The Truth Behind Hedge Fund and Private Credit “Excess” Returns

I have a lot I’ve wanted to say about private credit and I will get to that at some point in the future, but before I do, I wanted to start with something simpler.

Most people don’t understand that these alternative investment products (I assume private equity and venture capital have the same issue – I just haven’t done the math yet) generate most of their returns from leverage.

Why is this a problem?

Because most of the returns created by that leverage don’t go to the investor. They go to the investment firm. Investors take all the risk that comes with leverage but only get a small part of the return.

In fact, as I will demonstrate, without leverage, these products are uninvestable. People are paying high fees mainly to access leverage. If you want levered investments, you’d be better off levering an index fund.

Some of my old friends are probably nervous wondering what I’m about to write, though I’m pretty sure most will reluctantly agree with the conclusion. So here it is, the truth behind how your alternative investments actually make their reported returns.

Caveat: I am using approximate numbers in the examples below. I am sure some of my assumptions are out of date but if someone wants to plug in better numbers, I doubt it will change the conclusion.

Hedge Fund Math

Step 1: 4% Gross Returns

So the pitch to invest in a hedge fund is we’ll produce call it 4% “alpha” (i.e. excess returns) from stock (and or currency, commodity, etc.) trading. Better, since we do it “market neutral” – meaning there is (roughly) a short for every long – we have no “beta” or other “factor risks” which ensures you get that 4% with minimal risk!

PS: It is not easy to generate 4% alpha. That’s a topic too deep for this note but let’s just say it is achievable, but not everyone can do it. One can easily argue I am being generous allowing for 4%.

Now, one simple way an investor might respond to that is “great, can you buy the index with my money and then add your 4%? That way if the market goes up 8% on average, I’ll get 12% over time“.

After all, a 12% return is better than 4%. If I want low-risk and 4%, why not just buy a Treasury bond? But this isn’t how most large hedge funds operate.

Rather, they add the aforementioned debt. A lot of debt! Why? Well, I’ll explain that in a bit. Let’s do the math first.

Step 2: Add Debt = 4% x 5X = 20%

Different firms will use differing amounts of leverage but 5X is a good round number that is pretty representative from my experience.

So, the good news is you don’t need to add beta to increase your return from 4%. You can add debt instead! Nothing can go wrong with debt right?

Well, if you truly do earn 4% from stock picking every single year (or, more accurately, 0.33% every month cause one bad month can cause a margin call), then, yes, nothing can go wrong.

The problem is few firms are up every single month and when things go the wrong direction – even if just temporarily – things can spiral quickly. Your bank can cut your leverage limit or investors may ask to withdraw their funds, both of which require forced selling at the worst possible time.

But, let’s for now be happy and assume they consistently generate 4% alpha each year, so investors get a 20% return after leverage.

Actually, no they don’t. Here’s where it is about to get interesting. Investors get nothing like 20% returns.

Step 3: Take Out Fees (20% – 7.5% = 12.5%)

So most large hedge funds have something called a pass through fee. I could write an entire article about pass through fees and why investors should refuse to pay them, but let me give you the short version here.

“Pass through fees” are like a cost plus contract. Any expenses the hedge fund incurs to run the business get “passed through” to the investor. That means everything from Bloomberg terminals to cell phones to travel to portfolio manager salaries and so on.

Because investors are stupid and don’t demand any caps on expenses (think of it like an uncapped quote share!), hedge funds spend profligately on anything that might possibly add a tiny bit to the 4% number.

That means if I could pay for a private hurricane hunter plane that gave me updates on a major hurricane 20 minutes before the newest NOAA update, I would have (in theory only, I never tried to do anything like this) been able to expense that to investors.

In the real world, this is why there is a bubble in hedge fund manager pay because the hedge fund executives don’t bear the cost of parabolic signing bonus increases – the stupid investors do.

Anyway, you may have heard of the “old school” model of investors paying “2 & 20” for hedge fund expenses. This means the management fee was 2% of assets (I’ll cover the 20 below).

Well, that is so 1994! Pass through expenses have been known to reach double digits at some firms! That is not the case everywhere, so I am going to use a more common number of 7.5% which, as you’ll note, is nearly double our 4% alpha!

Step 4: Take Out More Fees! (12.5% x 0.8 = 10%)

But, wait, what about the 20% I referenced? That’s the “performance fee”. So the pass through fee is just reimbursing the hedge fund for expenses they incur. That isn’t available to pay year end bonuses!

For that, hedge funds charge a 20% performance fee. In our example, 20% of 12.5% is 2.5% so the net return to investors drops to 10%.

Thus, half of the post leverage return is eaten up by fees paid by investors!

Final Analysis: Investors Don’t Get Any Alpha!

So what’s our conclusion? Hedge funds work really hard to earn 4% alpha. It is very hard. I can speak from experience. However, given the uncontrolled spending, it now takes 10% to make that 4%.

If you say, “that’s a terrible business model, why would I pay 10% to make 4%. That means I lose 6%.” You would be correct and choose not to allocate to a hedge fund.

However, because most investors don’t ask what the underlying leverage is, they think it is terrific to pay 10% to get 20% “gross returns” – even though 16% of the 20% came from leverage!

One more calculation: Let’s say we instead returned to my original thought and invested like a hedge fund but, instead of using leverage, bought an index fund. If you assume a 8% annual S&P return and 4% alpha, you’d have 12% before fees. If you paid a traditional “2 and 20”, you’d subtract 2 from the 12 and 0.8 (aka 20%) from the 4, and arrive at a net return of 9.2%.

I would argue that 9.2% has a lot less risk than the levered 10% because it doesn’t risk the firm collapsing if performance is bad and your leverage is taken away.

Private Credit’s “Better Mousetrap”

If you thought that was fun, let’s do it again for private credit! Private credit funds claim to generate excess returns because they can obtain better terms and charge higher interest than banks can since they offer more flexibility to the borrower.

That is all true. It’s also true that the extra yield they get does not result in higher returns for the investor.

I have less direct experience here so my assumptions are based on data I’ve found in the public domain which appears to pass the reasonability test. Again, you can change some numbers if you like but I don’t think you will change the conclusion.

Step 1: 9% Gross Returns

We begin with the interest rate the borrower agrees to pay to the private credit lender. This will vary as market interest rates change, by credit profile of the borrower, etc. but 9% seems to be a pretty common assumption so let’s work with that.

Step 2: Add Debt = 9% x 2X – 5% = 13%

Private credit uses far less leverage than hedge funds. My research indicates credit funds typically have a 50/50 capital/equity cap structure, meaning they borrow $1M for every $1M in their fund.

Thus, if you raise $1B, you can make $2B of loans at 9%. This results in a 18% gross return but you then need to subtract the cost of borrowing (hedge funds can lend their securities to largely offset the cost of borrow which is why I didn’t subtract an interest cost above) which I assume to be 5% for this exercise.

Step 3: Take Out Fees (13% – 1.5% = 11.5%)

Private credit fees are lower than hedge fund fees. They don’t have (that I am aware of) pass through expenses and base expenses tend to be lower than hedge funds with management fees closer to 1.5%.

So this seems like a win for private credit, at least relative to hedge funds, right? Well, let’s finish the exercise before we draw premature conclusions.

Step 4: Take Out Credit Losses (11.5% – (1.5% x 2) = 8.5%)

This is an additional step we didn’t have for hedge funds. Lenders will make bad loans! In recent years, this has been closer to 1% of assets but that has been during a very benign credit cycle.

More conservative assumptions would assume 2-2.5% losses over a cycle (which means we are probably due for 3+%!). However, it’s a bull market where everyone is optimistic so I am going to be generous and assume only 1.5%.

But there is one extra step to consider. Recall, most funds are levered at 2X so if 1.5% of loans default that has a 3% impact on investor’s capital, which takes our returns down to 8.5%.

Step 5: Take Out More Fees! (8.5- (8.5-7.0) x .15 = 8.3%)

OK, that looks more complicated! What did I just do there?

First, incentive fees at private credit funds tend to be closer to 15% than 20%. Also, those fees are not paid until after the investor makes a guaranteed minimum return which is 7% in this example.

Thus, if the fund was up 10% before the incentive fee, the investors get 7% plus 85% of the difference between 10% and 7%, which is another 2.5%. Add those together and the investor would earn 9.5% net and the fund manager 0.5% in performance fees.

Because I assumed more realistic loan losses, the starting return is lower (8.5%) which means the incentive fee is lower and only cost investors about 0.2%.

So, after all that, the investor ends up with 8.3%, a lower return than the unlevered loan yield – and had to take on leverage to achieve it!

Final Analysis: Investors Don’t Get Any Excess Return

What is the point in locking your money up in a private credit fund and taking on leverage to achieve the same return as the unlevered yield?

While not as egregious as hedge funds, once again, all the value of the leverage accretes to the fund manager where the investor takes all the residual downside risk.

This may not be obvious to investors given how low credit losses have been in recent years so they are used to getting more like a 10% return after fees.

Still, you can go invest in a public local bank and they will likely make you a return on equity well north of 8.3%. Plus, you have the liquidity to sell your stock at any time.

There really isn’t any good reason to tie one’s money up in a private credit fund unless your primary goal is to avoid daily mark to market risk in a publicly traded bank stock or from owning a portfolio of public corporate credit bonds.

Homemade Leverage

If you want to add leverage to investments, there is nothing stopping you from creating it on your own (though I wouldn’t advise it!). There are these things called margin loans. There are other ways to do so as well – borrow against your business or home.

The point being there are ways to add leverage to your investment without giving your money to a private credit fund or hedge fund manager. Also, most investors in alternative assets are pension funds or other institutions who have plenty of ways to lever up cheaply.

How would a homemade levered portfolio compare to an “off the shelf” one?

Let’s start with equities. It is relatively easy to get 50% leverage on equities so, if the S&P goes up 8% long term, then you pick up an extra 4%.

Note, that 4% is the same as the “alpha” hedge fund managers work so hard to provide you but, in this case, you don’t pay 10 points in expenses to achieve it!

Now, some would argue that the hedge fund alpha is better because it has no market risk (beta = 0 vs. 1 in a S&P index) but what’s the greater risk? That stocks go down in the long term or that a hedge fund makes bad investment decisions and underperforms?

I would suggest it’s the latter. I am much more confident I can make 12% buying the S&P and levering it up 50% than I am that I can hire people who will consistently produce 4% alpha in addition to my unlevered S&P holdings.

So, when you think about it, there is really no reason for hedge funds to exist, at least not at the current expense structure. At some point, investors will realize this and demand an end to pass through and to replace it with a fixed expense load.

As for private credit, this is even simpler. In a favorable credit environment I can make 10% in a private credit fund. Alternately, I can buy a portfolio of corporate bonds at 6% and put on 2X leverage myself rather than paying a fund manager to do so. That’s 12%. I win!

Now, the homemade approach does bring daily mark to market volatility but if I’m holding the bonds to maturity, I don’t really care about that. More importantly, if I suspect credit is about to get worse, I can sell those bonds instantly whereas private credit investors, as they’ve learned recently, can’t get their money out.

So, if I have better returns and better liquidity, why on Earth would I invest in private credit over just buying corporate bonds myself?

Surely, if you’re a large pension fund you are capable of buying and holding corporate bonds and the costs to administer them internally are far lower than paying high fees to an outside manager.

What Have We Learned?

A lot, hopefully! While there is certainly skill involved in managing a hedge fund or private credit portfolio, the alpha created more than gets eaten up in the cost of producing it.

Thus, just like index funds vs. active mutual funds, it is usually better to own the low cost index fund than to pay more for the actively managed one.

There is, of course, the paradox that if everyone indexed we would all get worse results. Some active investors are needed in order for the rest to free ride.

But the real lesson here is alternative products need to get their cost down low enough so that they actually provide excess return beyond just the “free lunch” from leverage.

The true test of a successful investment product is if it produces excess returns after fees and without leverage. There are some hedge funds and credit funds that no doubt do this, but the great majority do not and you should be skeptical before turning your money over to them.