Don’t look down: The risk beneath the return

It is mind-blowing that no one is asking how private credit funds actually generate their returns. But as the great Charlie Munger said, “Show me the incentive and I’ll show you the outcome”. Few investors and asset consultants are asking this fundamental question and it’s likely because the truth is rather inconvenient:

What are the actual constituents of private credit returns?

Despite the proliferation of private credit strategies, there is almost no standardised disclosure about what drives performance at a fund level. While investors hear about “superior risk-return profiles,” they are rarely shown a breakdown of what portion of return is coming from contractual cash interest and loan fees, how much is PIK-accrued interest, what’s due to valuation uplifts, and what role leverage plays in enhancing (or distorting) yield.

If you’re considering an allocation and you can’t get this breakdown from a manager, here’s a simple suggestion: Ask why? Demand better transparency and unpack the details.

Why does it matter?

There is growing evidence that the use of PIK interest is increasing. At the same time, competition among lenders, particularly in the oversupplied offshore markets and domestic real estate markets, has never been higher. This is driving a shift away from traditional return sources such as cash-paid interest and loan fees, towards less visible, more contingent forms of return. The omission of this crucial breakdown from both investor presentations and research ratings reports is a blind spot that obscures the quality of a fund’s return and the risk embedded within its loan portfolio. It can also lead to volatility in investors’ portfolios. Put simply: the constituents of return may reveal more about the underlying portfolio quality than any marketing deck or top-line yield figure ever could.

Breaking Down the Return Stack

While terminology may differ between strategies, the building blocks of private credit returns typically fall into four main categories:

1. Cash Yield: Interest, Loan Fees, and Realised Gains

The most tangible and desirable component of return comes from:

• Cash interest payments from borrowers
• Upfront and ongoing fees
• Occasional realised gains, e.g. early repayments at a premium or cash gains made from loan restructurings

This is the foundation of a private credit portfolio’s cash-generative appeal. However, as competition intensifies, funds are relying more heavily on other, sometimes less transparent drivers.

2. PIK Interest and Accruals

PIK (payment-in-kind) interest accrues to the loan balance rather than being paid in cash. It:

• May boost NAV/unit prices in the short term
• Defers realisation of return until exit or refinancing
• Often appears in increasing or higher interest rate environments, higher-risk structures or stretched borrower profiles

Increasing PIK usage may be a red flag for deteriorating underwriting discipline—yet it's rarely disclosed.

3. Unrealised Capital Gains

Funds may revalue loans upwards due to secondary price fluctuations, borrower performance improvements, or mark-to-model inputs. While sometimes legitimate, these:

• Are inherently subjective
• Can smooth or inflate returns
• May never be realised if loans repay at par

They make the fund look good—until reality catches up.

4. Leverage Effects

Leverage enhances returns by amplifying yield on your invested equity. But it may:

• Introduce liquidity and refinancing risk
• Magnify unrealised losses in downturns
• Go undisclosed in investor reports

When used carefully, leverage can improve loan deployment efficiency and liquidity. When overused, it conceals fragility.

Expect Greater Scrutiny

As a mature and growing asset class, investors, asset consultants, and fiduciaries will continue to demand greater transparency. If a fund is claiming double-digit yields in a low-default, low-volatility strategy - what is really behind it? Is it appropriate for the strategy? Is it sustainable? How much tail risk are you taking?

In certain private credit market segments where capital is abundant and deal discipline is under pressure, the composition of return is a clearer signal of quality than the headline number.

And yet, most of the market is silent on this. That silence says more than any glossy pitch ever could.