A trio of academics has a bold take on the booming $1.7 trillion private credit market: after accounting for additional risks and fees, the asset class delivers virtually no extra return to investors.
In a new study released by the National Bureau of Economic Research, the professors argued that direct lenders on the whole hardly produce any alpha — or extra compensation over broad market benchmarks.
That conclusion is sure to stir debate over a market that has more than doubled in size over the past five years thanks to the allure of higher and steadier returns compared to publicly traded debt.
"It's not a panacea for investors where they can earn 15% risk-free," said Michael Weisbach, a finance professor at Ohio State University who wrote the research with Isil Erel and Thomas Flanagan. "Once you adjust for the risk, they basically are getting the amount they deserve, but no more."
Behind the research is complex math used to untangle the alpha part of a return that's attributable to skill, and the beta part that might just come from stumbling into a bull market. Comparing stock pickers to a market benchmark like the S&P 500 is standard by now. But it's not obvious what the right yardstick is for private-credit funds, which make idiosyncratic and opaque loans to a wide variety of companies.
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To be clear, the study covers broad industry returns rather than any particular fund, and Weisbach is quick to add the asset class could still be a welcome source of diversification as long as investors can tolerate its lower liquidity.
The three economists looked at MSCI data for 532 funds' cash flows, covering their incoming capital and distributions to investors. They compare the industry's performance to stock and credit portfolios with similar characteristics, whose fluctuations end up explaining the majority of private-credit returns. The study makes the case that these private credit funds also carry some equity risk, since around 20% of their investments contain equity-like features such as warrants.
After accounting for those risks, they find that there's still alpha left on the table — which only vanishes once fees paid to these managers are deducted.
"It really is the first attempt to my knowledge of trying to look at private credit using both credit and equity benchmarks," said Tobias True, a partner at Adams Street Partners who applies data analytics to building private portfolios. "There is so much variety and diversity in the loan structures with the equity components and different levels of leverage. That's what really makes it challenging for us to separate alpha and beta."
The paper's conclusion might resonate with some investors, or limited partners, who are starting to question the hefty costs as interest rates rise and competition for their dollars intensifies. Meanwhile, default risks are also rising as tighter monetary policy squeezes corporate borrowers. With fund-raising now slowing after a few years of rapid growth, some private credit funds have started to waive fees to investors.
As private markets boom, some quants — most notably Cliff Asness of AQR Capital Management — have suggested that investors are being misguided by returns that mask volatility and may be less impressive than they seem.
True at Adams Street Partners, who co-wrote one of the first papers on private-credit performance, cautions that until the industry is faced with its first downturn, it may be hard to measure real alpha. But he says the NBER study is a good step toward digging beneath the surface of private-credit returns.
"It's not going to give anyone a magic formula where they can go in and say, you haven't delivered any alpha," he said. "Maybe it just raises awareness that there's additional risk and the excess performance wasn't really worth it in some cases."
