Private Credit Panic: What's The Secret Behind The Attractive Historical Returns?

Private credit has returned 10.34% on average over the past 5 years, 10.6 percentage points more than investment-grade bonds. What is private credit, how are these returns possible, and what are the risks? Is this the next subprime crisis waiting to happen? 

Transcript

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9.4 to 10.34% historical returns on private credit. What are the risks? Hello everyone and welcome back to Markets with Marcos. I've been talking a lot about private credit with our VAP members over the past few weeks, so as requested, this weekend we're kicking off our multi-part private credit series on the channel. Because it seems that no matter where you look, you can't get away from the glaring headlines about a possible private credit collapse. Like this recent one here from Reuters. Private credit alarm bells echo 2007 subprime. So, as we often do here at Diamond Nasdaq, let's try to separate the facts from the fiction so that you can really understand what's happening and how this may or may not impact your money. Here are the three topics that we'll be covering in part one of our private credit miniseries. 1. What is private credit? 2. How has private credit performed historically? 3. What are the risks of private credit? Let's get started. What is private credit? Private credit in its widest definition is money that anyone who's not a bank is lending to someone else. So for example, if you as a private person lend a family member or an old friend some money, be it to help with buying a house or to start a business, that would be considered private credit. As you can already see from these examples, private credit in the sense of loans made by anyone who's not a bank has three main characteristics. First, it's flexible. You can lend how much money you want to whoever you want for as long as you want. You set the conditions. Second, you don't have to report this private loan or get approval from any regulators. And third, a private loan will generally be illiquid. If you suddenly need your money back, you could ask the borrower whether they can pay you back early, of course. But if they don't have the cash readily available, then you're basically stuck with the loan. Now, the same basic principles that we just discussed for friends and family loans, that private credit is generally flexible, but intransparent and illiquid, so these principles also apply to the professional end of the market, the segment that is currently generating all the headlines. Private credit in this much narrower professional sense is also called private debt or direct lending, and will be using private credit, private debt, and direct lending interchangeably throughout the rest of this video. The main professional non-bank providers who lend money directly to a company or to finance a specific project are private credit funds, business development companies, BDCs for short, and some similar alternative asset managers. This direct lending segment of the market has grown very fast since the great financial crisis. As Chen and I vividly remember, this global market meltdown started in 2008-2009 when too many borrowers started defaulting on subprime mortgages, meaning mortgages to borrowers with bad credit that were non-investment great or high yield, as the industry calls it. And as the crisis kept escalating, it wiped out quite a few banks and brokers, including Lehman Brothers, Bear Stearns, and Washington Neutral. So when regulators understandably wanted to prevent a repeat of such a crisis, they tightened the rules under which banks can lend to subprime borrowers. But that had one unintended consequence. Most smaller and mid-market companies are almost by definition subprime, because many of them just aren't big enough and or don't have the track record or revenues yet to be considered investment grade. And this is especially true for startups. And while regulated banks didn't stop lending to subprime companies and projects completely, they had to reduce their exposure substantially. This opened up a market niche for private credit companies, and they moved right into it, because these private credit companies didn't have to follow the newly tightened rules that the banks had to. So at this point, depending on how conservative or opportunistic you might be, you were either thinking that this was a disaster waiting to happen, or that it may have potentially made some early private credit investors a lot of money. Which brings us nicely to the next part of today's discussion. How has private credit performed historically? So, this strategy that private companies had of lending to subprime firms and projects that regulated banks could no longer lend to, it worked really well for a while. JP Morgan estimates that private credit AUM or assets under management grew at over 14% keger over the past decade, but is still only about 9% of total corporate borrowing. This would translate into maybe$1.3 to$1.7 trillion in direct lending in the US at the time of this taping. And this market grew so fast, not only because subprime companies needed loans, but also because directly lending to them generated very attractive returns for investors in the past. The Cliffwater Direct Lending Index or CDLI is probably the most widely used index for the direct lending market to subprime companies. It does not track every single private loan, but it does track a good part of the market. The CDLI was the first published index tracking the direct lending market and currently covers about 20,000 directly originated middle market loans, totaling$514 billion, as they say here. This table from Cliffwater compares the total returns of private credit, the direct lending index or CDLI, this column here, to three types of public lending. And please note that the CDLI data for 2025 is shown in red not because this was a loss, but because it's still an estimate at the time of this taping. The next two columns show public lending to subprime companies, meaning companies that might be the most comparable to the CDLI. Here we have the Bloomberg High Yield Bond Index, which focuses on tradable subprime bonds. And next to it we have the Morningstar LSTA Leveraged Loan Index, which, as the name says, tracks syndicated leveraged loans. Syndicated leveraged loans are essentially subprime loans that are given out by a group of banks, a syndicate. And for good measure, we have the final column with the Bloomberg Aggregate Bond Index. It is not directly comparable to the three subprime indices that we just showed you. The Bloomberg Aggregate Bond Index tracks all investment grade bonds in the US, including US Treasuries, and reflects an average credit rating of AA, meaning bonds that have significantly higher credit quality than the subprime loans that are the core of the private credit market. However, it is still a useful benchmark if you want to get a feeling for how much of a premium investors got in the past for going into higher-risk investments. And what this table shows us is that over the past 21 years, from 2005 to 2025, private credit, the CDLI, would have been the best performer in 13 years. Publicly traded subprime bonds, the Bloomberg High Yield Bond Index, would have been ahead in six years. The investment grade index, the Bloomberg Aggregate Bond Index, would have been the winner in two crisis years, 2008 during the global financial crisis, and 2020 with COVID. And for completeness, the Morningstar LSTA US Leveraged Loan Index did not outperform the three other indices in any year. So in summary, private credit, direct lending, as measured by the CDLI, would have outperformed the other three indices on this table over the past 5, 10, and 21 years. Over the past 21 years, direct lending generated an average total return of 9.53% per year, about 3% points ahead of high-yield bonds, about 4.5% points ahead of leveraged loans, and more than 6% points ahead of investment grade bonds. Over the past 10 years, the picture is very similar. Direct lending generated a total return of 9.40% per year, again almost 3% points more than high-yield bonds, 3.5% points more than leveraged loans, and 7.5% points more than investment grade bonds. The results over the past 5 years may actually be the most interesting. Over this period, direct lending showed a total return of 10.34% per year, the highest number on this lower table with the multi-year averages, and a bit higher than the 10 and 21 year averages. This 10.34% average total return over the past five years was 5.7% points ahead of high-yield bonds, 3.9% points ahead of leveraged loans, and a whopping 10.6% points more than investment grade bonds, which stood on an average total return of negative 0.26% over the same 5-year period. And the main driver for these 5-year numbers was presumably that private credit, as well as leveraged loans, have floating interest rates, which went up in parallel when the Fed started raising rates after COVID. In contrast, both high-yield and investment grade bonds, with their mostly fixed coupons, suffered principal losses when interest rates went up, but the interest income did not. Overall, this is, of course, an attractive historical track record for private credit. That said, our community of Diamond Nestec regulars are also familiar with two iron rules of investing. Past performance is not indicative of future results or outcomes. And high risk, high return. Which leads us directly into the next topic for today. What are the risks of private credit? As we've just seen, private credit has performed quite well in the past. And here are the key reasons why private credit was able to deliver such a strong historical track record. First, probably the main reason is that investors demand an illiquidity premium for private lending versus public alternatives. By definition, private credit is private, meaning not traded in an organized way. This means that private credit investors may not be able to get out of a private loan before maturity at all, or even if they do find a potential buyer, these investors may have to accept a steep discount when they sell. That's why private credit has to pay an illiquidity premium. Second, private lending may have an advantage from lighter regulation. Banks, and especially the larger ones, are tightly supervised by what observers sometimes call a complex web of regulators, potentially including the Federal Reserve Bank, the Federal Deposit Insurance Corporation, the Office of the Controller of the Currency, and individual state regulators. These regulators impose strict capital requirements that are monitored closely, as well as limits on leveraged lending and a host of other rules. Private lending actors, on the other hand, such as private credit funds and business development companies, are normally only subject to much lighter supervision by the SEC, the Securities and Exchange Commission, which may reduce their cost of capital and allow for a generally leaner and more nimble setup. And the third reason for private credit's strong track record is that private lenders initially had a lot of market power when they first moved in to fill the gap that was created when regulated banks reduced their subprime lending. From a historical perspective, this may initially have allowed private lenders to select the best deals, negotiate robust interest rates, and also to require adequate collateral and covenants to secure their lending. And there's a fourth point that is closely related to the third one. One that is more hotly debated in the market. Credit risk. Now, private credit is mostly subprime, non-investment grade or high yield, or even chunk if you want to borrow the term for bonds. This means that you should expect some losses when you own private credit, but also that you should be compensated for that extra risk with extra income. So far, so uncontested. And this clearly helps explain why private credit returns are generally higher than for investment grade loans or bonds. However, here comes the part that may be more surprising. The CDLI, the Cliff Water Direct Lending Index from earlier, shows that over the 20 years from 2005 to 2024, private lending's credit losses were on average 1.01% per year, which is actually lower than the 1.49% for high-yield bonds, and roughly in the same range as leveraged loans. In other words, private credit's long-term risk profile may look better than that of public bonds, and not significantly worse than leveraged bank loans. Defenders of private credit find that plausible and point to the fact that, just like for leveraged bank loans, private lenders may be closer to their clients and hence be able to not just negotiate stronger collateral protection, but also to detect and potentially mitigate potential issues earlier than would be the case for publicly traded bonds. Other market observers, however, are not entirely convinced. They point to the generally lower transparency in private markets, which may make it hard to compare the historically default numbers. The unspoken question here is whether we really see all loan losses in private credit in real time, or whether lenders might try to put a wheel over inconvenient problems. For example, some recent publications have highlighted that payment in kind, or PIC for short, has risen for some funds. PIC is an arrangement where interest is not paid in cash, but is instead added directly to the principal balance of the loan. The interest due is paid in kind by debt, so to speak. Now, sometimes similar arrangements are part of the plan from the beginning. Like when a student only has to start paying interest on a loan once he or she graduates, or when a company can add interest to the principal until a new factory starts bringing in the revenue that can then be used to pay the coupons. But it's also easy to see how a pick arrangement could be used to camouflage what would otherwise be classified as a default. A failure to pay all interest in full and on time. And even if you believe that the statistics are accurate, the historical track record may still reflect a first mover advantage that may go away over time. Remember, when private credit started taking off, the initial lenders had market power, meaning they could select the best deals and impose their conditions. Fast forward to the present though, and the private credit space has become much more crowded. And when many private lenders are fiercely competing against each other, they might be tempted to become more lenient with their conditions and or to start extending loans to less robust names. All of which would very likely lead to higher credit risk, meaning default risk, going forward. The jury is out on this one, and only time will tell. What we do know though is that sometimes investors want out of a position before they even know for sure what's happening. And especially so when headlines are warning of doom and gloom. But what do the facts and numbers really show, right? And could the current private credit fallout actually be an opportunity for the right investor? That's what we'll be talking about in the next part of our Diamond Nasdaq private credit investing miniseries. What do you think of private credit after watching today's video? And what other questions do you have? And are there specific private credit opportunities that you find interesting right now? Or is this not for you? Drop a comment below and let me, Chen, and everyone else know. And stay tuned for our next private credit video. Thanks for watching and see you again soon.