Why Private Credit May Not Be as Good as It Looks

Factor in risk adjustments and fees, and this fast-growing asset class’s high returns get whittled down, an academic paper finds.


Private credit has gotten very popular among investors, as it has delivered superior returns, overshadowing those of investment-grade bonds and junk. Over 15 years running from the onset of the 2008 global financial crisis through 2023’s third quarter, it has returned around 8% annually, besting IG bonds (3%) and high-yield (6%), according to global investment  firm Hamilton Lane.

The trouble is, when accounting for private debt funds’ risk adjustments and higher fees, their luster dims, per a paper put out by the National Bureau of Economic Research, a private nonprofit organization.

Private credit typically charges higher rates than do banks, as the borrowers have difficulty securing bank loans. Hence, the loans are riskier. At the moment, the default rate is around 3%, but a recession could worsen that considerably. Private loans often are floating rate, which means they insulate investors from inflation.

The NBER study, written by three finance professors from Ohio State University—Isil Erel, Thomas Flanagan and Michael Weisbach—found that the “rates at which private debt funds lend appear to be high enough to offset the funds’ fees and risks, but not high enough to exceed both their fees and investors’ risk-adjusted rates of return.”

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While the study did not identify how much more private loans yield than traditional bank loans, their interest rates appear to be in the mid-teens. The funds, however, usually charge their investors—enticed by those lush yields—1.5% management fees and 15% of the profits. In other words, a big chunk of the returns go into the fund general partners’ pockets.

Meanwhile, private loan funds are seeing a lot of investments pouring in. As a report from McKinsey & Co, put it, “growth in private debt has largely been driven by institutional investors rotating out of traditional fixed income in favor of private alternatives.”

As the McKinsey described the trend, “Dollars have accrued to the strategy in search of high yields, with downside protection driven by a senior position in the capital stack.” Private debt assets under management increased 27% in 2023 over the prior year, to $1.7 trillion, Preqin data indicate.

But returns are off lately, mostly due to a slowdown in private equity, which uses a lot of private debt. Hamilton Lane calculated that 2023 returns were down to 6.8%.

Over time, though, private credit can boast that it has held up well compared with two other prominent alternative investments, junk bonds and leveraged loans, according to a BlackRock Inc. report. It showed that the Cliffwater Direct Lending Index, a proxy for private debt (it launched in 2005) outperformed the Bloomberg USD High-Yield Corporate Bond Index and the Morningstar PSTA USD Leveraged Loans Index in 12 of the last 17 years, through the third quarter of  .

Against legacy asset classes, meaning equities and fixed income, private credit has held its own, even in bad years. In 2022, a rough year for both stocks and bonds, the private debt index was up 4.2%, versus minus 14.7% for junk and minus 3.3% for lev loans. The S&P 500, the standard benchmark for stocks, was down 19.4%, and the Bloomberg US Aggregate Bond Index, which tracks investment-grade corporate bonds and Treasurys, was off 13%.

In 2008, the year of the global financial crisis, when almost all assets suffered badly except for Treasury bonds, private debt lost just 6.5%, as high-yield tumbled 26.2% and lev loans were down 29.1%. The S&P 500 skidded 38.5%, but the Agg, thanks to its Treasury exposure, gained 5.2%.

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SEC Seeks Institutional Investor Reps for Advisory Committee

The independent committee needs representatives of pensions and mutual funds to bolster investor protection.

 



The Securities and Exchange Commission is seeking five new representatives to join its Investor Advisory Committee, an independent group that aims to protect investors and improve securities regulations.

According to the regulator, the committee is open to members of the public who represent the interests of institutional investors, such as pension funds and registered investment companies, as well as representatives of individual equity and debt investors, including mutual fund investors.

The committee, established under the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 and independent of the SEC, advises and consults with the regulator on its regulatory priorities, securities product regulation, trading strategies, fee structures and disclosure effectiveness. It is also involved with initiatives to protect investor interests and promote investor confidence in the securities marketplace.

No fewer than 10 and no more than 20 members are appointed by the SEC to serve four-year terms on the committee, which includes an investor advocate, a representative of state securities regulators and a representative of senior citizens. The committee’s members are expected to participate in public meetings, which take place three to four times per year, either virtually or at the SEC’s headquarters in Washington, D.C. The public meetings may include panel talks, as well as discussions about and votes on committee recommendations.

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Committee members are also expected to join one of four subcommittees, which develop panels and recommendations for full committee consideration and meet virtually between committee meetings. The subcommittees currently consist of the Investor as Owner Subcommittee, the Investor as Purchaser Subcommittee, the Market Structure Subcommittee and the Disclosure Subcommittee. There is also a working group on access and inclusion, which includes representation from each subcommittee.

After SEC staff determine the eligibility of the applicants, the regulator will review the candidates, make nominations and vote on a slate of new members to serve on the committee.

“The Investor Advisory Committee and its diverse and talented members are key to ensuring a wide array of investor perspectives are represented in SEC policymaking,” said SEC Chairman Gary Gensler in a release. “I look forward to working with the members of the Investor Advisory Committee to continue to uphold the SEC’s mission of providing transparent and fair markets for all investors.”

Candidates interested in serving on the committee can email a statement of interest, including relevant information on their background and experience, no later than April 26 to iac-candidates@sec.gov.

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