I get pitched a lot of financial products. The one that I have been pitched the most in recent years is private credit, and private-credit strategies are being marketed and sold to retail investors, too.
Private credit consists of non-publicly traded loans issued by non-bank entities such as private credit funds or business development companies to fund private businesses. It’s surrounded by hype – and is one of the fastest-growing asset classes.
While private credit looks compelling on the surface, the tradeoff between higher risk and higher expected returns is not what it’s often made out to be.
The part of the private credit market that gets pitched most often to retail investors is private credit funds. These are funds that raise money from investors and make direct loans to private companies, typically ones that are unable to get bank loans.
The loan terms are negotiated individually with each borrower, and the terms often contain features that traditional fixed-income investments would not, like a structured equity component. For example, the lender may get warrants giving them the right, but not the obligation, to purchase equity in the borrower for a specified price within a specified time period.
These relatively risky loans already command a higher interest rate than a bank loan, but private credit funds also build their fees into the rate. A typical fee structure would be 1.5 per cent plus a performance fee of 15 to 20 per cent of returns above a set target. All-in, 3 per cent to 4 per cent in fees would be typical.
Between lending to higher-risk borrowers and containing equity features in the loan contracts, private credit can start to look a lot more equity-like than bond-like. This is where it gets interesting.
Owing to its nature as a private asset class, that high risk will not show up as volatility, which can weigh on publicly-traded stock prices. The result is what appears to be high returns, low risk, and low correlations to public markets.
This touches on the questions that every investor should be asking before allocating to an asset class: what risks am I taking and how do I expect them to be compensated?
Understanding risk in illiquid assets can be complex. One interesting perspective comes from a 2023 paper in the Financial Analysts Journal titled Direct Lending Returns.
The author looks at publicly listed business development companies, or BDCs – closed-end funds that engage in direct lending and trade on the public market. They have been shown to be good benchmarks for the returns of private credit funds.
To evaluate BDC performance, the author constructs a benchmark consisting of small-cap value stocks and leveraged loans, because these public assets explain most of the variation in BDC returns.
They find that when BDC performance is evaluated based on net asset values – the values of the underlying assets reported by the BDCs in their regulatory filings – they outperform liquid benchmarks by 2.74 percentage points per year.
The problem is that investors in BDCs do not earn these returns. Publicly listed BDCs don’t always trade at their net asset value; they tend to trade at a discount, particularly during times of market stress.
The market is a pricing machine that absorbs huge amounts of information, which then determines a price. When the market assigns a price below the reported net asset value, it suggests that the net asset value may not be accurate.
On a market-value basis, BDC outperformance is eliminated. This suggests that when properly benchmarked and properly priced, the apparent excess risk-adjusted returns of private credit funds may evaporate.
Along similar lines, a 2024 working paper, Risk-Adjusting the Returns to Private Debt Funds, applies a cash-flow based method to form a replicating portfolio that mimics the risk profiles of a large sample of private credit funds.
The authors find that using both equity and debt benchmarks to measure risk, an investor in a typical private debt fund is not getting anything special for the risk they are taking in these funds - their risk-adjusted excess return is indistinguishable from zero.
These results are not surprising. Theoretically, skilled fund managers will attract assets to their fund up to the point where they are no longer able to generate excess risk-adjusted returns.
The result is that managers collect all the benefits of their skill as fees, and investors in their funds earn returns in line with the risk they are taking.
In the case of private credit funds, it does appear that they are able to apply skill in identifying, negotiating, and monitoring opportunities to make private loans to firms, and they charge fees accordingly.
If investors are aware of these realities, I have no issue with them pursuing private credit, but I think it’s problematic when risky, high-fee investment products are being marketed as safe and stable.
Retail investors may not have the tools or knowledge to evaluate the risks they are taking in private credit funds. In many cases, they will be taking risks that they may not fully appreciate, paying high fees, and not getting anything special in return.
Benjamin Felix is a portfolio manager and head of research at PWL Capital. He co-hosts the Rational Reminder podcast and has a YouTube channel. He is a CFP® professional and a CFA® charterholder.