The Paper Trail: Simple Arithmetic

There has been no shortage of commentary on private credit this year. Most of it has followed a familiar script: concerns around liquidity, a few high-profile bankruptcies (primarily in bank-led deals), "SaaSpocalypse" worries, and suddenly an entire asset class is cast in a much harsher light.

Some of that scrutiny is healthy. But much of it has been grounded in sensationalism rather than data-driven analysis.

A handful of papers this month take a different approach. My friend Chris Schelling at Aksia analyzed the historical frequency and severity of losses in private credit. I wrote something similar in The Arithmetic of Direct Lending, decomposing historical returns into income, losses, fees, and leverage. And a recent NBER paper steps back even further, examining the structure of private credit itself and highlighting high equity cushions, limited maturity mismatch, and a funding model that looks very different from the banking system it’s often compared to.

None of these rely on sweeping generalizations or hyperbole. Just observable data and straightforward math.

And that’s the point. In an asset class driven largely by contractual cash flows and loss avoidance, outcomes tend to be more predictable than the headlines would suggest. Even under more conservative assumptions, the range of outcomes is narrower, and more explainable, than many seem to believe.

April's edition of The Paper Trail touches on this hot-button topic and many other investment themes:

• Direct lending return drivers
• Private credit loss math (frequency vs. severity)
• Rethinking the endowment model  
• The case for municipal bonds
• Hidden costs of passive investing
• True alpha in macro strategies
• Infrastructure as a core allocation
• Private credit and financial stability
• Quant crowding concerns
• Market reactions to geopolitical shocks
• Equity portfolio construction in a changing world 
• The duration of competitive advantages
• Private assets and liquidity constraints
• Sports franchises as an asset class
• Realizations in GP stakes

What happens when you break direct lending returns into their core components?

"Direct lending is often described as complex, but its return drivers are anything but. Income, losses, fees, and leverage have governed private debt results for more than 20 years and across multiple cycles. Viewed through that lens, the range of outcomes is not only understandable, but remarkably consistent."

The Arithmetic of Direct Lending (Cliffwater)

What actually drives losses in private credit—frequency or severity?

"Traditional metrics for risk, including defaults and volatility in public markets, are intended to proxy for the risk of permanent capital impairment – losing money. In truth, in all investing, that is the only risk that matters. So why not investigate the risk of principal loss directly? This risk can be separated into two dimensions – the probability of loss (how likely it is to occur) and severity of loss (how much will be lost on average if it occurs)."

 
Perspectives on Private Credit Risk (Aksia)

Does the endowment model need modernization?

"We don’t believe the endowment model is broken. In our view, it excels at the ‘art’ of asset allocation: emphasizing diversifying alternative investments, seeking alpha-generative skill, and leveraging a long investment horizon to capture risk and illiquidity premia. However, it has not placed as much emphasis on adopting the ‘science’ of portfolio construction: technological and analytical tools that help detect and adapt to changes in market structure."

The Endowment Model Reimagined (Neuberger)

Are munis compelling again after years of low yields?

"Many US private families reduced US tax-exempt municipal bond (muni) exposure in recent years as low yields, poor performance, and elevated volatility weakened the case for tax-exempt fixed income. That rationale now looks much less compelling. With yields higher and a more meaningful tax advantage of munis, tax-exempt bonds should play a larger role in the portion of the portfolio intended to diversify equity risk."

US Private Families Should Revisit How Munis Fit Within a Broader Diversification Strategy (Cambridge Associates)

What are the hidden costs of passive investing?

"Additions tend to experience positive returns before inclusion and negative returns after, while deletions tend to experience the opposite pattern. These price movements are consistent with trading pressure around index changes and suggest that index reconstitution events can create systematic performance headwinds for index investors."

Index Reconstitution Effect Within Small Caps (Dimensional Fund Advisors)

How much of global macro performance is true alpha?

"Global macro returns often reflect a combination of equity beta and trend-following exposure. When these components are isolated, the remaining excess returns—true alpha—are more limited and vary significantly across managers."

Assessing Alpha in Macro Strategies (AlphaSimplex)

Why is infrastructure becoming increasingly central to portfolios?

"The convergence of hyper-competitive geopolitics, technological transformation, and economic regime change has heightened the criticality of infrastructure: it is the platform upon which competitiveness, productivity and resilience will be built."

Infrastructure Is No Longer An Option: At the Center of Geopolitics, Technology, and Economic Regime Change (KKR)

Is private credit structurally fragile, or just perceived that way?

"Private credit funds are highly capitalized, with equity typically accounting for 65–80% of total assets—more than six times the capitalization of U.S. banks, where equity represents about 10%. Debt usage is moderate and largely reflects bank credit lines used for liquidity management. Fund lives average 10–12 years, while underlying loan maturities are generally shorter, implying little or no maturity mismatch—unlike banks, which fund long-term assets with short-term callable deposits."

Private Credit, Balance Sheets and Financial Stability (NBER)

Is quant crowding a real risk today?

"Recent attention from investors and the financial media has revived questions about the risk of ‘quant crowding.’ Based on a clear definition of the concept and available evidence, we view these concerns as largely misplaced. By several measures, today’s environment bears little resemblance to that which preceded the 2007 quant crisis, and potential indicators of crowding do not raise alarm."

Misplaced Anxiety? A Reassessment of Crowding in Systematic Investing (Acadian)

How do markets typically behave after geopolitical shocks?

"Markets have historically been far more sensitive to financial crises than to geopolitical events. While wars can create short-term volatility, they have rarely been the primary driver of sustained equity drawdowns."

Apocalypse Now? (Man Group)

How should equity portfolios adapt to accelerating technological change?

"Most portfolios struggle not at the extremes, but in the ‘unproductive middle,’ where companies lack both the predictability of resilient businesses and the upside of truly optional ones."

Portfolio Construction in Times of Accelerating Change (NZS Capital)

Is the market underestimating how long competitive advantages last?

"The value of a business is not just a function of how much it can earn, but how long it can earn returns in excess of the cost of capital. Small changes in the duration of excess returns can have a meaningful impact on intrinsic value."

Competitive Advantage Period: The Neglected Value Driver (Counterpoint Global)

How should private assets fit within a modern portfolio construction framework?

"The limit on private asset exposure, as we have articulated before, is likely liquidity. We are seeing the liquidity issue emerge as a sharp concern this quarter. We argue that, even aside from the current issue of a potential mismatch in expectations of liquidity in the funds that have got into difficulty, liquidity should be a key constraint. This view recognizes the heightened liquidity risks in a world where institutional portfolios in aggregate have become more illiquid, shifts in market microstructure have made liquidity in public markets more fragile, and central bank liquidity is less plentiful."

Private Assets in Portfolios: Reassessing the Strategic Case (AllianceBernstein)

Do sports franchises offer unique portfolio characteristics?

"Even under conservative scenarios, the results suggest that premium sports franchises exhibit properties that can improve portfolio efficiency relative to traditional and alternative asset classes"

Asset Allocation with Premium North American Sports Franchises (Arctos Partners)

Are GP stakes more liquid than the market assumes?

"One of the first questions a prospective investor typically asks about GP stakes is, ‘How do you achieve liquidity?’ It’s a fair question, but it reflects what we believe to be a common misconception—that the strategy is inherently illiquid in a way other non-control private equity strategies are not. As it pertains to GP stakes investments, while the sample size is small, we believe the success rate for liquidity has been strong in comparison to their targeted holds"

Accelerating Liquidity in GP Stakes (Bonaccord Capital Partners)