Do private debt fund returns offset their risks?

As private debt sees a meteoric surge in assets amid growing demand from advisors and investors alike, a study from the National Bureau of Economic Research examines how the alternative investment class performs relative to their risks.

In a working paper published April, researchers from Ohio State University and NBER analyzed data from the Burgiss-MSCI database to examine private debt funds’ risk-adjusted returns. Using that data, they created a replicating portfolio that mimics the risk profiles of private debt funds.

Once a niche market, the private credit market has exploded into a $1.5 trillion pie, as one estimate has it, prompting a rush among fund management giants to get in on the action.

“Promised returns must be large enough to offset the probability of default, the systematic risk of these defaults, and also the fees that the fund earns,” the researchers noted.

Based on gross returns, determined by cash flows received from portfolio firms without adjusting for feed charged by general partners, they found private debt funds have gross alphas in the neighborhood of 4 percent.

“The return that borrowers pay in excess of the risk-adjusted interest rate approximately equals the fees that the private debt funds charge,” the proponents of the research said.

Based on data on the distribution of cash flows to limited partners, the researchers found private debt funds have an internal rate of return of 8.6 percent, with an average net present value of 34 cents per dollar of capital invested. But that’s based on risk-free rates, which the authors argue aren’t an appropriate benchmark.

When discounting cash flows using corporate bonds, they found a statistically significant risk-adjusted profit of $0.11 per $1 of capital invested, representing a statistically significant alpha of 1.8 percent when annualized over the duration of the funds.

“[G]ross-of-fee abnormal returns are positive, and using only debt benchmarks also leads to positive abnormal returns as funds contain equity risks,” the researchers said.

Aside from being underpinned by loans that are riskier than most other debt, the researchers noted roughly 20 percent of private debt funds’ portfolios include equity features, making them more “equity-like.”

“The rates at which private debt funds lend appear to be high enough to offset the funds’ fees and risks, but not high enough to exceed both their fees and investors' risk-adjusted rates of return,” the researchers concluded.