Private Debt Excess Returns

A recently published academic study’s conclusion that private debt produces no after-fee excess return has caught the attention of some familiar naysayers in the business press.  We briefly critique the paper below and, contrary to the authors’ conclusion, find a large and statistically significant 4% after-fee excess return using a different, but more familiar risk measurement methodology coupled with a transparent and contemporary database of private debt performance.

A Brief Critique

The paper “Risk-Adjusting the Returns to Private Debt Funds,” by Isil Erel, Thomas Flanagan, and Michael Weisbach (EFW), April 2024 (National Bureau of Economic Research) concludes that private debt funds offer no excess return after fees when adjusting for risk.  The paper suffers at least four weaknesses, compromising its usefulness to current investors:

1. The paper covers a period, 1992 to 2014, that misrepresents the character of private debt in its current form.  Private debt funds for most of the period examined by the authors were structured equity, mezzanine, and second lien funds with very little senior secured first lien loans that comprise over 80% of private debt funds today.  These earlier funds were small, many focused on non-cash yield, and with high fees.  It is unsurprising that the authors find that these funds had high equity exposure and little or no excess return after fees.
2. With a few exceptions, those managing private debt portfolios today are very different from preFinancial Crisis managers, who often included public high yield and distressed debt into their private debt funds.
3. The authors use a recently developed approach to quantifying risk that is inconsistent with current risk management convention and inconsistent with the way virtually all investors think about risk as volatility in periodic return.
4. The data set used by EFW in their paper is not transparent and suffers from significant backfill bias that can distort findings, either positively or negatively.

A More Familiar Approach with a Very Different Result

An approach to risk-adjusting return in order to identify excess return where the source of return may be multi-asset is a regression approach first suggested by Nobel Laureate Bill Sharpe.  We apply this methodology, often called “style analysis,” to the Cliffwater Direct Lending Index (CDLI), a transparent, quarterly index of private middle market loans with returns (gross-of-fee) covering the period September 30, 2004, to December 31, 2023.

Following Sharpe’s approach, quarterly CDLI returns, the dependent variable, are regressed against two independent variables: the Russell 3000 Index, representing equity risk, and the Morningstar LSTA US Leveraged Loan Index, representing credit risk.

Private debt, represented by the CDLI, earns 6.19% and 5.85% annual excess returns, risk-adjusted and gross-of-fee, over the entire 19.25-year study period and trailing 10-years, respectively.  The Sharpe-based regression results assign public equity and credit exposures of 6% and 23%, respectively, over the 19.25year period and 0% and 44%, respectively over the trailing 10-year period.  All exposures are statistically significant except for the 10-year equity value equal to 0%.

Our findings are very different from EFW findings, both in the size of the excess return assigned to private debt and its exposure to equity risk.  Our findings are also consistent with what practitioners have observed from private debt.

Fees and Leverage

Fees and expenses for unlevered private debt typically average no more than 2%, giving a net, riskadjusted excess return equal to approximately 4%. While most private debt funds use leverage8 to increase return, leverage will generally not change risk-adjusted excess return.

Original Article

All posts are the opinion of the contributing author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CAIA Association or the author’s employer.

About the Author: