Key Takeaways
- Private market returns flatter risk-adjusted ratios unless they are first adjusted for smoothing, leverage, fees, credit losses and illiquidity.
- PitchBook found that de-smoothing raises private equity volatility from 9.8% to 17.1%, enough to roughly halve a reported Sharpe ratio.
- For lenders, expected loss (default rate times loss given default) can turn a higher-yielding unsecured loan into the weaker risk-adjusted choice.
- Senior direct lending has recorded lower annual loss rates since 2017 than leveraged loans or high-yield bonds, though manager dispersion is wide.
- Ask where the return comes from, how robust the protections are, how transparent the reporting is and what happens in the downside.
Picture two private credit opportunities on the same desk. One pays a 12% coupon on a subordinated, unsecured loan to a mid-market company. The other pays 8% on a senior secured note backed by a pool of receivables. On headline yield, the first wins by four points. Once you account for where each sits if things go wrong, how often borrowers default and how much is recovered, the answer can reverse.
That is the problem with private market returns. The numbers investors are shown are real, but they are produced in ways that flatter them: valuations that move slowly, leverage that sits out of sight, fees taken before the investor sees a penny, and losses that arrive in clusters. Run a Sharpe ratio on those figures unadjusted and private assets look almost too good to be true.
This article sets out what to adjust for before comparing private market returns with each other or with public alternatives. If you need a refresher on the ratios themselves, our guide to what risk-adjusted returns are covers the Sharpe, Sortino and Calmar ratios with worked examples.
Why private market returns need adjusting
Risk-adjusted measures divide return by risk. In listed markets both halves of that sum come from daily prices. In private markets, the return is reported by the manager, the risk is inferred from quarterly valuations, and both are shaped by the structure the investor holds. Five adjustments matter most: smoothing, leverage, fees, credit losses and illiquidity.
Adjustment 1: smoothed valuations
Private assets are valued by models and appraisals, usually quarterly. Valuers anchor on the previous mark and move gradually, so reported returns are smoother than the underlying economics. Lower reported volatility pushes up every risk-adjusted ratio.
The effect is large. A PitchBook analysis of quarterly returns from 1999 to 2020 found that removing the smoothing raised private equity volatility from 9.8% to 17.1%, venture capital from 21.2% to 53.2% and real estate from 11.8% to 17.0%. For private equity, that alone would roughly halve a reported Sharpe ratio.
Private credit is less affected, because most of its return is contractual interest, which is cash received. But marks on loans still lag reality, and a loan carried at par can be worth considerably less if it has to be sold. The fix is to look through to cash: income actually received, defaults and recoveries, and the price at which comparable loans trade.
Adjustment 2: leverage
Leverage raises returns in good years and losses in bad ones, and in private markets it can sit at three levels: in the borrower, in the fund, and in the vehicle the investor holds.
A simple example: a portfolio of loans yielding 8% is financed half with investor capital and half with borrowing at 6%. The investor's return rises to 10%, because they keep the 2% spread on the borrowed half. If the loans lose 4% in a bad year, the investor's capital loses 8%. The yield improved by a quarter; the downside doubled.
When comparing funds, ask for returns on an unlevered basis, or at least the level and cost of leverage. A 10% levered return and an 8% unlevered return may represent identical underlying assets.
Adjustment 3: fees and costs
Private market fees are higher and more varied than public ones: management fees, performance fees, structuring and arrangement fees, and fund expenses. Gross returns can look strong while net returns are ordinary.
Consider a fund earning 11% gross that charges a 1.25% management fee, a performance fee and around 0.5% of expenses. If total costs come to 2.5%, the investor receives 8.5%. Every risk-adjusted comparison should use net returns, and should compare them with the net return of the public alternative, where costs may be a fraction of a percent.
Adjustment 4: credit losses
For any lending strategy, the coupon is the maximum the investor can earn. What they keep depends on how many borrowers default and how much is recovered. The basic adjustment is:
Expected loss = Default rate × Loss given default
Default rates are currently moderate. Proskauer's Private Credit Default Index put the rate at 2.51% in Q2 2026, down from 2.73% in the first quarter. What differs sharply between investments is the loss when default happens, and that depends on security and seniority.
Return to the two loans at the start, using illustrative assumptions:
| Measure | Subordinated, unsecured loan | Senior secured, asset-backed note |
|---|---|---|
| Headline yield | 12% | 8% |
| Normal year: default rate × loss given default | 3% × 80% = 2.4% | 2% × 20% = 0.4% |
| Loss-adjusted yield, normal year | 9.6% | 7.6% |
| Stress year: default rate × loss given default | 9% × 80% = 7.2% | 6% × 20% = 1.2% |
| Loss-adjusted yield, stress year | 4.8% | 6.8% |
In a normal year, the four-point gap shrinks to two. In a downturn, the senior secured note comes out ahead, and with far less variation between good and bad years. That is a better risk-adjusted return, and it comes from structure: security over assets, priority in the capital stack, and covenants that let the lender act early.
Adjustment 5: illiquidity
Private investors should be paid for locking up their money. The question is whether the extra return is a fair price for that lock-up, or simply compensation for more credit risk. The illiquidity premium should be measured against a public asset of the same rating, seniority and duration, never against cash.
Liquidity terms also change the investor's experience. In March 2026, several large evergreen private credit funds received redemption requests above their quarterly limits, including a record 7.9% at Blackstone's BCRED. Investors who expected to be able to leave found they had to queue, which is a risk no volatility figure captures.
Comparing private credit with public alternatives
Once the adjustments are made, how does private credit compare? Long-run data suggests the asset class has held up well, partly because private lenders can negotiate security and covenants that public bondholders rarely get.
| Feature | Senior direct lending | Leveraged loans | High-yield bonds |
|---|---|---|---|
| Liquidity | Low; held to maturity | Traded, but can be thin | Traded daily |
| Pricing | Quarterly valuations | Daily market prices | Daily market prices |
| Typical security | First-lien, covenants | First-lien, often covenant-lite | Often unsecured |
| Annual loss rate since 2017 | 0.4% | 1.1% | 2.4% |
Loss rates: Morgan Stanley Investment Management, citing Cliffwater data, via ABF Journal.
Over a longer window, the Cliffwater Direct Lending Index has a 20-year loss rate of around 1.01% a year, against 1.49% for high-yield default losses, according to the same source. The index returned 9.3% in 2025, driven by 10.4% of interest income, according to Cliffwater. Index averages hide wide dispersion between managers, which is why the adjustments above matter at the level of each individual investment.
The questions to ask before investing
At Kingsbury & Partners, our Credit Committee (formerly the Product & Risk Committee) applies a discipline we describe as "regulating the unregulated": bringing to private deals the scrutiny that public markets impose through disclosure and daily pricing. Four questions sit at the centre of it, and any allocator can ask them of any manager.
- Where does the return come from? Sustainable cashflows from the underlying assets, or financial engineering through leverage and fees?
- How robust are the protections? Collateral, servicing arrangements, covenants and the investor's position in the structure.
- Can you see what you own? Regular reporting, transparency on the underlying loans and enforceable rights.
- What happens in the downside? Realistic default and recovery assumptions, and how they change the return in a stress scenario.
What this means for investors
Private market returns are not directly comparable with public ones until they have been adjusted. De-smooth the volatility, look through leverage, use net returns, deduct realistic credit losses, and judge the illiquidity premium against a matched public asset. Only then do the Sharpe, Sortino and Calmar ratios mean what they claim to mean.
The adjustments tend to favour strategies where the return is contractual, the security is real and the structure is simple. In private credit that usually means senior secured lending against identifiable assets, held to maturity, of the kind we focus on through our structured credit approach. Whatever the strategy, the same rule holds: a higher headline return is worth having only if it survives the adjustments.
Frequently Asked Questions
Why do private market returns look less volatile than public markets?
Private assets are valued quarterly using models and appraisals that move gradually, which smooths reported returns. Once that smoothing is removed, private equity volatility moves much closer to listed equity levels.
Does private credit offer better risk-adjusted returns than high-yield bonds?
Historically, senior direct lending has paid higher yields with lower annual loss rates than high-yield bonds. Results vary widely by manager, seniority and security, so each investment needs its own assessment.
What is expected loss in private credit?
Expected loss is the default rate multiplied by the loss given default. Deducting it from the headline yield gives a truer picture of what a lender will keep.
Is IRR a risk-adjusted return?
No. IRR measures the annualised return on cashflows, but it says nothing about volatility, leverage or the chance of loss, and it can be influenced by the timing of distributions.
How do you compare private equity returns with public markets?
The standard approach is a public market equivalent (PME) analysis, which invests the same cashflows in a public index and compares the outcomes. It gives a fairer comparison than setting an IRR beside an index return.
How does leverage affect risk-adjusted returns?
Leverage raises both returns and losses. It can lift headline returns while leaving the risk-adjusted return unchanged or worse, especially once the cost of borrowing rises.
