This paper on private credit investment is the fifth in a series on alternative investments. The alternatives industry is making a concerted effort to gather more assets from individuals due to declining appetite from institutional investors. The purpose of the series is to help individual investors recognize the drawbacks of alternative investments before plunging in. If you are considering private credit for your portfolio, you should be aware of the following issues:
According to a National Bureau of Economic Research study, private debt funds have provided no risk-adjusted return advantage to investors.
Private credit has a much higher downside risk than most believe.
Because assets in private credit have surged in benign conditions, the category has not faced a serious test at its current size and scope.
Success in private credit investment requires specialized organizational capabilities and access.
What is Private Credit?
Private credit firms provide loans and other types of credit, primarily to privately held companies. These firms are typically private partnerships that deploy capital received from institutional investors such as pension funds, non-profits, and insurance companies.
Although there is overlap between the activities of banks and private credit firms, private credit firms are not organized or regulated like banks. Senior secured loans made directly to middle-market companies account for about half of private credit assets. Other types include distressed debt (loans to companies in financial distress) and specialty finance (non-corporate lending, such as mortgages or asset-backed finance).
Why Private Credit?
The apparent advantages of investing in private credit include:
A greater opportunity set: There are more than 200,000 middle-market businesses in the US.
Higher returns: Past returns of private credit exceed the returns of other fixed income categories.
Perception of “illiquidity premium”: It is generally believed that illiquid investments inherently offer an “illiquidity premium,” leading to higher returns than for equivalent liquid investments.
Perception of low volatility and correlation: The reported returns of private credit appear to have low volatility and low correlation to other investment types.
Returns as Reported Can Be Misleading
Private credit performance can be challenging to decipher. Reported investment results are based on the Internal Rate of Return (IRR), a deeply flawed metric which typically exaggerates true performance. Valuations as reported by private credit firms can flatter results as well, particularly when the value of loans is falling. For more on why IRR is a misleading performance metric, see “The Tyranny of IRR,” a two-part series by Professor Ludovic Phalippou of Oxford University on the CFA Institute website.
But The Reported Returns Look Great
The reported 10.0% annual return of private credit for the past twenty years nearly matches the 10.5% annual return of the S&P 500. It is also much higher than could have been obtained in other primary fixed income categories.
The following chart shows the cumulative return over the past twenty years for five categories of fixed income investments:
Barclays Aggregate: Benchmark for intermediate-term US investment grade fixed income.
Leveraged Loans: Bank loans to below-investment-grade or highly leveraged borrowers.
US High Yield: Public debt of below-investment-grade companies.
Business Development Companies (BDCs): Publicly traded funds that lend to small- and mid-sized companies.
Private Credit: IRRs for illiquid private credit funds organized as private partnerships.
Private Credit Assets Growing Quickly
Investors, encouraged by strong historical returns, have poured money into private credit. There was only $200 billion in US private credit in 2007, the year before the Global Financial Crisis. Assets now total approximately $1.6 trillion, recently surpassing both the US high yield and leveraged loan markets.
Private Credit May Provide No Net Skill-Based Return
It’s difficult for investors to know if they are being compensated fairly for the risks taken. A detailed study by the National Bureau of Economic Research found that, on average, they are not. The research compared the net returns received by limited partners to those available from comparable liquid assets and concluded: “Our estimates suggest that the risk-adjusted abnormal return on $1 of capital invested in private credit funds is indistinguishable from zero.”
The study revealed that gross returns earned by private credit firms were 4% per year higher than liquid benchmarks — but fees absorbed all of this excess, leaving investors with no additional benefit.
Private Credit is Riskier Than it Looks
Reported private credit volatility of about 8% per year is misleadingly low because valuations are smoothed. To assess real-world risk, one can examine publicly traded Business Development Companies (BDCs). During the 2007–2009 and 2020 bear markets, BDCs lost significantly more than the S&P 500. Over the past two decades, the BDC index has been nearly twice as volatile as the S&P 500. To match the risk-adjusted return of the S&P 500, BDCs would have needed to deliver 17.5% annually instead of their actual 7.5%.
Concerns From the IMF
The International Monetary Fund’s April 2024 Global Financial Stability Report devoted an entire chapter to private credit and its potential systemic risks. While the IMF does not view private credit as an imminent threat, it highlighted several risk factors:
Private markets are lightly regulated and opaque compared to bank lending or public debt markets.
Private loans are illiquid, unrated, and subjectively valued, making rising risks hard to detect.
Private credit has never endured a severe downturn at its current scale, leaving risk controls untested.
Rapid growth, competition, and capital deployment pressures may have eroded lending standards.
Leverage across participants could amplify systemic stress during downturns.
Retail investors may not fully understand the risks involved.
The IMF also warned about the impact of rising rates on borrowers, noting that most private credit lending is floating-rate. Between December 2021 and late 2024, the average interest coverage ratio for borrowers fell from 3.0 to 1.6. While defaults remain low, payment-in-kind (non-cash) interest has doubled in five years to roughly 9% of income.
Who Should Invest in Private Credit?
Outcomes in private credit vary widely. The investors best positioned to succeed are large, experienced institutions — such as university endowments — that can perform deep due diligence, maintain access to top-tier managers, and monitor performance rigorously. Individual investors without comparable expertise, resources, or access are unlikely to achieve similar results and may instead experience average or below-average outcomes.
Summary
Private credit has produced appealing historical returns, but much of this may be illusionary. The sector has grown dramatically in favorable conditions and has yet to face a major stress test at scale. Research shows that investors, after fees, earn no better risk-adjusted returns than comparable liquid assets. When the next downturn comes, it will likely expose the true risks, valuation practices, and manager quality in the space — potentially offering better future entry points.
[2] Erel, Isil, Flanagan, Thomas & Weisbach, Michael. “Risk-Adjusting the Returns to Private Debt Funds.” NBER Working Paper, March 2024. https://www.nber.org/papers/w32278
Alternative Investments Reality Check Part 5
What’s Discussed
This paper on private credit investment is the fifth in a series on alternative investments. The alternatives industry is making a concerted effort to gather more assets from individuals due to declining appetite from institutional investors. The purpose of the series is to help individual investors recognize the drawbacks of alternative investments before plunging in. If you are considering private credit for your portfolio, you should be aware of the following issues:
What is Private Credit?
Private credit firms provide loans and other types of credit, primarily to privately held companies. These firms are typically private partnerships that deploy capital received from institutional investors such as pension funds, non-profits, and insurance companies.
Although there is overlap between the activities of banks and private credit firms, private credit firms are not organized or regulated like banks. Senior secured loans made directly to middle-market companies account for about half of private credit assets. Other types include distressed debt (loans to companies in financial distress) and specialty finance (non-corporate lending, such as mortgages or asset-backed finance).
Why Private Credit?
The apparent advantages of investing in private credit include:
Returns as Reported Can Be Misleading
Private credit performance can be challenging to decipher. Reported investment results are based on the Internal Rate of Return (IRR), a deeply flawed metric which typically exaggerates true performance. Valuations as reported by private credit firms can flatter results as well, particularly when the value of loans is falling. For more on why IRR is a misleading performance metric, see “The Tyranny of IRR,” a two-part series by Professor Ludovic Phalippou of Oxford University on the CFA Institute website.
But The Reported Returns Look Great
The reported 10.0% annual return of private credit for the past twenty years nearly matches the 10.5% annual return of the S&P 500. It is also much higher than could have been obtained in other primary fixed income categories.
The following chart shows the cumulative return over the past twenty years for five categories of fixed income investments:
Private Credit Assets Growing Quickly
Investors, encouraged by strong historical returns, have poured money into private credit. There was only $200 billion in US private credit in 2007, the year before the Global Financial Crisis. Assets now total approximately $1.6 trillion, recently surpassing both the US high yield and leveraged loan markets.
Private Credit May Provide No Net Skill-Based Return
It’s difficult for investors to know if they are being compensated fairly for the risks taken. A detailed study by the National Bureau of Economic Research found that, on average, they are not. The research compared the net returns received by limited partners to those available from comparable liquid assets and concluded: “Our estimates suggest that the risk-adjusted abnormal return on $1 of capital invested in private credit funds is indistinguishable from zero.”
The study revealed that gross returns earned by private credit firms were 4% per year higher than liquid benchmarks — but fees absorbed all of this excess, leaving investors with no additional benefit.
Private Credit is Riskier Than it Looks
Reported private credit volatility of about 8% per year is misleadingly low because valuations are smoothed. To assess real-world risk, one can examine publicly traded Business Development Companies (BDCs). During the 2007–2009 and 2020 bear markets, BDCs lost significantly more than the S&P 500. Over the past two decades, the BDC index has been nearly twice as volatile as the S&P 500. To match the risk-adjusted return of the S&P 500, BDCs would have needed to deliver 17.5% annually instead of their actual 7.5%.
Concerns From the IMF
The International Monetary Fund’s April 2024 Global Financial Stability Report devoted an entire chapter to private credit and its potential systemic risks. While the IMF does not view private credit as an imminent threat, it highlighted several risk factors:
The IMF also warned about the impact of rising rates on borrowers, noting that most private credit lending is floating-rate. Between December 2021 and late 2024, the average interest coverage ratio for borrowers fell from 3.0 to 1.6. While defaults remain low, payment-in-kind (non-cash) interest has doubled in five years to roughly 9% of income.
Who Should Invest in Private Credit?
Outcomes in private credit vary widely. The investors best positioned to succeed are large, experienced institutions — such as university endowments — that can perform deep due diligence, maintain access to top-tier managers, and monitor performance rigorously. Individual investors without comparable expertise, resources, or access are unlikely to achieve similar results and may instead experience average or below-average outcomes.
Summary
Private credit has produced appealing historical returns, but much of this may be illusionary. The sector has grown dramatically in favorable conditions and has yet to face a major stress test at scale. Research shows that investors, after fees, earn no better risk-adjusted returns than comparable liquid assets. When the next downturn comes, it will likely expose the true risks, valuation practices, and manager quality in the space — potentially offering better future entry points.
References
[1] Atlas Capital Advisors – Alternative Investments Commentary: https://ocio.atlasca.com
[2] Erel, Isil, Flanagan, Thomas & Weisbach, Michael. “Risk-Adjusting the Returns to Private Debt Funds.” NBER Working Paper, March 2024. https://www.nber.org/papers/w32278
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