The private credit market is estimated to have reached $3 trillion in assets over the past decade on the promise of delivering higher returns than public credit. But as billion-dollar corporate defaults start to rock the credit markets, concerns have arisen about the investing case behind private credit.
“Private credit fund managers tout the high risk-adjusted returns of the sector with little hard evidence or pushback,” said Jeff Hooke and Xiaohua Hu of Johns Hopkins Carey Business School, along with Michael Imerman, an assistant professor at the University of California at Irvine Paul Merage School of Business, in a recent report published in the Journal of Private Markets Investing.
The academics took a deep dive into the performance of private credit funds with vintage years between 2015 and 2020 and found that these funds “barely outperform or in some cases underperform” the benchmark, an ETF that invests in similar underlying senior-secured debt. The academics analyzed performance using a metric that looks at the total value of a fund, relative to the amount of money paid into the fund to date. They found that a “significant share” of that total value is composed of unliquidated loans whose value is open to interpretation by the managers, what they call “mark-to-myth.” The danger, the professors posit, is that “this is akin to the problem faced by public illiquid investments leading up to the global financial crisis, as they were not properly marked to market.”
Unsurprisingly, the industry is fighting back against this assertion. Cliffwater, an industry consultant on alternatives that is also in the private credit business with a $30 billion BDC — a business development company — argued in a widely distributed memo that “private credit funds outperformed public credit by 4.82 percent per annum, or 2.83 percent per annum adjusted for differences in leverage” on a time-weighted basis over the same period.
Such excess returns came from comparing Cliffwater’s publicly traded BDC Index to the benchmark ETF used in the academic study. The academic study, however, compares closed-end funds to the ETF.
The debate in part hinges on which methodology is used to calculate the returns. As Cliffwater noted, private credit funds typically use the internal rate of return (IRR) methodology, which it said is similar to the time weighted return (TWR) methodology used to analyze the BDC performance.
Many critics view IRR as a flawed measure for a number of reasons, among them the fact that it assumes reinvestment at the same rates as achieved early in the fund. “The IRR is impractical in the context of private debt, in which the reinvestment of intermediate cash flows at equivalent rates are unavailable and the impact of fund-level borrowings is difficult to assess,” the recent study asserted.
The academics looked instead at something called the “total value to paid-in” or TVPI as the primary performance measure. TVPI measures “both realized and unrealized income as well as the principal amount of debt remaining as its estimated value,” which they call a “holistic” view. (As II recently reported, Morgan Stanley has said that more investors in private equity broadly are looking at such measures.)
One example: For senior private debt funds with a vintage year of 2018, the IRR is 10.3 percent. But more than 79 percent of the fund’s TVPI comes from unrealized residual value “that relies heavily on the fund’s valuation models,” according to the study. Even a nine-year-old fund has 50 percent of its TVPI coming from unrealized, or residual, value.
“The TVPI and IRR are very dependent on mark to markets [valuations] provided by the private credit and BDC managers themselves, so they grade their own homework,” Hooke said. The BDCs and private credit funds can also use fund level leverage to inflate IRR. “You can’t manipulate TVPI, like you can IRR,” he added.
The academics said that the high levels of outstanding loans in the funds “has resulted in a new trend of private credit managers establishing continuation funds to help generate liquidity to repay investors in older vintages.”
In response, Cliffwater argued that these high levels of residual loan value are “no surprise” because it is “primarily loan principal that is expected to be repaid at maturity.” Cliffwater added that “TVPI is a private equity fund return of capital measure and was never intended as a performance measure because it does not factor in time.”
The debate over private credit’s returns is likely to gain more attention as retail investors are allowed greater access to alternatives.
For example, PitchBook senior strategist Hilary Wiek said in a new note that retail investors who are gaining access to private equity are actually more likely to be offered funds that are dominated by private debt. Private debt makes up $68.4 billion out of the $110.1 billion of total evergreen fund assets tracked by Morningstar, which owns PitchBook.
“The vast majority of the assets managed for individuals are invested in private debt and real estate,” she said.
Institutional Investor is holding its annual Private Credit Forum Texas November 18 - 19.
