Why Private Credit May Not Be as Good as It Looks

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.”

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%.