AQR: How to Model Future Returns and Risks of Private Credit

The asset class mirrors public high yield — with some tweaks, according to the manager.

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Illustration by II

Private credit is all the rage, but investors are still contending with how to determine expected returns and risk.

Alternative investment firm AQR proposes a methodology for doing just that in its latest report on capital market assumptions.

The firm argues that public credit, specifically high yield, can be the anchor for a CMA model, overlaid with characteristics reflective of private credit’s unique properties.

The model comes at a critical time, as allocators look for ways to juice returns amid a more challenging investment environment.

“When you’re dealing with privates there’s going to be a ton of heterogeneity because the data sources are so poor,” said Pete Hecht, managing director and head of North America portfolio solutions group for the firm. “I haven’t found any rigorous private credit frameworks because that data is hard to find.”

Hecht and his team went ahead and built their own framework. First, they considered the benefits and drawbacks of investing in private credit altogether.

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According to AQR, there are factors that could drive up private credit’s return, including the illiquidity premium, the borrower’s willingness to pay more for the flexibility and certainty that private credit offers, fewer defaults, better workouts when things go wrong, and the disintermediation of banks.

But there are strikes against private credit, too. Private credit managers charge higher fees, and AQR suggests that investors may overpay for price smoothing. Credit quality deterioration could also be hidden from investors, as private credit managers report information less frequently than their public credit peers.

“Private credit is smoothed,” Hecht said. “Information leaks in slowly over time. When we correct for that, it turns out that” in aggregate private credit has performed in line with leveraged loans and high-yield indices and there is no alpha.

Part of AQR’s methodology relies on research published on private credit performance in the Journal of Alternative Investments, entitled “Performance of Private Credit Funds: A First Look.” Those researchers found that a leveraged loan index is the most appropriate tool for benchmarking private credit. They also found that private credit performs as well as, if not better than, leveraged loans. However, as AQR points out, higher fees appear to offset some of these returns.

AQR essentially modeled its expected private credit returns by creating hypothetical floating-rate levered high yield corporate bonds. The firm starts with expected public high yield credit returns as a proxy, then subtracted duration to model floating rate debt and accounted for leverage, which magnifies returns and volatility.

“We allow the model to make adjustments for leverage,” Hecht said.

The firm notes that investors who use this model can adjust the leverage and credit quality based on their own portfolios, allowing them to personalize their assumptions depending on their institution’s needs.

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