“Once a majority of players adopts a heretofore contrarian position, the minority view becomes the widely held perspective.”[i]
DAVID SWENSEN, late CIO of the Yale Investments Office
Over the past several years, private credit fund managers have raised enormous amounts of capital, and future inflows are only expected to increase. Figure 1 shows the total assets under management of private credit funds from 2005 to 2023. Institutional investment plans constitute the bulk of these assets, and many investment consultants continue their aggressive pushes to add more.
The following article questions the merits of such recommendations. It begins by explaining the distinct nature of alternative asset class investment cycles. Next, it explains the origin and evolution of the private credit boom, which now resides squarely in the “flood” stage of the investment cycle. Finally, it explains how a deep-seated conflict of interest at the heart of the investment consulting model is causing flood waters to rise despite dismal prospects for most investors.
Figure 1: Private Credit Assets Under Management (2005-2023).
Sources: Financial Times, Prequin, The Wall Street Journal; CION Investments.
Alternative Investment Cycles
The Fall 2024 issue of the Museum of American Finance’s Financial History magazine includes my article, “A 45-Year Flood: The History of Alternative Asset Classes.” It explains the origins of several alternative asset classes such as venture capital (VC) and buyout funds. It then explains why these asset classes have attracted massive inflows of institutional capital over the past several decades. Most importantly, the article explains the distinct investment cycle through which alternative asset classes progress. The cycle roughly includes the following three phases.
- Formation: A legitimate void appears in capital markets. For example, in the aftermath of World War II, US companies had a wealth of opportunities to commercialize war-related technologies, but banks remained skittish because of their experiences during the Great Depression. This prompted the formation of the VC industry.
- Early Phase: Innovative capital providers generate exceptional returns as the number of attractive opportunities exceeds the supply of capital available to fund them. The experience of VC and buyout fund investors, such as the Yale University Endowment, in the 1980s is a perfect example.[ii]
- Flood Phase: In pursuit of new revenue streams, opportunists launch a barrage of new funds, and then a herd of followers invests in them. This invariably compresses future returns because the supply of capital far exceeds the number of attractive investment opportunities. In 2024, all major alternative asset classes — including private equity, VC, private real estate, hedge funds, and now private credit — have attributes that are consistent with the flood phase.
In comparison to traditional asset classes like publicly traded US equity and fixed income, alternative asset classes have much higher fees, significant illiquidity, hidden risks, mind-bending complexity, and limited transparency. Making matters worse, most alternative asset classes have resided squarely in the flood phase for several decades.
Unsurprisingly, multiple studies show that, on average, alternative asset classes detracted value from institutional investment plan performance rather than added it over the past few decades. For example, a June 2024 paper published by the Center for Retirement Research at Boston College cited four studies showing significant value detraction. The paper also presented the Center’s own research suggesting that alternatives added slightly less than no value relative to a passive 60/40 index over the past 23 years.
Despite the high fees, hidden risks, and lackluster results, trustees massively increased allocations to alternatives over the past few decades. According to Equable, the average public pension plan allocated 33.8% of their portfolio to alternatives in 2023 versus only 9.3% in 2001. Private credit is just the newest alternative investment craze, but its trajectory followed the same well-trodden path. Now, just like those that came before, it is stuck in the flood phase.
The Dynamics of the Private Credit Boom
“Experience establishes a firm rule, and on few economic matters is understanding more important and frequently, indeed, more slight. Financial operations do not lend themselves to innovation. What is recurrently so described is, without exception, a small variation on an established design, one that owes its distinctive character to the aforementioned brevity of the financial memory. The world of finance hails the invention of the wheel over and over again, often in a slightly more unstable version.”[iii]
JOHN KENNETH GALBRAITH, financial historian
In the aftermath of the 2008/2009 global financial crisis (GFC), the US commercial banking system tightened lending standards and restricted loan issuance in several market segments. This enabled banks to restore their depleted reserves and strengthen their balance sheets. It also opened a temporary void in capital markets, which triggered a sharp rise in demand for private credit.
Much like the formation of VC funds in the aftermath of World War II, private credit was hardly a novel innovation. It has existed in various forms for centuries. But the latest variation on this “established design” was widespread use of the limited partnership model. The key advantage of this model is that it offers fund managers protection against bank runs, which is a timeless risk for commercial banks. The cost of this protection, however, is borne almost entirely by fund investors rather than fund managers. Investors must accept much higher fees, many years of illiquidity, and an enormous lack of transparency regarding the nature and value of the underlying loans in which they are invested.
Overlooking these disadvantages and enamored by returns produced in the early phase of the private credit cycle, trustees have poured hundreds of billions of dollars into this asset class over the past several years. They have all but ignored multiple red flags that invariably materialize in the flood phase. Why are institutional investors increasing their allocations to private credit? Because investment consultants are advising trustees to do so.
Investment Consulting and Mean-Variance Obfuscation
“You don’t want to be average; it’s not worth it, does nothing. In fact, it’s less than the [public] market. The question is ‘how do you get to first quartile?’ If you can’t, it doesn’t matter what the optimizer says about asset allocation.”[iv]
ALLAN S. BUFFERD, treasurer emeritus, MIT (2008)
The investment consulting profession emerged in the 1970s and initially provided trustees only with performance reporting services. Bank asset management departments provided discretionary management of institutional plan assets. Over several decades, consultants encouraged trustees to abandon the banks due to high fees and lackluster returns revealed in banks’ performance reports. Ironically, however, investment consulting firms steadily added their own services, which differed little from those offered by the banks. By the 1990s, a key component of investment consulting services was recommending increasingly complex asset allocation strategies and active managers. The foundation of these recommendations was a relatively simple mathematical modeling tool called mean-variance optimization (MVO).[v]
MVO is based on Harry Markowitz’s Nobel-prize winning research on portfolio management. His research demonstrated that investors could improve risk-adjusted returns by diversifying portfolios among investments with imperfect return correlations. MVO is simply a tool that enables investors to visualize this principle. Inputs into MVO models include expected return, volatility, and correlations for various asset classes. The output is a set of model portfolios that maximize return for a given level of risk.
MVO is useful in the sense that it helps trustees visualize the risk/return tradeoffs of various portfolio allocations. But it is far too imprecise to provide value when analyzing anything much beyond broad asset classes, such as US equity and fixed income. The reason is that the three inputs — expected return, volatility, and correlations — are highly imprecise. This is especially true with alternative asset classes like private credit, because the return history is short and lacking in transparency. Making matters even worse, future return expectations are often inflated because the return history is skewed upward by outsized returns achieved during the early phase of the alternative asset class cycle.
The imprecision of MVO inputs is a big problem. But even if the assumptions were reasonably accurate, they would say nothing about the most important decision factor for private credit investors, which is the skill of the people making the recommendations. When an alternative asset class enters the flood stage, it is essential for investors to be highly skilled and capable of sustaining that skill for decades. Yet MVO models tell investors nothing about the presence or absence of skill. Moreover, the non-discretionary status of investment consultants protects them from disclosing their track records. Unlike discretionary asset managers, non-discretionary consultants need not report the aggregate results of their approved manager lists. Unsurprisingly, virtually none voluntarily provides a track record that is verified by an independent third party. This is roughly equivalent to a mutual fund manager refusing to provide investors with an audited track record of their past performance. Who would invest in such a fund?
Barbarians at the Unguarded Gates
“Given the reality that [consulting] firm economics depend on clients continuing to use their services, why would they be expected to tell their fee-paying clients that they are on a “mission improbable?”[vi]
CHARLES D. ELLIS, former chair of the Yale University Endowment investment committee
In 2024, trustees of institutional investment plans are surrounded by consultants who have a deep-seated incentive to recommend alternative investments for little reason other than because their business models depend on clients believing that these recommendations add value. They are not required to prove their skill. They only need clients to believe unsubstantiated claims that they have it. More than any other reason, this is why investment consultants pepper trustees with recommendations to allocate to alternative assets like private credit. There are few safe havens. Even Vanguard’s former OCIO clients are now at risk of falling sway to the belief that alternative investments add value. Mercer completed its acquisition of Vanguard’s OCIO unit on March 15, 2024, and it remains to be seen whether the company will honor Jack Bogle’s legacy.
Trustees often assume that investment consultants serve as unbiased gatekeepers who protect them from a perpetual flood of ill-conceived investment sales pitches. Yet the reality is that nearly all consultants abandoned their posts long ago, leaving the flood gates wide open. The next time your investment consultant pitches an allocation to private credit, respond with a few pointed questions of your own. Demand a thorough explanation of the costs, risks, and, most importantly, the quality and integrity of their own track record.
The reality is that private credit entered the flood phase several years ago. It is not a pristine, undiscovered watering hole. It is a treacherous swamp full of opportunists. If your consultant cannot prove beyond any reasonable doubt that they are uniquely capable of defying the formidable odds of success in this asset class, it would be prudent to assume that they are not.
[i] David Swensen, Pioneering Portfolio Management, 2009 ed. (New York: The Free Press, 2009).
[ii] For more information on the history of the investment strategy at Yale University, see “Chapter 25: Manufacturing Portfolio Complexity” in Investing in U.S. Financial History: Understanding the Past to Forecast the Future.
[iii] John Kenneth Galbraith, A Short History of Financial Euphoria, 4th ed. (New York: Penguin, 1990).
[iv] Larry Kochard and Cathleen Rittereiser, Foundation and Endowment Investing: Philosophies and Strategies of Top Investors and Institutions. (Hoboken: John Wiley & Sons, Inc., 2008).
[v] For more information on the history of the investment consulting profession, see “Chapter 25: Manufacturing Portfolio Complexity” in Investing in U.S. Financial History: Understanding the Past to Forecast the Future.
[vi] Charles D. Ellis, Figuring It Out: Sixty Years of Answering Investors’ Most Important Questions. (Hoboken: John Wiley & Sons, Inc., 2008).