Research Shows Private Credit Funds Benefit Investment Managers More Than Limited Partners

Private credit funds have been a hot investment trend in recent years, attracting capital from asset owners looking for higher returns in a low-interest-rate environment. However, new research from academics at The Ohio State University suggests that while private credit funds may be lucrative for investment managers, they may not be as beneficial for their limited partners.

The working paper, authored by Isil Erel, Thomas Flanagan, and Michael Weisbach, questions the “specialness” of private credit as an asset class capable of earning alpha. Using a novel method to evaluate risk-adjusted returns, the researchers found that private credit returns adjusted for both debt and equity risk were essentially zero. Adjusted only for corporate debt risk factors, the net alpha on a fund was a modest 1.8 percent.

The study analyzed data from 532 private credit funds between 1992 and 2015, focusing on factors such as fund size, internal rate of return, and fee structures. The average fund size was $783 million, with an average internal rate of return of 8.6 percent for limited partners. However, when discounting cash flows for corporate bond risks, investors were only earning a small alpha.

The researchers noted that the abnormal return from the gross cash flows of these funds was roughly equivalent to the fees paid by investors, suggesting that the loans may be priced above their fundamental risks. This discrepancy in returns raises questions about where the value is being captured within the private credit ecosystem.

Overall, the study highlights the importance of understanding the risk-adjusted returns of private credit funds and the potential impact on limited partners. As asset owners continue to allocate capital to alternative investments like private credit, it is essential to consider the underlying factors that drive returns and ensure alignment between general partners and limited partners.