The returns generated by private credit funds seem to primarily benefit fund managers, not investors. According to a recent study published by three economists from the American National Bureau of Economic Research (NBER) there is no extra return left for investors after accounting for costs and risks.
The study «Risk-Adjusting The Returns To Private Debt Funds» analyzes cash flow data from 532 private credit funds established between 1992 and 2015. The researchers compared incoming capital to distributions to investors.
The rates at which private credit funds borrow money appear to be high enough to cover fees and risks but too low to generate additional returns for investors, once risks are accounted for.
Researchers Isil Erel, Thomas Flanagan, and Michael S. Weisbach, all affiliated with Ohio State University, argue that although alpha may be achieved, it disappears once fees are paid to fund managers.
Compensated for Risk
The first issue is a familiar one, namely the price tag of the funds. The costs of private credit funds typically consist of a management fee of 1.5% and a carried interest of 15% (a share of the profits). This is lower than the compensation for private equity funds but significantly higher than that of other lenders providing private loans. The risk is also much higher, the researchers state.
«As other non-bank lenders have much lower costs, private credit funds must borrow at much higher rates than other non-bank lenders, and they often deal with lower quality borrowers who have no other sources of capital.»
Many private credit funds also supplement the loans in their portfolios with equity or instruments such as warrants to enhance returns.
«Our estimates indicate that, once adjusted for fees and risks, private debt funds offer their investors returns that are appropriate for the risks they face, but no more than that,» the report states.
Booming
Private debt funds, accounting for an estimated $1.5 trillion in managed assets in 2023 according to data from Preqin, are nonetheless the fastest-growing category in the lending market, with the market doubling in the past five years.
The growing popularity of private credit is largely attributed to institutional investors rotating out of traditional fixed-income securities in favor of private alternatives, and this is not without reason.
From the beginning of the global financial crisis in 2008 to the third quarter of 2023, the annual return was approximately 8%, which is better than investment-grade corporate bonds (3%) and high-yield (6%).