Risk management, long the exclusive purview of large, publicly traded financial institutions and a cornerstone of regulatory compliance and systemic stability, is now a critical consideration for the rapidly expanding world of private markets. Frameworks historically designed for giants like JPMorgan Chase or Bank of America, encompassing intricate methodologies for measuring interest rate risk, credit exposure, and liquidity stress, are finding a new and urgent relevance in private credit funds, business development companies (BDCs), hedge funds, and other alternative investment vehicles. These entities, increasingly performing the intermediation functions traditionally held by commercial banks, must now adopt a more sophisticated approach to valuation that mirrors the rigor of public markets.
The divergence between public and private market valuation practices has historically been stark. Public markets, driven by transparency mandates and regulatory oversight, developed robust frameworks for assessing interest rate sensitivity, credit exposure, and liquidity stress. These mechanisms ensured that asset valuations reflected real-time market conditions and potential vulnerabilities. In contrast, private markets often relied on opaque illiquidity premiums and long-term, often static, assumptions. However, this landscape is undergoing a profound transformation. The emergence of semi-liquid structures, the integration of tokenization technologies, and the growing accessibility of private market investments to retail investors are fundamentally altering the risk profiles of these vehicles. As private assets begin to exhibit behaviors more akin to their publicly traded counterparts, the principles of bank-grade risk management become not just beneficial, but essential for accurate valuation.
The Convergence of Risk and Valuation in Private Markets
This increasing convergence between public and private market characteristics necessitates a paradigm shift in how private assets are valued. Traditionally, the Net Asset Value (NAV) of a private fund was considered a relatively stable, often quarterly, figure. However, the introduction of semi-liquid or tokenized products fundamentally alters this perception. NAV is now subject to the same dynamic forces that influence public market valuations, including interest rate volatility, which can impact borrower solvency and the intrinsic value of loans. Furthermore, credit deterioration, often masked by "extend-and-pretend" strategies, poses a significant hidden risk. Liquidity shocks, a direct consequence of investor redemption pressures in semi-liquid structures, can also rapidly destabilize valuations.
These risks are precisely those that are priced daily in public markets. By applying bank-grade risk frameworks, private funds can ensure that their valuations are not only reflective of contractual terms but also of the prevailing economic realities and the evolving risk landscape. For investors, this convergence presents a significant opportunity. Those who proactively adopt integrated risk-valuation models will be better positioned to price private assets accurately, manage liquidity effectively, and navigate the increasingly stringent regulatory and market norms that are likely to emerge. In essence, the same discipline that underpins resilience in public markets is rapidly becoming a competitive advantage in the private sphere. A move away from siloed risk measurement towards an integrated valuation framework will empower investors and managers to gain a holistic understanding of how risk management directly impacts the overall value of their firms and portfolios.
Private Credit’s "Second Act": Growth and Emerging Systemic Importance
The growth trajectory of the private credit market has been nothing short of remarkable, signaling a significant evolution from its origins as a niche investment area. As recently characterized by CAIA Association, the private credit market is entering its "Second Act," a phase marked by increasing complexity and potentially higher volatility compared to its earlier, more benign period of growth. This evolution is underscored by a dramatic increase in the volume of private corporate loans. From approximately $310 billion in 2010, the market expanded to an estimated $1.7 trillion by the end of 2024. Projections for the future are even more ambitious, with some analyses suggesting a potential total addressable market of $30 trillion in the coming years. This expansion is fueled, in part, by a strategic shift from traditional direct lending towards asset-based lending, opening new avenues for capital deployment.
This substantial growth transforms private credit from a peripheral market segment into a potentially systemic force with wide-ranging economic implications. As this sector matures and expands, the importance of robust risk management and valuation techniques, comparable to those employed by traditional commercial banks, becomes paramount for both fund managers and investors. The interconnectedness of these markets means that the stability and accurate valuation of private credit vehicles can have ripple effects across the broader financial ecosystem.
Key Risks and Integrated Valuation Approaches
Understanding and incorporating the primary risks faced by both banks and private credit funds is crucial for developing comprehensive valuation methodologies. Three core areas of overlapping risk stand out: interest rate risk, credit risk, and liquidity risk.
Interest Rate Risk: A Nuanced Challenge
While commercial banks often grapple with interest rate risk stemming from a mismatch between fixed-rate assets and floating-rate liabilities, private credit funds typically employ floating-rate loans. This structure offers a degree of protection against rising interest rates, as the interest income generated by the fund can adjust in tandem with its borrowing costs. However, this benefit is not without its own set of challenges. The burden of increased interest payments is effectively transferred to the borrower. As interest rates climb, there is a point at which servicing these higher costs becomes prohibitively expensive, potentially leading to borrower defaults and, consequently, a decline in the market value of the fund’s loan portfolio.
A sophisticated valuation model must therefore assess this tipping point – the level at which rising rates render loan repayment unfeasible for borrowers. This analysis directly impacts the estimated market value of the fund’s assets. To frame this, the "MRT" mnemonic – Magnitude, Riskiness, and Timing of cash flows – can be a useful tool. A firm’s or fund manager’s strategic approach to risk can be summarized by the "ART" of risk management: Accept, Remove, or Transfer. Accepting a risk means leaving it unhedged. Removing risk involves diversifying into low-correlation assets. Transferring risk is achieved through hedging instruments like derivatives or insurance. A manager’s choice within this "ART" framework directly influences the Magnitude, Riskiness, and Timing of cash flows, and thus, the firm’s or fund’s market value. For instance, a decision to accept unhedged interest rate risk on a portfolio of floating-rate loans might initially seem beneficial, but it exposes the fund to significant downside if rates surge beyond a sustainable level for borrowers.
Credit Risk: Navigating "Extend-and-Pretend"
Credit risk remains a significant concern, particularly in light of the increasing prevalence of "extend-and-pretend" strategies within the private credit space. This practice, where lenders ease loan terms to delay or avoid recognizing defaults, has become more critical as borrower interest coverage ratios have declined. Data indicates a drop from 3.0x in 2020 to approximately 1.5x in 2025 for borrowers in the private credit market. This presents a substantial valuation dilemma: how does one accurately assess the value of a loan that appears to be performing well only because the lender has modified its terms?
For accurate market valuation of private credit funds, robust credit risk hedging strategies, analogous to those employed by banks, are essential. The "extend-and-pretend" scenario highlights the potential for delayed defaults, which can subtly but persistently erode a fund’s portfolio value over the long term. A comprehensive valuation must account for the probability and impact of such scenarios, rather than relying solely on current, potentially artificial, performance metrics.
Liquidity Risk: Adapting to Evolving Investor Demands
Liquidity risk, a familiar challenge for traditional banks, is also emerging as a significant factor for private credit funds. While bank runs, particularly among uninsured depositors, have been starkly illustrated in recent events like the Silicon Valley Bank collapse in March 2023, private credit funds face their own set of liquidity pressures. Traditionally, illiquid structures with long lock-up periods for investors were designed to mitigate these risks. However, as private credit exposure expands to include retail investors and institutional players like insurers (who often seek to match investment durations with their long-term liabilities), the demand for liquidity is likely to increase.
The ability of a private credit fund to manage its capacity to provide liquidity to investors, especially during periods of market stress or heightened redemption requests, is a critical component of its overall valuation. This includes assessing the diversification of the investor base, the tenor of investor commitments, and the availability of secondary market mechanisms or contingent financing facilities.
Beyond Private Credit: Broader Implications for the Shadow Banking System
The valuation challenges discussed for private credit funds are not isolated to that specific segment. Insurance companies and hedge funds, which are increasingly engaging in private lending as part of the expanding "shadow banking" system, also face similar valuation complexities. Insurance companies, driven by the need to duration-match their long-term liabilities, may increase their allocation to private lending to seek attractive investment opportunities. Hedge funds, on the other hand, might focus on distressed debt or private credit secondaries, requiring a deep understanding of underlying credit and liquidity risks. In all these instances, a thorough assessment of interest rate, credit, and liquidity risk management practices is indispensable for both effective fund management and informed investment decisions.
An Integrated Approach to Valuation
The overarching message is clear: risk management is not an isolated function but an integral part of a financial institution’s or fund’s overall valuation. For the alternative investment space, and particularly for the rapidly growing private credit sector, capturing how and to what extent risks are managed within an integrated valuation technique is more critical now than ever before. This holistic perspective ensures that valuations are not merely a snapshot of current performance but a forward-looking assessment of the institution’s resilience and its capacity to generate sustainable value in an increasingly complex financial environment. The adoption of such integrated frameworks will not only enhance the accuracy of valuations but also contribute to greater market stability and investor confidence.
About the Contributors:
John Sedunov is a Professor of Finance at Villanova University’s School of Business. His research interests encompass financial institutions, financial crises, FinTech, and risk management. Professor Sedunov’s scholarly work has been published in leading academic journals, including Management Science, the Journal of Financial Intermediation, the Journal of Financial Stability, the Journal of Banking and Finance, and the Journal of Financial Research. He currently serves as a banking subject editor for Emerging Markets Review and as an associate editor for The Financial Review, the Journal of Financial Research, and The Quarterly Journal of Finance. Professor Sedunov’s research and commentary have been featured in various prominent media outlets, such as The Wall Street Journal, Financial Times, USA Today, cnbc.com, U.S. News & World Report, CNN, Kiplinger, The Washington Post, The Los Angeles Times, the Pittsburgh Post-Gazette, the San Francisco Chronicle, and Bankrate. In addition to his research endeavors, Professor Sedunov teaches courses focused on the risk management of financial institutions and alternative investments.
Michael Pagano is a Professor of Finance at Villanova University’s School of Business, specializing in financial institutions, risk management, and corporate finance. His research has been published in respected journals like the Journal of Financial Economics, the Journal of Financial Intermediation, and the Journal of Banking and Finance. Professor Pagano has served as an associate editor for The Journal of Financial Research and The Financial Review. His work has been cited in major financial publications, including The Wall Street Journal and The Financial Times. He is a co-author of the textbook Managing Financial Institutions: An Integrated Valuation Approach.
Learn more about CAIA Association and how to become part of a professional network that is shaping the future of investing, by visiting https://caia.org/.
[1] Sedunov, J., & Pagano, M. (2025). Managing Financial Institutions: An Integrated Valuation Approach. World Scientific. This textbook develops a practical approach for incorporating risk management into common stock valuation techniques as it relates to commercial banks and other financial institutions.
