Does private credit generate excess returns?

Open Editor's Digest for free

Rula Khalaf, editor of the Financial Times, picks her favorite stories in this weekly newsletter.

Good morning. We hope our fellow American eclipse observers come out in high spirits and without fried corneas. There was much discussion in the Financial Times' New York office yesterday: Was the eclipse an economic boost or a drag? Supporters argued that caravans of eclipse tourists flocking to cities along the path of totality would drive up spending. Crowds of office workers milling around outside in frightening half-light will hurt productivity, Drager answered. what you say? Email us: robert.armstrong@ft.com and ethan.wu@ft.com.

Alpha Private Credit

Uncovered went through a period last summer where we were obsessing over what the expected returns for private credit would be, and where those returns would come from. “The promise of private credit is that for a loan to a borrower of a certain creditworthiness, it can receive returns that are slightly better than, or less volatile than, or at least uncorrelated with, other forms of lending,” we wrote: “Private bonds.” This possibility may stem, variously, from the fact that some borrowers will pay large sums to avoid public bond and loan markets; stricter contract terms; stricter bilateral borrower-lender relationships; or the lack of a mark of market valuation. But The difficult question is whether the risk-adjusted performance is greater or less than the fees [the] The “smart, hard-working people” who run private trusts charge their investors fees.

Three Ohio State University researchers argue in new research that the excess returns from private credit are roughly equal to the fees charged by managers. This means that fund investors do not receive excess returns. The returns that investors receive may be high, but they are only high enough to compensate them for the higher risks they have taken.

The authors, Issel Erel, Thomas Flanagan, and Michael Weisbach (whom I will call EFW) use the Burgiss-MSCI database that includes fund-level data on cash flows contributed by and paid to investors (i.e. limited partners) in private trusts opened between 1992 and 2015. The advantage of this dataset is that it tracks cash flows over the entire life cycle of funds.

The backbone of the analysis is using cash flow data to find the appropriate rate at which to discount cash flows over time – including the correct “beta”, or measure of market risk. A fund or group of funds that provides investors with cash flows with a present value greater than zero when discounted with the correct beta has generated excess returns—returns that more than compensate for the risk taken, or “alpha.” A negative present value indicates insufficient risk returns.

The key is the method used to determine discount rates. EFW uses a risk factor model that compares the cash flows of private credit funds with those of publicly traded assets, and finds that private credit cash flows have risk characteristics similar to debt and equity. This makes sense, because private credit target borrowers tend to be quite risky, some private credit deals sometimes include equity ancillaries such as warrants, and private debt funds may end up owning the equity outright in the event of a default. Payment.

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

It is very important to remember that the EFW does not argue that investing in private credit is a bad idea. The main idea promoted by private equity funds and private credit funds alike is not that their risk-adjusted returns are higher than those of public equities or fixed income. Instead, returns are uncorrelated with public markets, so they can contribute to improving risk-return trade-offs in a diversified portfolio. Nothing in the EFW argument changes this. I asked Flanagan and Weisbach whether the diversification argument still applies, and they said it certainly does.

The EFW argument does not mean 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. As efficient as the market is, no asset classes do. To the extent that private credit did this over a given period, it would have discovered permanent inefficiency, or a free lunch. Free lunches may exist, but they are generally very difficult to find and exploit.

Stephen Nesbitt, CEO of Cliffwater, an investment adviser specializing in private markets, rejected EFW's argument in a brief written response. He argues that the period covered by the study distorts today's private credit industry. At the time, subprime and second-lien lending segments dominated the industry, and many funds were mixing junk bonds and distressed loans into investment portfolios, whereas today the industry focuses on first-lien loans. At that time, he says, funds tended to be small and fees were high. Next, he points out that the Burgess-MSCI database is not transparent and suffers from backfilling bias, that is, it only includes data on funds that have chosen to report results. Finally, he says the relatively new factor model used by the EFW program “is not compatible with current risk management convention.” Using a more standard approach and Cliffwater's database of middle market loans, he found significant excess returns after fees from private credit.

I will not get into the debate about which measurement method and database is best. Nesbitt is clearly right that the private debt industry is changing very quickly; The industry is growing so fast that it cannot be avoided. The point about backfill bias is a bit odd, although that would have inflated the returns in the EFW study rather than diminished them.

Nesbitt's response, whether I agree with him or not, raises a really big question: If private credit, as an asset class, systematically generates excess returns, where does it come from?

One good read

Somaya Keynes talks about the Jamaican debt miracle.

FT Podcast is not protected

Can't get enough of Unhedged? Listen to our new podcast, hosted by Ethan Wu and Katie Martin, for a 15-minute dive into the latest markets news and financial headlines, twice a week. Catch up on previous editions of the newsletter here.