |
|---|---|---|---|
| 0.00% | 0.00 | 8.94 | 0.06 |
| 1.00% | 0.70 | 8.24 | 0.76 |
| 2.50% | 1.75 | 7.19 | 1.81 |
| 4.00% | 2.80 | 6.14 | 2.86 |
| 6.00% | 4.20 | 4.74 | 4.26 |
Even with no defaults at all, the 9.00 per cent distribution is not fully earned. Each point of annual default rate costs 0.70 points of return because the losses are levered 1.75 times. The fund would earn nothing only at a default rate of 12.77 per cent.
| Leverage | Gross income | Interest | Management fee | NII | Expected return |
|---|---|---|---|---|---|
| 0.00x | 10.25 | 0.00 | 1.25 | 7.13 | 6.13 |
| 0.50x | 15.38 | 3.12 | 1.88 | 8.33 | 6.83 |
| 0.75x | 17.94 | 4.69 | 2.19 | 8.94 | 7.19 |
| 1.00x | 20.50 | 6.25 | 2.50 | 9.54 | 7.54 |
Doubling the gross income from 10.25 to 20.50 adds 1.41 points of expected return. Borrowing at 6.25 against loans at 10.25 is profitable, but the manager's fee on gross assets, the incentive fee and the levered losses each take a slice of the gain. The general case is worked in how much leverage adds to a private credit fund's return.
Reading coverage as proof the distribution is earned. Net investment income over the distribution is 99.3 per cent here, close enough to look safe. But net investment income is before credit losses, and an adviser's 1.00 per cent wrap fee sits outside the fund altogether. After both, the investor's expected return is 6.19 per cent, against 9.00 on the statement. The same test for listed vehicles is in how to calculate a BDC's dividend coverage.
Write the stack per unit of NAV, scale the asset-based lines by one plus leverage, and subtract losses after the incentive fee: 7.19 per cent expected on a fund paying 9.00. The difference is not hidden, it is just paid out of NAV. The Credit Investor holds this fund beside bonds, a loan fund and three BDCs in one portfolio, and the free workbook for this case runs its fee stack, NAV path, repurchase proration and gate quarter by quarter.
Because the distribution is set by the board and the return is what the loans earn after costs. An illustrative fund paying 9.00 per cent on its NAV earns 8.94 per cent of net investment income and loses 1.75 per cent a year to defaults, an expected return of 7.19 per cent. The 1.81 point gap comes out of NAV, which falls from 25.00 to 23.50 over three years.
On an illustrative interval fund with 0.75x leverage, gross income is 17.94 per cent of NAV. Management fee, expenses and incentive fee take 4.31 points, 24.05 per cent of it; add 4.69 points of interest on the borrowing and 50.18 per cent of the gross income never reaches the investor.
It raises the expected return less than it raises the gross. In an illustrative fund on 10.25 per cent loans, moving from no leverage to 1.00x lifts gross income from 10.25 to 20.50 per cent of NAV but the expected return only from 6.13 to 7.54, because interest, the management fee on gross assets and credit losses all grow with the balance sheet.
This article is one calculation from The 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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