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Private Credit 

Sami Vukelj

It is called private credit’s golden age because with heightened interest rates you can earn double-digit yields on first-lien debt. And that, for Blackstone’s co-founder Steve Schwarzman, is “about the best thing you can do.“

But according to a new paper from the National Bureau of Economic Research, private debt’s portrayal may not be so shiny and underneath what is marketed as a low-risk, high-return strategy is anything but.

“Most debt funds make loans that are substantially riskier than Schwarzman’s characterization of them. It is not at all clear if, in practice, private debt funds’ returns are sufficiently large to offset their risk,” said the report.

The researchers evaluated the risk-adjusted returns of private credit funds, considering the facts that private borrowers are generally riskier and smaller companies that lack access to bank financing, and take into account the substantial fees that LPs pay into funds. They try to also find out if the promised returns are large enough to offset the probability of default.

They conclude that “the risk-adjusted abnormal return on $1 of capital invested in private credit funds is indistinguishable from zero”, implying that investors only earn a rate of return appropriate for the risks they face, with no additional alpha.

But their caveat is that their findings rely on a methodology that adjusts for risks correlated with both debt and equity returns, and when they only use debt as a risk factor, the risk-adjusted profit comes out to about $0.11-$0.12 per $1 invested, or 1.8% net alpha.

In that regard, the return profile looks much better, but they maintain that private credit funds contain enough equity-like characteristics (because their loans are substantially riskier than most other debt investments, and because about 20% of portfolios include equity features) and that equity-specific risk factors must be accounted for to gain an accurate picture, thus zero alpha.

“Rents earned by the funds from making private direct loans accrue to the general partners, not the limited partners. These rents appear to reflect compensation for identifying, negotiating, and monitoring private loans to firms that could not otherwise raise financing,” concluded the report.

So the researchers argue that the bargain is not all that good for investors from a risk-adjusted perspective. It’s unclear how much of those technical details about the source of returns and the relative merits of them on a risk-adjusted basis matter while LPs continue to get paid, and borrowers continue to avoid default, keeping everyone happy.

As they say on Wall Street, this tour rolls on.

The current interest rate environment has helped juice returns for creditors across the leveraged finance universe, but they’ve also burdened borrowers with higher interest costs that can pressure cash flows. Where problems arise, however, is where that famed private credit flexibility comes into play.

The latest example is the rise of delayed draw term loans (DDTLs) as a source of funding for borrowers to cover interest payments with, as we reported this week.

While DDTLs are fairly standard features of private credit loans, often used to fund bolt-on acquisitions (find our monthly tracker for March here) this usage is a novel way of avoiding payment defaults and a replacement for comparable tools such as PIK instruments.

This maneuver, along with similar features like preferred equity, also allows lenders to work around fund limitations on the percentage of credit investments that can be PIK instruments, for example.

So maybe we’ll come out on the other side of this period of macro uncertainty and elevated default expectations with a better understanding of private credit’s true merits, since lenders needed some real borrower stress to showcase just how flexible they can be, particularly vis-à-vis banks.

Lending when rates are at their highest level in decades is when the stakes pick up, the margin for error narrows, and creditors have to then get creative. While the ‘golden age’ initially referred to returns, it could also come to reflect the innovations in structuring and maneuvering that we’re witnessing in the market.

Regulators and LPs may view some of these tactics with more skepticism, and there’s still plenty of time for these tactics to backfire as rates potentially stay higher-for-longer.

But if they successfully stave off waves of bankruptcies, it’ll be hard to argue with the results.

How do you make a name for yourself in private credit today? Plenty of the biggest names are into their second decade of operating, and sponsors work regularly with familiar names. Yet that hasn’t deterred new entrants.

This time it is the turn of AGL Credit Management to make a splash into the market. Taylor Boswell, who spent five more than five years at Carlyle, including three as the firm’s CIO of direct lending, today heads up the newly established private credit platform.

And while Boswell is not a new face to the market, AGL is, so there are likely challenges ahead. But what is in a name? AGL Credit Management announced the launch of their private credit platform this week, alongside an exclusive cooperation agreement with Barclays.

Headline narratives like to paint an adversarial picture between banks and funds, but as we’ve documented here, the reality is slightly different. The relationship between both sides is much more intertwined. And in the case of AGL, the involvement of Barclays might be the cutting edge they need to make a name in today’s crowded market.

“So our collaboration allows those sophisticated borrowers to see both options in one place…we don’t see this as a zero sum game where only one market wins in the long term,” Boswell told 9fin in an interview.

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