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Measuring risk in the private credit markets

July 15, 2025 | 4 min read
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The direct lending market has experienced dramatic growth and become a vital and growing part of institutional investors’ portfolios, offering potentially attractive risk-adjusted returns with higher current income than most fixed income alternatives. For middle market direct lenders (“MMDLs”) such as Principal Alternative Credit (“PAC”), the ability to properly analyze the underlying risk profile of a borrower and preserve against principal loss is the primary determinant of future returns.

Investors in corporate bonds and broadly syndicated loans often benefit from external ratings to help assess the relative credit quality of borrowers. MMDLs rely on more subjective, investment team member assessments of credit risk instead of more objective measures.

Principal Alternative Credit draws on Principal’s 65 years of experience assigning internal credit ratings to derive its rating for middle market loans . Underpinning those ratings are third- party resources like Moody’s Risk Calc and Nationally Recognized Securities Ratings Organizations (NRSRO) ratings, but perhaps most importantly our own objective quantitative internal ratings framework, which we refer to as PAC CreditIQ.

To construct this framework, we reviewed years of various financial metrics in an effort to identify the factors that best explain the credit risk of a borrower. We included many popular time-tested credit metrics along with numerous additional ratios often cited by fixed income investors or ratings agencies. We compared the results of this research to the methodologies of Moody's and Standard & Poor’s.

Our goal was to construct a framework, backed by empirical data, that can be consistently applied across all middle market transactions and inform our assessment of a borrower’s risk profile expected throughout the life of a loan, focusing on the key determinants of business and structural risks.

Drivers of credit risk

The results from our research highlighted key drivers of risk that we captured in our framework. Here are some of the notable themes and how we have captured them in PAC CreditIQ.

A borrower’s risk profile is heavily influenced by loan-to-value (tranche-level debt to enterprise value)

Rating agency ratings frameworks exclude this metric due to the changing value for many publicly traded issuers whose equity market valuation fluctuates daily. However, private markets remove these fluctuations and allow equity owners to focus on long-term value creation.

To capture loan-to-value (“LTV”), we not only include the ratio in our framework but also financial metrics which have a highly predictive relationship to enterprise value (“EV”) multiples in order to test valuations against their historical drivers. While EV is a point in time and subject to changes in market conditions, the investment team analyzes historical multiples throughout a business cycle along with capturing a forward-looking view of key business drivers which will impact the expected borrower’s equity cushion for a proposed loan.

The investment team also monitors changes in public and private market valuations, which might result in LTV changes and thus rating changes throughout the life of the loan, providing transparency to investors regarding the quality of their portfolio over time. Exhibit 1 specifically illustrates the general increase in middle market buyout multiples which have largely been funded with additional equity.

Volatility in financial results significantly impacts risk

Fluctuations in operating performance caused by macro (i.e., economic cycle, shifts in industry demand drivers) or micro (i.e., integration challenges, customer loss) factors have a material impact on a borrower’s risk profile. The data highlighted a notable bias towards companies with a low standard deviation in past results. Lenders desire a steady and predictable stream of cash flow to support their debt, but fluctuations in past performance increases the potential that future trends might also be volatile and could weaken the ability of a borrower to service its debt. We have captured this risk through several factors in our matrix including end-market cyclicality, competitive barriers to entry, and customer concentration.

Exhibit 1: Middle market debt & equity buyout multiples and loan-to-value

Debt (bottom bar)
Equity (top bar)
LTV
Middle market debt & equity buyout multiples and loan-to-value.

As of 31 December 2024. Source LSEG LPC. Past performance is not a guarantee of future results.

Although debt levels have moved slightly higher since 2013, the expansion of buyout multiples has been supported by a significant increase in equity contribution.

Capital intensive businesses carry embedded risk factors

Businesses with sizable capital outlays carry notable risk factors that challenge a borrower’s credit profile. Along with the adverse impact to cash flow due to capex requirements, these businesses often carry lower margins and sizable fixed cost structures. In order to diligence an investment in capital intensive industries, the investment team focuses its diligence on the strength of customer relationships, barriers to entry (e.g., patents, geographic proximity to customers, a high degree of integration in customer’s design and manufacturing processes, etc.), customer contracts, fleet age and utilization, and the replacement cycle.
Fixed income

Footnotes

Experience includes investment management activities of predecessor firms beginning in the investment department of Principal Life Insurance Company.
Disclosure

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Risk Considerations

Investing involves risk, including possible loss of principal. Past Performance does not guarantee future return. All financial investments involve an element of risk. Therefore, the value of the investment and the income from it will vary and the initial investment amount cannot be guaranteed. Investments in private debt, including leveraged loans, middle market loans, and mezzanine debt, are subject to various risk factors, including credit risk, liquidity risk and interest rate risk. Private credit involves an investment in non-publicly traded securities which are subject to illiquidity risk. Portfolios that invest in private credit may be leveraged and may engage in speculative investment practices that increase the risk of investment loss.

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MM12926-02 | 06/2025 | 4577746-092026