As a portfolio manager and the head of research at PWL Capital, I get pitched on a lot of financial products. The one that I've been pitched on by far the most in the last few years is private credit funds. Private credit consists of loans similar to bonds, except they're non-publicly traded loans created by non-bank entities like private credit funds or business development companies to fund private businesses. This asset class is promoted to retail investors for its high yields and stable returns, but as you can probably guess, I'm skeptical. I'm Ben Felix, portfolio manager at PWL Capital, and I'm going to tell you what private credit looks like under its smooth and shiny veneer. Private credit is one of the fastest growing asset classes. The dramatic growth has likely been driven by investor demand for high floating rate yields during a period of low interest rates and by tightened capital requirements for banks, pushing small and mid-sized companies to find alternative sources of credit. The two factors combined - investors seeking yield and companies needing non-bank lending - has

resulted in the growth that we've seen for this asset class. The fastest growing part of the private credit market is private credit funds. These are funds that raise money from investors, often retail investors, and make direct loans to private firms, typically firms that can't get bank loans due to their credit worthiness. Loan terms are negotiated individually with each borrower, and the terms often contain features that traditional fixed income would not, like a structured equity component. The interest rates on these loans are high; the borrowers are too risky for banks, which means that the loans already command a higher interest rate. But private credit funds also have to build their high fees into the rate they charge. A typical fee structure would be 1.5% plus a performance fee of 15 to 20%, all in that ends up being around 3 to 4% in fees. Between lending to higher risk borrowers and containing equity features like warrants, private credit can start to look a lot more like equity than like a bond. But due to its nature as a private asset class, that risk will not

show up as volatility. The result is what appears to be high returns, low risk, and low correlations to public markets. Private loans are not valued daily like a stock and don't have a secondary market to establish a price, so their reported returns will not reflect the true volatility in the value of the underlying assets. Additionally, the valuations of the loans are highly subjective, with different funds assigning materially different values to the same loan. When private credit assets are marked down, the marks will tend to be much more muted than a comparable publicly traded asset. This ends up being important when evaluating the past performance and risk of the asset class. Smooth returns and generous valuations on private loans can make private credit look much more attractive than it actually is. This starts to touch on the question that every investor should be asking before allocating to an asset class: What risks am I taking and how do I expect them to be compensated? Financial assets represent discounted future cash flows. Their value changes when discount rates or cash flow expectations change.

always true, but in some cases, like in private markets, the asset is not valued every day and is not valued by the market. One interesting perspective on the effect of this comes from a 2023 paper in the Financial Analyst Journal titled Direct Lending Returns. The author looked at publicly listed Business Development Companies or BDCs, closed-end funds that engage in direct lending and trade in the public market. BDCs are relevant to private credit since they're required to invest at least 70% of their assets in non-public equity and debt of US corporations, and they've been shown to be good benchmarks for the returns of private credit funds. To evaluate BDC performance, they construct a benchmark consisting of small-cap value stocks and leverage loans, since these public assets explain most of the variation in BDC returns. This just means that the publicly listed BDCs have returns that look similar to small-cap value stocks and leverage loans, an important insight that we're going to come back to later. They find that when BDC performance is evaluated based on net asset values.

those are the reported values of the underlying assets by the bdcs in their regulatory filings. They outperform liquid benchmarks by 2.74 percentage points per year, and they have high sharp ratios. That actually sounds pretty good. It's like you can take risks similar to publicly listed assets while earning significantly higher returns. But the problem is that publicly listed bdcs don't always trade at their net asset values, particularly during times of Market stress. They tend to trade at a discount. The market is a pricing machine that absorbs huge amounts of information and outputs a price. When the market assigns a price below the reported net asset value, it might suggest that the net asset value is not accurate. On a market value basis, bdcs do not outperform the liquid Benchmark. This suggests that when properly benchmarked and properly priced, the apparent excess risk-adjusted returns of private credit funds may evaporate. Along similar lines, a 2024 working paper on risk-adjusted returns to private debt funds applies a cash flow-based method to form a

replicating portfolio that mimics the risk profiles of a large sample of private credit funds. The authors find that using both equity and debt benchmarks to measure risk, a typical private debt fund produces an insignificant abnormal return to its investors. This means that investors are not getting anything special for the risk they're taking in these funds. Their risk-adjusted excess return is indistinguishable from zero. They do find that if Equity is removed from the benchmarks, private credit starts to look really good. This again highlights the importance of proper benchmarking and suggests that anyone adding private credit to their portfolio as part of their fixed income allocation may really just be increasing their overall exposure to the equity risk premium. The other interesting observation from this research is that gross of fees, private credit funds have large and significant excess returns. Theoretically, skilled fund managers will attract assets to their fund up to the point where they are no longer able to generate excess risk-adjusted returns. The end result is that managers collect all of the benefits of their skill as fees and

investors in their funds earn returns in line with the risk they're taking. Some research on private Equity has cheekily referred to it as the billionaire Factory because private Equity managers generate large fees for themselves while delivering net returns similar to public equities for their end investors. In the case of private credit funds, it does appear that they are able to apply skill in identifying, negotiating, and monitoring private loans to firms that could not otherwise raise Finance. That is impressive. It is skill they charge a rate to those borrowers that approximately equals the risk-adjusted borrowing rate plus the fees that the private credit funds charge. The end result, in line with what theory would predict, is that fund managers absorb the benefits of their skill as fees and the end investors in private credit funds end up taking a whole bunch of risk, paying high fees, and getting returns that they could get much cheaper with better liquidity using publicly listed assets. I think it's fine if investors are fully aware of these realities and dive into private credit anyway, but I

think it's much more problematic when high-fee investment products are being marketed as safe and stable, while having high expected returns. Retail investors may not have the tools or knowledge to evaluate the risks that they are taking. Let's not forget that in addition to the hard-to-measure risks that I've mentioned, many private credit funds are illiquid. Illiquidity is not great under any circumstances, but private credit funds will tend to gate redemptions at times when liquidity is in high demand. When I talk about these funds being risky and potentially illiquid, it's easy to dismiss my comments as alarmist, but I'm not joking here. In Canada, there have been recent examples of private credit funds halting their cash distributions and gating redemptions. And because private credit has been sold to retail investors who are often relatively unsophisticated, many of these investors have been blindsided when that risk shows up. Romson Investment Corp, a large private lender, has cut its distributions multiple times and frozen redemptions as it deals with loan defaults.

ninepoint partners LP has stopped paying cash distributions and skipped its current Redemption window. The period where investors are typically able to get some of their money out due to the fund having insufficient cash. It makes sense when you think about it. Those high in floating rate loans to risky borrowers seem great when everything is going well, but in recent history, we've seen a sharp rise in interest rates, making it harder for those high-risk borrowers to repay their loans, resulting in a cash crunch for the private credit funds. For most retail investors, allocating to private credit will result in high fees, confusion about the amount of risk they're actually taking, and potential illiquidity in return for these unfavorable characteristics. There is no evidence of a compensating excess risk-adjusted return since it gets absorbed by manager fees, an observation consistent with an efficient market for manager skill. Thanks for watching. I'm Ben Felix, a portfolio manager at pwl Capital. If you want to learn more about how pwl decides whether to invest in asset classes like private credit, you can book a meeting with us below.

The Hidden Risks of Private Credit

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My name is Ben Felix. I am a Portfolio Manager and the Head of Research at PWL Capital. I am a CFA charterholder and CFP professional. I am securities licensed in Canada by CIRO.

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