Floating-rate loans pass every rate cut straight to the investor. How much of it lands depends less on leverage than on how the leverage is priced.
Per 100 of equity, a direct lending fund loses the rate cut on all its loans and saves it only on its floating-rate borrowing. On illustrative loans at SOFR + 5.50 per cent with 1.0x of fund leverage, a 100 basis point cut lowers the return before incentive fee by 100 bp if the leverage is a floating facility, the same as an unlevered fund, but by 150 bp if half of it is fixed-rate notes and by 200 bp if all of it is. What decides the sensitivity is not how much the fund borrows but how the borrowing is priced.
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 →
Direct lending's appeal through the rate rises was simple: almost every loan floats, so higher base rates flowed straight into income. The same mechanism runs in reverse. An investor comparing funds as rates fall needs one number for each fund: how many basis points of net return each 100 bp of SOFR cut removes. It can be read from the fund's balance sheet in a few lines.
| Input | Value |
|---|---|
| Loan coupon: SOFR plus spread | SOFR + 5.50% |
| SOFR floor on the loans | 0.75% |
| Starting SOFR | 4.25% |
| Fund leverage, debt to equity | 1.0x |
| Floating facility, 50% of the debt | SOFR + 2.25% |
| Fixed-rate unsecured notes, 50% of the debt | 6.00% |
| Management fee, on gross assets | 1.25% |
| Fund expenses, on equity | 0.40% |
| Credit losses, on assets | 1.00% |
| Income incentive fee: rate; hurdle; catch-up | 12.5%; 6.0%; full |
Work per 100 of equity, so the fund holds 200 of loans and owes 100.
Pre-incentive return = (1 + L) × (loan yield − fee − loss) − interest on debt − expenses
Loan yield = 4.25 + 5.50 = 9.75%, income 19.50
Interest = 50 × (4.25 + 2.25)% + 50 × 6.00% = 3.25 + 3.00 = 6.25
Fee 2.50, expenses 0.40, losses 2.00
Pre-incentive return = 19.50 − 6.25 − 2.50 − 0.40 − 2.00 = 8.35%
In Excel: =(1+L)*(MAX(SOFR,Floor)+Spread-Fee-Loss)-L*(Fl*(SOFR+FacSpread)+(1-Fl)*Fixed)-Exp
The 8.35 per cent clears the full catch-up threshold of 6.0 ÷ (1 − 12.5%) = 6.86 per cent, so the incentive fee is 12.5 per cent of all of it, 1.04, and the investor nets 7.31 per cent.
At 3.25 per cent SOFR the loans yield 8.75 per cent, so income falls by 2.00 on 200 of loans. The floating half of the debt now costs 5.50 per cent, saving 0.50; the fixed notes still cost 3.00. Interest falls from 6.25 to 5.75, and the pre-incentive return from 8.35 to 6.85 per cent: 150 bp for a 100 bp cut.
The general rule follows from the formula. A cut of Δ costs (1 + L) × Δ on the loans and saves L × f × Δ on the debt, where f is the floating share:
Sensitivity = (1 + L − L × f) × Δ
All-floating debt (f = 1): (1 + 1 − 1) = 1.0, so 100 bp. Half fixed: 1.5, so 150 bp. All fixed: 2.0, so 200 bp.
| SOFR | Unlevered | 1.0x, all floating | 1.0x, half fixed | 1.0x, all fixed |
|---|---|---|---|---|
| 4.25% | 7.10% | 8.10% | 8.35% | 8.60% |
| 3.25% | 6.10% | 7.10% | 6.85% | 6.60% |
| 2.25% | 5.10% | 6.10% | 5.35% | 4.60% |
| 1.25% | 4.10% | 5.10% | 3.85% | 2.60% |
| 0.50% | 3.60% | 4.85% | 3.22% | 1.60% |
| Drop for a 200 bp cut | 200 bp | 200 bp | 300 bp | 400 bp |
The table shows the trade a manager makes when it issues fixed-rate notes. At 4.25 per cent SOFR the all-fixed fund earns 50 bp more than the all-floating one. Two hundred basis points of cuts later it earns 150 bp less. Unless the notes are swapped to floating, fixed-rate fund debt is a bet that rates will not fall, placed with the investors' money.
The floor matters only at the bottom. Below 0.75 per cent the loans stop repricing, but the floating facility does not, which is why the all-floating fund loses only 325 bp for a 375 bp cut to 0.50 per cent, against 350 bp unlevered. A floor that the fund's own borrowing lacks is a small asymmetry in the investor's favour; its value is set out in how much a SOFR floor is worth.
| SOFR | Pre-incentive return | Incentive fee | Net to investors |
|---|---|---|---|
| 4.25% | 8.35% | 1.04 | 7.31% |
| 3.25% | 6.85% | 0.85 | 6.00% |
| 2.25% | 5.35% | 0.00 | 5.35% |
Of the first 150 bp lost, the manager's fee falls by 19 bp, about 13 per cent, so investors lose 131 bp. Further down the curve the cushion runs out: below the 6.0 per cent hurdle, reached at a SOFR of about 2.68 per cent, there is no fee left and investors bear every basis point. The hurdle mechanics are in how the income incentive fee is calculated.
| Leverage, half fixed | Net at 4.25% SOFR | Net at 2.25% SOFR | Drop |
|---|---|---|---|
| 0.0x | 6.21% | 5.10% | 111 bp |
| 0.5x | 6.76% | 5.22% | 153 bp |
| 1.0x | 7.31% | 5.35% | 196 bp |
| 1.5x | 7.85% | 5.47% | 238 bp |
With half the debt fixed, every half-turn of leverage adds about 42 bp of sensitivity to a 200 bp cut. With all-floating debt it would add none before fees: leverage raises the level of the return, and only the fixed portion of the debt raises its sensitivity to rates. How leverage changes the level, and the loss rate the fund can absorb, is worked in how much leverage adds to private credit returns.
The common error is to multiply the rate cut by the fund's gross exposure: "1.0x levered, so a 100 bp cut costs 200 bp". That is right only for a fund whose borrowing is entirely fixed. The opposite error is to assume a floating facility makes leverage neutral at every level of rates; below the loans' floor it does not, and the fund then gains slightly from cuts on its debt. Ask the manager for the floating share of its liabilities before modelling any rate path.
The sensitivity of a direct lending fund to rate cuts is (1 + L − L × f) per basis point before fees: one for one with floating leverage, up to two for one at 1.0x of fixed-rate debt. The income incentive fee cushions the first cuts and none of the later ones. The lender's model behind the book's case, with its coverage ratios and stress, is in the free workbook for this case.
Only if the leverage is fixed-rate. With a floating facility, each extra 100 of loans loses the cut on its coupon and saves the same cut on the borrowing, so a 1.0x levered fund loses 100 bp for a 100 bp cut, like an unlevered one. If half the debt is fixed at 6.00 per cent, the same cut costs 150 bp in the illustrative case.
Only once SOFR falls below the floor, and floors in direct lending are often well below current rates. In the illustrative case the 0.75 per cent floor does nothing until SOFR has fallen 350 bp from 4.25 per cent; it then protects the last 25 bp of a cut to 0.50 per cent, and the fund's floating facility keeps getting cheaper below it.
The manager's income incentive fee falls with income, so investors bear less than the full drop. Above the catch-up, a 12.5 per cent fee absorbs 12.5 per cent of a cut. In the illustrative fund a 100 bp cut reduces the pre-incentive return by 150 bp and the fee by 19 bp, so investors lose 131 bp. Below the 6.0 per cent hurdle there is no fee left to absorb anything.
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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