Professor Isil Erel, David A. Rismiller Chair in Finance at The Ohio State University and Academic Director of the RISK Institute, delivered a talk at Inquire Europe Autumn Seminar 2024 on the growth of private credit markets. She highlighted the rise of private debt as “one of the largest and fastest-growing assets in the private capital markets,” noting that private debt funds manage “approximately $1.5 trillion in assets under management as of the year 2023, in the US alone, growing significantly in Europe and Asia as well.” These funds primarily provide “direct loans to firms that typically cannot get loans from banks […] because these are on average riskier borrowers.” Despite their rapid growth, little is understood about the risk-adjusted returns of these funds.
Erel’s talk focused on key questions: “Are private debt funds really earning up normal returns as implied by the practitioners? […] Or do these higher returns simply reflect riskier investments?” Using methodologies borrowed from prior literature, notably Gupta and Van Nieuwerburgh’s 2021 paper, her findings suggest that “private debt funds lend at rates only high enough to cover their risks and the fees that the GPs charge.” Additionally, “despite their name, a non-trivial amount of their portfolios are in equity-like claims,” requiring adjustments for both bond and equity risk factors.
The researcher employs MSCI Burgess data, which provides net-of-fee cash flows to limited partners (LPs), covering private credit funds from 1992–2018. This dataset includes distributions, contributions, and NAVs but lacks portfolio-level details. Contributions peak in the first two years and distributions in years 4–6. The funds, averaging $783M in size, 5.5 years in duration, and an 8.6% IRR, feature portfolios comprising loans, common equity, preferred equity, and warrants, with equity stakes averaging 15–22%. As Erel noted, “although they are called debt funds, they have a significant chunk of their investment in equity-like instruments. And that’s why we believe to not only adjust for bond factors, but also equity factors.”
Building on existing methodologies, the researcher uses cash flows and public benchmarks, assuming the law of one price to estimate portfolio prices. Benchmarks include zero-coupon treasury bonds, interest rate factors, bond and equity benchmarks, liquidity adjustments, and more. Cash flow variations are modeled with two types of benchmarks: rollover benchmarks, which reinvest gains period by period, and gain match benchmarks, which compound returns over the investment horizon. “Unlike in the case of bank loans […] private debt contributions are delayed over the life of the fund as well. I have to adjust for that and construct my benchmarks that have matched contributions.” While some might argue that bond factors are sufficient, Erel counters, “I would be arguing against it and go to include equity factors as well and get zero net alpha. So in short, no abnormal returns to LPs, but I would get some alpha if I were to use only bond factors.”
Finally, the research explores heterogeneity across fund types, such as generalist, mezzanine, and distressed funds. The study concludes that while private debt funds advertise high returns, there is no evidence of abnormal net alpha for LPs after accounting for risk and fees. The high returns largely reflect substantial equity-like investments and associated risks. Despite attractive IRRs, “investors should be cautious about claims of exceptional performance, as the net gains are largely consumed by fees and proper risk-adjustment considerations.”
View the research in full via : https://www.inquire-europe.org/event/autumn-seminar-2024-valancia-spain/
The prize committee of Inquire Europe decided to award the prize for the best paper presented at the Autumn Seminar 2024 to the paper of Professor Erel and her co-authors Michael Weisbach (Ohio State University) and Thomas Flanagan (Ohio State University) Click here to read more.