Estimating the Company-Specific Risk Premium for Private SMEs: A Practical Debt Spread Approach

When valuing a private company, the discount rate is where most of the real work - and most of the debate - happens. One component sits at the centre of that debate more than any other: the Company-Specific Risk Premium, or CSRP.

The CSRP is the additional return an equity investor demands above and beyond the market, size, and country risk premia already embedded in the cost of equity. It is meant to capture the idiosyncratic risks of the specific business being valued, its volatility, its competitive fragility, its key-person dependencies, the quality of its cash flows.

The problem is that there is no formula for it. Published guidance, including from Kroll (formerly Duff & Phelps), acknowledges openly that the CSRP is a matter of professional judgment, typically ranging from 0% to 10%. Left unconstrained, that range can swallow an entire valuation argument. A CSRP of 2% and a CSRP of 10% can produce equity values that differ by a factor of two or more for the same business.

For practitioners working with private SMEs in Mauritius and across Africa where public market comparables are very thin, equity transaction databases are sparse, and US-derived empirical benchmarks (Kroll CRSP decile data, Feldman PE surveys) carry currency and structural mismatches, a more grounded, locally anchored method is essential.

The debt spread offers exactly that, I believe.

The Core Idea

When a commercial bank prices a loan to a private company, it is performing a credit risk assessment. The spread charged above the benchmark lending rate (say PLR), the loan margin, is the bank's quantification of that company's idiosyncratic default risk. It reflects the lender's informed, arms-length judgment about the business: its cash flow stability, its management quality, its sector risk, its collateral position.

This is precisely the information the CSRP is trying to capture.

The calculation is straightforward. Take the company's marginal cost of debt, the rate at which it can borrow today, and subtract a local "risk-free" benchmark, such as the yield on a government treasury bill or bond of comparable tenor.

Debt Spread = Marginal Cost of Debt - Risk-Free Rate Proxy

In Mauritius, for example, SMEs are usually charged between 2.50% to 3.50% above PLR on term loans. Let's assume 3.50% for a 5-year term loan.

Therefore:

Marginal Cost of Debt = PLR (6.65%) + Loan Margin (3.5%) = 10.15%.

BOM 5-Year Yield: 5.58%

Debt Spread = 4.57%

This spread is already meaningful. It is a market-derived, transaction-based signal of company-specific risk, produced by an informed third party with full access to the borrower's financial information.

The Equity Uplift

But the debt spread is not yet the CSRP. Equity is structurally riskier than debt - see Modigliani & Miller (1958, 1963). A lender has priority in a wind-down, receives contractual interest payments, and often holds security. An equity holder receives nothing until all creditors are paid. The risks that a lender prices into a loan spread are a subset of the risks an equity investor faces.

To convert the debt spread into an equity risk proxy, apply a leverage-based uplift:

CSRP (equity) = Debt Spread × 1 / (1 − D/(D+E))

Let's say a company has a debt-to-total-capital ratio of, say, 20%.

CSRP = 4.57% × 1 / (1 − 0.20) = 4.57% × 1.25 = 5.71%

The resulting figure is now a theoretically consistent equity risk premium, anchored in observed credit pricing, adjusted for the structural subordination of equity.

Why This Works in the African and Mauritian Context

Three features make this approach particularly well-suited to SME valuations in emerging and frontier markets.

Bank lending is universal. Even where public debt markets are thin or equity transaction databases are absent, SMEs generally have access to a banking relationship. Loan pricing is observable. The data exists at the level of the individual company.

Local government yields are increasingly available. Central banks across Sub-Saharan Africa publish treasury bill and government bond yields regularly. These benchmark rates can serve as the risk-free proxy. Using a local benchmark rather than the US T-Note also does not require any inflation differential adjustment.

It is defensible under scrutiny. In any transaction, dispute, or regulatory context, a CSRP derived from a bank's actual credit pricing is far harder to challenge than a number drawn from qualitative judgment. It is objective, arms-length, and specific to the subject company. Courts and counter-party advisors find empirical market-based evidence far more persuasive than analyst assertion.

A Note on What the Method Cannot Do

The debt spread captures credit risk — the probability that the company fails to service its debt. It does not capture illiquidity of the equity stake, exit risk in a shallow private market, governance risk in a family-owned business, or the volatility of earnings below the default threshold. These are real equity risks that a pure debt spread will systematically understate.

This is why the leverage uplift is necessary but not always sufficient. In markets with thin acquirer pools and no secondary market for private equity interests, a modest additional qualitative overlay above the leverage-adjusted spread may be warranted. The key discipline is to document it, bound it, and not allow it to become the unconstrained plug that the CSRP so often is in less rigorous valuations.

Applicability

While this method provides an empirically grounded approach, it is always advisable to use other approaches and triangulate. You may want to look up: Kroll CRSP intra-decile spreads (10z minus 10y) which provides a USD empirical benchmark of approximately 4%–5%, which, adjusted upward for the MUR/African private market context, suggests a floor similar to what the debt spread produces and Feldman & Feldman (2023) who document an average firm-specific risk premium of approximately 2% for PE buyout transactions, with a range of 0% - 6%, consistent with the debt spread method sitting toward the upper end for smaller, less liquid businesses.

If you have reached this far, you must have used CSRP at least once in your life. Tell us how you approach this estimation, and let us know what you think about the Debt Spread Approach.