Private debt funds seem to be the latest too-good-to-be-true asset class on Wall Street. Private debt funds claim to offer high returns with minimal risk. One fund even shows that its investors have earned ten units of return for each unit of risk. U.S. stocks have historically offered about a half unit to three-quarters of a unit of return for each unit of risk, so this private debt fund is off the charts in terms of return to risk ratio, or is it?
Unlike public investments, private assets such as private debt do not trade in public markets, resulting in smoothed prices that do not fluctuate as frequently or dramatically. While private debt may generate high income, it can carry just as much risk as debt traded in public markets. Plus, there could be illiquidity risk, high management fees, and potential due diligence shortcomings.
Just because an asset isn’t marked to market does not mean it has less risk. Any American bank CEO can tell you private debt, i.e., bank loans not marked to market, can have significant risk.
Jason Zweig explains in The Wall Street Journal:
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.
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.”
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.
Read more here.