The true return on private debt

Yesterday, I wrote about how investors are falling prey to potentially overstated returns in private equity. At the risk of turning this week into ‘private assets week’, I want to address the returns of private credit today.

Private credit has become the hottest asset class in 2024, it seems. There is hardly a day when I don’t get a news alert about some private credit hotshot leaving a big bank to start their own fund or a bank announcing massive investments in the space. As usual, this boom is fuelled by pension funds, family offices, and other institutional investors chasing uncorrelated and stable returns with low to medium risk. And as usual, products are marketed with the promise of delivering exactly that – at least in hindsight based on past returns.

But when it comes to private credit, it seems not even past returns can live up to this promise, according to a study from the Ohio State University.

The paper opens with a quote from Blackstone co-founder Steve Schwarzman in the Financial Times on 16 October 2023:

“If you can earn 12 percent, maybe 13 percent on a really good day in senior secured bank debt, …with almost no prospect of loss, that’s about the best thing you can do.”

I am sure this quote will never come back to bite him.

The researchers use different methodologies to estimate the return of private credit after fees. I will restrict myself to the NPV methodology that estimates the alpha over the risk-free rate during the lifetime of a fund but other methodologies in the paper come to the same conclusion. The research uses the returns of 532 private credit funds until the end of 2015.

The chart below shows that the average cumulative return above the risk-free asset is 33.9% in this sample. And since the average lifetime of a fund is somewhere around 5.5 years, that amounts to an internal rate of return (risk-free plus alpha) of 8.6% per year. That’s pretty good for a ‘low-risk’ asset class.

But therein lies the problem. Comparing returns to the risk-free asset is not fair because private credit is essentially high yield debt structured by banks and specialist asset managers. So, at the very least, one needs to adjust the outperformance by the risk factors inherent in bond investments. If one does that, the lifetime cumulative alpha is still 10.5%.

But as I said, private credit are high yield loans, so they are riskier than normal bonds and effectively lie somewhere between stocks and bonds. So, instead of using bonds as the reference point one can adjust the alpha by the risk factors in stocks or, even better, the combined risk factors of stocks and bonds. Once the performance of private credit is adjusted for the risk factors of both stocks and bonds, the resulting alpha over the lifetime of a fund is… drum roll… -0.1%.

In essence, this research indicates that even in the past, holding private credit was likely not going to improve a portfolio that already was diversified between stocks and bonds. And that is to say nothing about future returns when more investors are chasing a limited set of opportunities. And we all know what that tends to do to performance.

Cumulative alpha of private credit

Source: Erel et al. (2024)