Private Debt

CHAPTER 9Risk Premiums in US Middle Market Lending

Risk premium is an often‐used term in finance to identify factors common to a group of securities where, because that group possesses unique risk‐generative characteristics that cannot be diversified away, there exists an expected or ex ante return attributable to that common factor. Oddly, while called a risk premium, it is a return premium for taking risk.

It is also worth emphasizing that risk premiums accrue to common factors that are nondiversifiable or can't otherwise be eliminated through diversification. Consequently, risk premiums are considered beta and not alpha. When risk premiums are found in less traditional asset classes or investment strategies they are sometimes referred to as alternative beta.

Most familiar to investors, and perhaps the largest risk premium, is the equity risk premium. Stock risk can't be diversified away in portfolio construction so investors, being risk averse, demand a premium return for holding stocks in a portfolio. A wealth of historical data has verified the existence of a stock risk premium, measuring somewhere between 4% and 6% over long periods. Another familiar example is the term structure premium, reflecting the common factor among long‐dated bonds that the risks relating to lending at fixed rates for long periods of time can't be diversified away and deserves a premium return relative to short‐term lending. Again, historical studies have attributed 1–2% in premium return to ...