Getting the Sharp End of the Investing Stick Investors are flooding into funds that specialize in private debt. Many claim to offer mouthwatering returns at extremely low risk, but those claims depend on an unrealistic definition of ‘risk.’ ALEX NABAUM By Jason Zweig April 28, 2023 11:00 am ET 23 Imagine an investment that can deliver high returns with barely any risk, almost completely independent of the stock market. Good luck finding that. But you can easily find funds that make such grandiose claims. They’re common in one of the hottest areas in markets today, private investments. Consider a recent online factsheet from Cliffwater Enhanced Lending Fund, a $1.5 billion portfolio of private debt. The document said the fund had a Sharpe ratio of more than 10 and a beta of zero. Those are statistical measures of risk and return; a Sharpe ratio exceeding 10 indicates a fund earned extraordinarily high returns for the amount of risk it took, while a beta of zero means it fluctuated far less than the stock market. NEWSLETTER SIGN-UP The Intelligent Investor Jason Zweig writes about investment strategy and how to think about money. Subscribed After criticism from several investors on Twitter, Cliffwater promptly updated the document. “We decided to remove the Sharpe ratio from the factsheet as it appears to distract from the substance of the fund,” said Philip Hasbrouck, co-head of asset management at Cliffwater. Many funds investing in private credit, or nontraded debt, say these assets offer mouthwatering returns at extremely low risk. William Sharpe, the emeritus Stanford University finance professor and Nobel laureate in economics who devised what became known as the Sharpe ratio, laughed when I asked him this week whether funds can generate such a high score on his measure. “Maybe that’s Sammy Sharpe’s ratio,” he said. “Who’s Sammy Sharpe?” I asked. “I don’t know!” Prof. Sharpe cackled. “But that can’t be my ratio.” Advertisement - Scroll to Continue This isn’t some academic debate about how many kinds of risk can dance on the head of a pin. The key point is that funds investing in private assets must not be judged by the same standards of risk as public investments. Because assets like private debt, by definition, don’t trade in public markets, their reported prices are “smoothed,” meaning they don’t fluctuate nearly as often or as sharply as conventional stocks and bonds. That means that customary measures of risk, which are based on how much prices vary, don’t apply. These funds specialize largely in direct loans to small and midsized companies. They’re part of the long boom in alternative investments, or assets other than mainstream stocks and bonds. Few other alternatives have been hotter. Private-credit interval funds and nontraded business-development companies, two categories among several types of investment vehicles that focus on such debt, took in more than $40 billion in new money in 2022, up 47% from 2021, according to PitchBook. It isn’t hard to see why. Private debt produces attractively high income and helps diversify portfolios consisting mostly of traditional stocks and bonds. The corporations and other borrowers that incur private debt are hungry for capital, so they have little choice but to pay rates that can hit 11% or more. The loans are typically short term, maturing in seven years or less. They tend to pay floating, rather than fixed, interest rates. So they don’t suffer severe losses when rates rise. With no public trading, private debt’s prices don’t fluctuate much. Loans pay off or they don’t. That doesn’t mean there’s no risk. Industrywide, according to a 2021 survey, private-credit funds aim to achieve a rate of return of about 8% if they don’t use leverage or borrowed money; leveraged private-credit funds seek to earn roughly 11%. In today’s market, though, you can earn 5% on virtually risk-free U.S. Treasury bills, which you can sell anytime you want—and you don’t pay management fees. SHARE YOUR THOUGHTS What does investing risk mean to you? Join the conversation below. In many cases, private credit is packaged in interval funds, which allow you to withdraw only a portion of your money, generally four times a year. Other private-credit vehicles have minimum holding periods of one year. Not being able to get your money out when you need it isn’t a statistical risk; it’s a real one. Management fees on private-credit funds are high, typically starting at 1.25% annually and sometimes approaching 3%. Incentive fees, in which the managers take a 10% to 15% of any excess over a target rate of return, are common. What you get for those fees may vary; that’s a risk, too. A recent survey found that one-third of U.S. private-credit funds don’t even do their own due diligence. Instead, they outsource research to accountants, consultants or lawyers. Does the hope of getting high returns justify locking up your money in an expensive fund? Maybe the investors buying these “alternative” funds are missing an even bigger—and better—alternative. What if, instead of buying the funds, you bought stock in the firms offering them? Giant firms whose stock is publicly traded, including Apollo Global Management Inc., Blackstone Inc., Carlyle Group Inc. and KKR & Co., offer private-credit funds. “If you buy the stocks, you’re getting a share of the fee income and the upside of their portfolios if they deliver returns like they have in the past,” says Bettina Lee, managing director at the Lam Group, an investment-advisory firm in Lake Oswego, Ore. “You’re on the side of the fee collectors instead of the side of the fee payers.” Testifying at a U.S. Senate hearing on mutual-fund expenses in 1967, economist Paul Samuelson said that after realizing how expensive some funds were, “I decided that there was only one place to make money in the mutual-fund business—as there is only one place for a temperate man to be in a saloon, behind the bar and not in front of the bar.” If your financial adviser pitches you on investing in a private-credit fund, consider whether you would be better off profiting from the customers than becoming one. Write to Jason Zweig at intelligentinvestor@wsj.com
Cool article. Private debt (direct lending) funds are indeed a cool vehicle - as opposed to private equity funds, the returns in private debt funds are easily predicted as all private debt fund investments (individual loans) are contracted. If a firm that took a loan with an investment fund defaults, there is always collateral in place (real estate, industrial machinery, aircrafts for example). They ofter pay a cash return quarterly. A perfect instrument for a pension fund who needs to predict their money cash inflows & outflows. There is another part of private debt funds, which specializes in more exotic lending: aircraft leasings, music royalties, etc. The returns in this area are already comparable with the PE returns.