Weekly Reads
Weekly Reads - May 8, 2024

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The real returns of private credit.

Private credit has become increasingly attractive for investors looking to capture higher yields when compared to public credit. However, a recent study released by the National Bureau of Economic Research claims that direct lenders hardly produce any excess returns. According to the study, lending rates appear to be “high enough to offset fees and risks, but not high enough to deliver compelling risk-adjusted rates of return”. The analysis was conducted by comparing the aggregate cash flows paid to LPs by 532 funds originated between 1992 and 2015 against broad market benchmarks. But instead of limiting the scope of the benchmarking exercise to only public credit, the study takes a novel approach. The process incorporates both debt and equity factors to ensure an accurate methodology when constructing a comparable portfolio of public securities. This is predicated on the assumption that private credit funds are “equity-like”, considering their loans are substantially riskier and that ~20% of their portfolios include equity features such as warrants. On the risk side, the study reiterates how private credit facilities include substantial fees that are ultimately embedded in the cost of borrowing. As such, LPs must receive a return sufficient to offset the risk they face after the fees have been paid (which also raises the risk of default). Finally, the returns must be adjusted to account for the fees earned by the fund. Accounting for all these additional risks and fees, the study estimates that the risk-adjusted excess return on capital invested in private credit funds is indistinguishable from zero. That conclusion is sure to challenge the prevailing perception of private credit’s superior returns, especially as interest in the asset class continues to grow.

The (public) job market is still hot.

The April labor-market report showed continued job growth (albeit at a slower pace), with more than half the increase concentrated in government, healthcare, and social assistance sectors. The unemployment rate slightly rose to 3.9%, with fewer payroll jobs added than expected, and previous months' job growth was revised down. This data suggests a slowing labor market, which has prompted stock market optimism on hopes that the Fed might finally begin to cut interest rates. However, substantial fiscal stimulus continues to drive job creation, particularly in government-related sectors. Sure, industries like leisure and hospitality have seen substantial job increases. But these have mostly been limited to part-time roles, evidenced by the fact that total hours worked still hover below pre-pandemic levels. In contrast, in progressive-leaning states, government, healthcare, and social assistance sectors are dominating job growth, potentially at the expense of other industries. Federal pandemic aid continues to support the labor market, particularly through increased healthcare spending and other transfer payments (which are often adjusted for inflation). While jobs in healthcare and social welfare are essential, they rely on government support- which narrows every day as the fiscal deficit grows. As such, sooner rather than later, the economy will need a private sector investment boom to sustain all of these government-financed jobs.