Private credit funds are lucrative for investment managers, but not for their limited partners, new research shows.
The asset class du jour, which asset owners have been pouring capital into in recent years while interest rates are higher and banks shrink their lending businesses, is inking risk-adjusted returns attractive to general partners. There just isn’t much alpha leftover for LPs.
This is according to a new working paper from academics Isil Erel, Thomas Flanagan, and Michael Weisbach at The Ohio State University. . “This growing role of nonbanks in providing credit to firms calls into question the role of the ‘specialness’ of traditional bank intermediation. Is private credit special, too, and capable of earning ‘alpha?’” the paper said.
The trio used a relatively new method to evaluate the risk-adjusted returns of private market assets, which regresses the cash flow of assets onto the payoffs of publicly traded benchmarks. This approach, applied to private debt, can help price cash flows, with adjustments for differences in those at the loan and fund level. Using that method, they found that abnormal private credit returns adjusted for both debt and equity risk, were “indistinguishable” from zero. Adjusted only for corporate debt risk factors, the net alpha on a fund is 1.8 percent. But they point out that private credit instruments have elements of both debt and equity risk.
The researchers used data from Burgiss-MSCI, including information on distributions, contributions, and net asset values of a sample of private credit funds. This data is sourced from limited partners. The academics supplemented this data with information from Pitchbook and Dealscan. They filtered the data to include only funds denominated in U.S. dollars.
The time period observed is between 1992 and 2015, a time period chosen to incorporate corporate bond returns and to allow for enough time to observe distributions. The researchers also excluded funds with fewer than five years of cash flow data.
In total, they looked at 532 private credit funds. The average fund size is $783 million, and the average internal rate of return of the net-of-fee cash flows received by limited partners is 8.6 percent. The average duration of the distribution is five and a half years.
They found that if the funds observed had a fee structure of 1.5 percent and 15 percent, investment managers would earn 3.1 percent annually. If the fees followed a 2-and-20 structure, these managers would earn 3.9 percent annually.
For limited partners, the distribution of cash flows received — when discounted at the risk-free rate — leads to an internal rate of return of 8.6 percent. However, when discounting the cash flows for corporate bond risks, investors are earning 11 cents for every dollar invested, generating 1.8 percent alpha. When the researchers added in equity risk, they found that investors earn 5 cents for every dollar invested.
“The abnormal return from the gross cash flows is approximately equal to the estimate of fees paid by the fund,” the paper said. “This pattern suggests that the loans are priced above their fundamental risks, but that any rents go to the GPs who manage the fund rather than the LPs who invest in it. Presumably, these GPs are adding value through their ability to source, negotiate, and manage deals.”
