Private credit returns are great (if you believe the marks)

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Alphaville attended the FT’s recent Future of Asset Management conference, and pretty much everyone we spoke with was hot for private credit.

No wonder! As Blackstone’s Steve Schwarzman said recently:

“If you can earn 12 per cent, maybe 13 per cent on a really good day in senior secured bank debt, what else do you want to do in life? . . . If you are living in a no-growth economy and somebody can give you 12, 13 per cent with almost no prospect of loss, that’s about the best thing you can do.”

Setting aside the minor quibble that if you’re making 12-13 per cent from something it is very definitely not almost risk-free, it’s clear that investors love this stuff. For example, almost two-thirds of insurance companies polled by BlackRock say they plan to ramp up their allocations to private credit.

Why? Well, Goldman Sachs estimated earlier this year that the reported volatility-adjusted returns of direct lending — the biggest and fastest-growing component of the private credit universe — have averaged 10 per cent annually from 2010-22 — and there was not a single down year over that period.

That is, if you believe the valuation marks. And it seems that at least some investors are taking them with a pinch of salt.

A recent paper by Antti Suhonen of the Aalto University School of Business highlights an interesting divergence between the net asset values and share prices of US business development companies — an important component of the direct lending industry.

From a sample of 47 listed BDCs over 2009-22, Suhonen found that based on their NAVs they generated average annual returns of 9.41 per cent, outperforming liquid credit markets by 2.74 per cent per annum.

Given the minimal volatility in private market valuation, they had a Sharpe ratio of 1.73. The Sharpe ratio is a measure of volatility-adjusted returns, and Alphaville would argue a silly thing to use in private markets with quarterly marks. To put that in context, the Sharpe ratio of BDC NAVs is not far off what Renaissance’s fabled Medallion fund is said to generate.

HOWEVER, if you just look at the total returns of BDC shares, the annualised returns drop to 8.63 per cent, and the Sharpe ratio becomes a more mundane 0.38 — significantly lower than for junk bonds and leveraged loans.

Suhonen says that the price-vs-NAV discrepancy is mostly a product of the BDC share sell-off since 2022, and notes that BDCs tend to trade a discount at times of stress and revert when things calm down.

However, to Alphaville’s cynical eye this looks more like public market investors are understandably taking a sceptical view of the actual value of some of the underlying loans BDCs have made in recent years.

Even private credit proponents that we talked to at the FT conference would privately admit that there is a LOT of extending-and-pretending quietly going on right now.

Private credit funds have raised so much money lately — of the industry’s estimated $1.5tn of assets under management a full $500bn might be uncommitted ‘dry powder’ — that it is tempting to just keep bankrolling a company that is struggling and pray for better days.

But if the long-predicted US recession actually ever does materialise, then the private credit aftermath is gonna be ugly. As JC Flowers & Co’s Chris Flowers told mainFT this week:

“Too many people have piled into private credit and it has a special feature that a chunk of it is funded with life insurance assets . . . One of these days, some life insurance company is going to get whacked on their private credit . . . You can have a run on a life insurance company.”

Such a run would require policy holders to pay surrender fees and step up the pace of their withdrawals significantly (35pc to 75pc). And even then, it could lead to the abandonment of state-based subsidiaries before any insurance group collapses. But it is indeed possible, so who knows?

Further reading:
— Insurers are not banks
— The private credit ‘golden moment’
— A private credit primer