Does private credit generate excess returns?

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Private credit alpha

Unhedged went through a period last summer during which we obsessed over what expected returns for private credit might be, and where those returns come from. “The promise of private credit is that for a loan to a borrower of a given creditworthiness, it can get returns that are either a bit better than, or less volatile than, or at the very least uncorrelated to, other forms of lending such as high-yield bonds,” we wrote. This possibility might derive from, variously, the fact that some borrowers will pay up to avoid public bond and loan markets; tighter contract terms; tighter bilateral relationships between borrower and lender; or lack of mark to market valuation. The hard question, though, is whether “risk-adjusted performance is greater or less than the fees [the] clever, hard-working people” who run private credit funds charge their investors.

Three scholars from Ohio State University argue in a new paper that the excess returns from private credit are about equal to the fees that the managers charge. Fund investors, that is to say, receive no excess returns. The returns investors do receive might be high, but only high enough to compensate them for the high risks they have taken. 

The authors, Isil Erel, Thomas Flanagan and Michael Weisbach (who I’ll call EFW) use a Burgiss-MSCI database that includes fund-level data about the cash flows contributed by and paid back to investors (that is, limited partners) in private credit funds that opened between 1992 and 2015. The virtue of this data set is that it tracks cash flows through the funds’ full life cycle.

The backbone of the analysis is using the cash flow data to find the appropriate rate to discount the cash flows through time — including the right “beta”, or measure of the riskiness of the market. A fund or set of funds that provide investor cash flows with a present value greater than zero when discounted using the correct beta have delivered excess returns — returns that do more than compensate for the risks taken, or “alpha”. A negative present value indicates returns inadequate to the risk. 

The key is the method used to determine the discount rates. EFW use a risk factor model that compares the cash flows of the private credit funds with those of publicly traded assets, and finds that private credit cash flows have both debtlike and equity-like risk characteristics. This makes sense, given that private credit’s target borrowers tend to be quite risky, that some private credit deals occasionally include equity “kickers” such as warrants, and that private debt funds can end up owning equity outright in the case of a default. 

It is the use of lower discount rates appropriate to pure debt instruments that creates the appearance of excess returns for private credit. “If you forget the cash flows are equity-like, you will mistakenly think they have a positive alpha [excess returns],” as Flanagan put it to me yesterday. 

It is very important to remember that EFW are not arguing that investing in private credit is a bad idea. The main pitch of private equity and private credit funds alike is not that their risk-adjusted returns are higher than those of public equity or fixed income. Instead, it is that the returns are uncorrelated with public markets, so they can contribute to better risk-return trade-offs in a diversified portfolio. Nothing about the EFW argument changes this. I asked Flannagan and Weisbach if the diversification argument still applies, and they said it absolutely did. 

Nor does the EFW argument imply that no individual private credit manager can generate alpha. The point is simply that private credit does not generate alpha systematically, as an asset class. To the degree the market is efficient, no asset classes do this. To the degree that private credit did this over a given period, it would have discovered a permanent inefficiency, a free lunch. Free lunches may well exist, but they are generally very hard to find and exploit.   

Stephen Nesbitt, the CEO of Cliffwater, an investment adviser specialising in private markets, has rejected the EFW argument in a brief written response. He argues that the period covered in the study misrepresents private credit industry today. The industry then was dominated by high-risk loan tranches and second-lien lending, and many funds mixed junk bonds and distressed loans into portfolios, whereas today the industry is focused on first-lien senior loans. He says funds then tended to be small and had high fees. Next, he notes that the Burgiss-MSCI database is not transparent and suffers from backfill bias, that is, that it only includes data on funds that chose to report results. Finally, he says that the relatively new factor model that EFW uses is “inconsistent with current risk management convention”. Using an more standard method and a Cliffwater database of middle-market loans, he finds significant after-fee excess returns from private credit.

I won’t get into the argument about which measurement method and which database is superior. Nesbitt is clearly right that the private debt industry is changing very quickly; the industry is growing so fast it could hardly avoid it. The point about backfill bias is a bit odd, though, as that would inflate, rather than diminish, the returns in the EFW study.

Nesbitt’s response, agree with it or not, raises a really big question, though: if private credit, as an asset class, does systematically generate excess returns, where do they come from?  

One good read 

Soumaya Keynes on the Jamaican debt miracle.

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