Research reveals the hidden cost of investing in private debt

By Joe Arnold
Fisher College of Business

The scenario is more widespread than ever: A mid-sized manufacturer needs capital fast to fund a leveraged buyout. A traditional bank won’t lend; it’s too risky, too complex too slow. Instead, the company turns to a private debt fund, which offers a loan at a steep interest rate, often 9-10% or higher, and it may even take a small equity stake or attach other incentives to sweeten the deal.

For borrowers, it’s a gamble. But what about private debt fund investors? The funds are billed as fast-growing, flexible and are increasingly popular with investors seeking higher returns than traditional bonds. But after accounting for risk and fees, are those returns actually better? 

Recent research from a trio of finance professors at Fisher provides some insights: They mostly aren’t. Once adjusted for both risk and fees, private debt funds deliver essentially zero excess returns, or what finance professionals call “zero net alpha.”

Why private debt?

Private debt has exploded in popularity, growing to more than $2 trillion in assets under management in 2025. These funds lend to companies that can’t easily access bank financing, so they can charge higher interest rates.

In practice, private debt funds invest in a range of opportunities, including:

• Loans to companies involved in leveraged buyouts (the most common use case) 
• Mezzanine financing (junior debt often paired with equity upside) 
• Distressed debt (lending to struggling companies) 
• Direct lending to small- and mid-sized businesses 

Many of these deals include equity-like features for investors, such as warrants or preferred equity, which can boost returns if the borrower performs well.

At a glance, private debt is a strong performer. The study finds that the average internal rate of return (IRR) to investors is about 8.6%, which compares favorably to traditional fixed-income investments.

But the devil is in the details. Those headline returns don’t account for two critical factors: risk and fees.

Private debt borrowers are often riskier than typical corporate borrowers. Defaults are more likely, and returns are more volatile than they appear. 

Private debt funds also have substantial fees, typically around a 1.5% annual management fee and 15% carried interest (a share of profits). These fees significantly reduce what investors actually take home.

When the researchers ― Isil Erel, Thomas Flanagan and Michael Weisbach ― adjusted returns for both risk (including both debt and equity-like risks) and fees, the picture changed dramatically.

Using advanced cash-flow-based models, the study compares private debt fund returns to a “replicating portfolio” of public market investments with similar risk.

The result?

After proper risk adjustment, the excess return is essentially zero. Essentially, investors in private debt funds earn close to what they would in public markets

“This finding means that private credit funds earn enough returns to compensate for the riskiness of the investment and cover management fees, but not more than that,” said Flanagan, an assistant professor of finance at Fisher.

An illusion of strong performance

The researchers found that if risk isn’t fully accounted for, especially the equity-like components, private debt can look attractive.

Compared only to corporate bonds, private debt appears to generate positive alpha (around 1.8%). But once equity risk factors are included, that alpha disappears. 

This is because private debt isn’t “just debt.” Around 15-20% of investments have equity-like features, which expose investors to stock-market-style risks. Ignoring that risk leads to overstated performance.

Who reaps the returns?

Gross returns (before fees) among private debt are strong, approximately 13.9% IRR, which generates meaningful alpha (about 4%).  

But investors don’t receive those returns. Instead, fees, captured by fund managers, absorb most of the excess returns, and the remaining returns to investors are just enough to compensate for risk 

This suggests that private debt funds are creating value; but that value accrues primarily to the managers, not the investors.

What’s the takeaway for investors and business?

For investors, private debt may still play a role in diversification, but expectations should be realistic. It’s not a guaranteed source of outperformance.

The key question, according to Flanagan, is whether the illiquidity and complexity are worth it for market-level returns.

For business leaders, private debt remains a valuable financing tool, particularly when speed and flexibility matter. However, the returns ultimately reflect both risk and the fund’s fee structure.

“Private credit delivers an adequate, not abnormal, rate of return relative to public market investments,” Flanagan said. “Although returns are not abnormal, investors may still find the asset class attractive for diversification and other reasons, such as establishing relationships with advisors.”

“For borrowers, private credit may provide financing options unavailable from traditional lenders, both in contract terms and in speed.”