Episode 305 - Is Private Credit Special?

Episode Summary

Executive Summary: The episode’s main focus is private credit, which the hosts argue is often marketed as safe, stable, and high-yield but is better understood as a riskier, illiquid equity-like exposure with muted reported volatility due to pricing smoothed by private valuations. They review academic evidence on BDCs and private credit funds suggesting that once risk is properly benchmarked, excess returns largely disappear and fees absorb manager skill. The episode also covers an upcoming webinar on compensation for business owners, reactions to proposed Canadian capital gains changes, value’s recent performance, Scott Galloway’s polarizing episode, and a few personal updates.

Main Topics: Private credit: what it is and why it’s booming (Priority: 5/5): Private credit is framed as non-bank lending to private companies through funds or BDCs. Growth has been driven by investor demand for floating-rate yield and tighter bank capital rules pushing borrowers toward non-bank financing. Why private credit can look safer than it is (Priority: 5/5): The hosts stress that private loans are marked infrequently and often by appraisal, not market price, which can suppress reported volatility and make the asset class appear lower-risk and more correlated-agnostic than it really is. Evidence from BDCs and private credit research (Priority: 5/5): They cite research showing that when BDCs and private credit funds are benchmarked against both equity and debt proxies, apparent alpha largely vanishes; using only fixed income as a benchmark makes the asset look misleadingly attractive. Fees, manager skill, and who captures the return (Priority: 4/5): The discussion argues that private credit managers may be skilled, but fees and spread capture most of the value. In efficient markets for manager skill, investors tend to receive market-like risk-adjusted returns while managers retain the excess economics. Behavioral benefits vs financial benefits of illiquidity (Priority: 4/5): They acknowledge a possible behavioral advantage: smoother reported returns can help some investors, especially retirees, feel more comfortable. But they question whether this psychological benefit justifies the fee, illiquidity, and risk opacity. Capital gains changes, value investing, and other community updates (Priority: 2/5): The episode also touches on Canadian tax-planning uncertainty around capital gains proposals, recent strong performance of value stocks in some markets, and mixed audience reaction to the Scott Galloway interview.

Key Arguments: Private credit is essentially private-market lending, but its returns often reflect equity-like credit risk rather than bond-like safety. Because private loans are not traded daily, reported volatility is suppressed and risk can be underestimated. The large yield premium often comes from lending to riskier borrowers plus substantial fund fees, not from free alpha. When private credit is benchmarked properly against both public equity and debt, abnormal returns are typically insignificant. If investors use private credit as a bond substitute, they may unknowingly increase equity exposure and illiquidity. Behavioral comfort from smoother returns may have value, but it does not necessarily imply superior expected returns. Manager skill in private markets is likely real, but in competitive markets much of that skill gets captured by managers through fees rather than investors through excess return. Using optimization tools or Sharpe ratios on smoothed private assets can lead to misleading portfolio recommendations.

Data Points: Private credit fee structure: 1.25% to 1.5% management fee plus 15% to 20% performance fee over a hurdle - Ben described common private credit fund fees and noted total fees often land around 3% to 4% all-in. Total private credit fund fees: 3% to 4% - Approximate all-in cost after management and performance fees. Growth ranking among asset classes: Second-fastest-growing after private equity - Private credit was described as one of the fastest-growing alternative asset classes by AUM. BDC benchmark outperformance on NAV basis: 2.74 percentage points per year - In the cited FAJ paper, BDCs appeared to outperform liquid benchmarks when measured using net asset values. Private credit fund abnormal return: Insignificant - A 2024 working paper found that a typical private debt fund produced no statistically meaningful abnormal return after proper risk adjustment. Webinar registration count: 450 to nearly 500 registrants - The upcoming business-owner compensation webinar was drawing strong interest. Capital gains tool usage: 111,000 page views and 842,000 calculations - Brayden’s capital gains tool on the homepage was being heavily used amid uncertainty over Canadian tax changes. Canada value premium: 10% annualized - From January 2021 to April 2024, Canadian value significantly outperformed Canadian growth on the cited index comparison. U.S. value premium: 1.56% annualized - Over the same January 2021 to April 2024 period, U.S. value modestly beat U.S. growth. MSCI Canada IMI Value Index: 15.17% annualized - Performance cited for Canadian value stocks over the discussed period. MSCI Canada IMI Growth Index: 5.15% annualized - Performance cited for Canadian growth stocks over the discussed period. Private credit allocation in optimized portfolios: Large allocations can appear optimal - The hosts criticized mean-variance optimizers for overstating private credit allocations because inputs are distorted by smoothed returns and illiquidity.

Pivotal Quotes: "“There’s no free lunch, is what the research that we’re talking about suggests.”" — Benjamin Felix: Summary judgment on private credit after discussing fees, benchmarking, and risk adjustment. "“This is the asset class by far that I’ve been pitched the most in the last few years.”" — Benjamin Felix: Opening discussion explaining why private credit was chosen as the main topic. "“You’re just getting compensation for the risk that you’re taking in the funds.”" — Benjamin Felix: Explanation of why apparent excess returns disappear once private credit is benchmarked appropriately.

Implications: Listeners should treat private credit as a risky, illiquid, fee-heavy exposure—not a bond substitute. The episode warns that smoothing can mask risk, so proper benchmarking and skepticism are essential as private credit products proliferate.