Buyer Beware: The Mirage of Private Credit Fund Returns

Private credit has become one of the fastest-growing corners of global finance, with industry  estimates placing assets under management at roughly $2 trillion as of 2024 (IMF, Apr. 2024);  industry data providers report a comparable trajectory, with the asset class reaching about $1.7  trillion in 2023 and projected to grow further (Preqin, Dec. 2024). The asset class is marketed on the  promise of steady income, muted volatility, and attractive risk-adjusted returns. Yet beneath those  narratives lies a structural problem: valuation opacity and the wide discretion afforded by fair-value  accounting. On closer inspection, a meaningful share of reported performance can be traced not to  economic fundamentals but to the latitude managers enjoy in marking illiquid assets—latitude that,  in aggregate, can strain investor trust and contribute to risks across the broader financial system. 

The Hidden Engine of “Success” 

Private credit’s appeal rests on an intricate machinery powered by a practice both commonplace and  contentious: the acquisition of distressed loans and bonds at bargain-basement prices, followed by  their upward revaluation. These assets, often sold by banks constrained by regulatory capital  requirements or by funds facing liquidity shortfalls, may reflect forced-seller dynamics rather than a  considered assessment of intrinsic value. For private credit managers, armed with the latitude  granted by accounting standards, this creates fertile ground—a chance to recalibrate “fair values”  through internal models untethered from observable market transactions. 

The implications ripple far beyond swelling Net Asset Values (NAVs). This alchemy crafts seductive  narratives of performance, inviting fresh capital like moths to a flame while justifying hefty  management fees. Yet for investors, these revaluations introduce risks—risks born not of economic  reality but of managerial discretion. The glittering façade serves the architects alone, leaving others  exposed to the brunt of eventual market corrections. 

Decoding Level 3 Opacity 

At the heart of these valuation practices lies a twilight zone of financial reporting—Level 3 assets, as  delineated by accounting frameworks like ASC 820 and IFRS 13. Unlike Level 1 assets, which bask in  the clarity of observable market prices, or Level 2 assets, which lean on comparable inputs, Level 3  assets are valued using unobservable inputs and management assumptions. Valuation here becomes  less a discovery than a projection, shaped by manager-imposed recovery rates, discount factors, and  speculative predictions of future cash flows. 

Proponents of this system often laud managerial expertise as both bulwark and justification, arguing  that these valuations reflect foresight and strategy. Yet the absence of external validation leaves  investors navigating an opaque mire—a terrain where annual audits and Limited Partner Advisory  Committees (LPACs) provide scant illumination. Within these shadowed margins of discretion, the  line between prudent judgment and opportunistic adjustment dissolves, fraying confidence in the  private credit ecosystem.

The Game of Winners and Losers 

In this delicate construct, fund managers emerge as unambiguous beneficiaries. Their compensation,  tethered to inflated NAVs, swells in tandem with perceived portfolio performance. By weaving a  narrative of consistent triumph, managers attract fresh capital, expand portfolios, and bolster their  fees. Yet this self-reinforcing cycle often exacts a hidden toll—the erosion of transparency and  investor protection. 

Sophisticated institutional investors, too, find themselves ensnared. LPACs, ostensibly guardians of  oversight, often lack the tools or appetite to challenge the nuanced methodologies underpinning  Level 3 valuations. Retail investors face an even steeper climb, lured by promises of stability but  unarmed to decipher the intricate accounting practices shaping their returns. 

Repercussions ripple outward. Sellers of distressed assets encounter artificially inflated benchmarks,  forced to accept lower bids or risk losing out entirely. Misaligned capital flows steer investments into  ventures predicated on rosy valuations rather than tangible performance. In a market as expansive  as private credit, these distortions risk cascading into systemic instability, threatening portfolios and  the broader financial landscape alike. 

Secondary Markets: The Heart of the Practice 

At the nexus of these valuation maneuvers lies the secondary market—a bustling arena where funds  trade distressed assets to recalibrate liquidity or reposition portfolios. The anatomy of a typical  transaction reveals much about the mechanisms at play. Consider a stylized example: Fund A, facing  looming liabilities, sells a portfolio of underperforming loans to Fund B at 70 cents on the dollar.  What often follows is a familiar pattern: Fund B revalues these assets upward, citing proprietary  models and recovery projections, while setting aside the recent transaction price on the grounds  that the sale was not orderly. (The figures used throughout this article are illustrative, intended to  show the mechanism rather than to describe a specific transaction.) 

Under fair value accounting principles, such as ASC 820 and IFRS 13, the price in an orderly  transaction is often the best initial evidence of fair value. However, the mechanism for ignoring a  recent transaction price typically hinges on the classification of the sale as “distressed” or “not  orderly.” Fund B may argue that the sale from Fund A was forced due to liquidity constraints,  thereby deeming the transaction price unreliable. This allows Fund B to rely on Level 3  “unobservable inputs,” including proprietary recovery assumptions and discount rates, to justify  upward revaluations. While technically permissible within accounting standards, this practice raises  critical questions about its intent and consequences. 

This valuation gap, enabled by Level 3 opacity, becomes fertile ground for discretionary mark-ups  cloaked as performance improvement. While the underlying economic fundamentals often remain  static, these adjustments varnish NAV growth, creating an alluring facade of success. Over time, this  practice pressures sellers to accept lower prices, undermining their bargaining power in a market  increasingly skewed by discretionary valuations. 

The Systemic Implications

As these practices proliferate, their ramifications extend far beyond individual funds. Inflated  valuations corrode investor trust, distort transaction benchmarks, and confound regulatory  oversight. They create precarious feedback loops: higher NAVs fuel greater leverage, magnifying  exposure to economic downturns. In crises, these fragile constructs risk collapsing, dragging  portfolios—and, potentially, economies—into their wake. 

Regulatory bodies have begun to stir. The U.S. Securities and Exchange Commission (SEC), through  its private fund adviser reforms adopted on Aug. 23, 2023 (SEC, Aug. 23, 2023), introduced measures  aimed at amplifying transparency and policing valuation integrity. However, these rules were  vacated in full by the U.S. Fifth Circuit Court of Appeals on June 5, 2024 (Fifth Circuit, June 5, 2024),  leaving a regulatory vacuum in their wake. The absence of enforceable standards exacerbates the  very risks these reforms sought to address, underscoring the urgent need for a renewed  commitment to oversight and accountability. 

A Close-Up on Industry Practices 

For an illustration of scale and stakes, one need look no further than documented industry behaviors  that epitomize the challenges of private credit valuation. Regulatory filings and investigative reports  provide examples where distressed loan portfolios are acquired at sharp discounts, only to be  revalued upward in time for quarter-end reporting. Justifications such as “recovery potential” and  “de-risked structures” abound, yet the timing and consistency of these adjustments raise critical  questions about their intent. 

These practices align with structural incentives endemic to private credit, underscoring the critical  need for transparency. Without rigorous disclosures and independent validation, investors remain  vulnerable, navigating a landscape where managerial gains often outweigh economic substance. 

Spotting the Red Flags 

How, then, can investors protect themselves in this murky terrain? Vigilance is key. Indicators of  valuation risks include: 

• Upward markups that cluster around quarter-end or year-end reporting dates, with little  corresponding change in borrower fundamentals. 
• Reported fair values that diverge materially from recent transaction prices, with sales  routinely reclassified as "distressed" or "not orderly" to justify ignoring observable evidence.
• Heavy reliance on Level 3, model-based valuations with limited disclosure of key inputs such  as recovery rates, discount rates, and default assumptions. 
• Absence of sensitivity analysis showing how NAV would move under reasonable changes in  those key assumptions. 
• Reported returns that are smoother than the underlying credit environment—or peer funds  with comparable exposures—would suggest. 
• Performance fees or carried interest accruing on unrealized, marked-up gains rather than on  realized cash-on-cash returns. 
• Limited independent verification: narrow audit scope, infrequent third-party valuations, or  advisory committees without the resources to challenge valuation methodologies.

Due diligence is non-negotiable. Investors must demand granular disclosures, independent audits,  and transparent methodologies. These safeguards, though challenging to implement, offer the  clearest defense against the risks lurking beneath the surface. 

A Call to Reform 

As private credit stretches toward new horizons, its rapid growth demands a parallel commitment to  transparency and accountability. The sector’s future hinges on its ability to reconcile ambition with  integrity, innovation with responsibility. Investors, fund managers, and regulators alike must  confront the uncomfortable truths that shadow this industry. 

Regulation must evolve to meet the moment. Enhanced valuation standards, stricter disclosure  requirements, and penalties for misrepresentation are essential pillars of reform. Collaborative  frameworks, leveraging industry expertise, can foster self-regulation while aligning with broader  oversight objectives. 

Ethics must guide this transformation. Fund managers face choices that ripple far beyond immediate  returns—choices that determine whether their business models empower or exploit. Investors, too,  must weigh their pursuit of profit against the systemic risks their decisions may fuel. The collective  will to address these challenges will dictate whether private credit emerges as a beacon of  innovation or a cautionary tale of ambition unmoored. 

Technology may also play a supporting role. A tamper-evident distributed ledger that records  acquisition prices and subsequent valuation adjustments could improve auditability and make  discretionary mark-ups easier to detect, though it would not by itself determine fair value or  constrain the assumptions that feed valuation models. 

Artificial intelligence (AI) and machine learning also hold promise for improving valuation accuracy.  These technologies can analyze vast datasets to identify patterns and correlations that may be  overlooked by human analysts. For example, AI-driven models could incorporate real-time data on  macroeconomic indicators, industry trends, and borrower creditworthiness to generate more  objective valuations. While these tools are not a panacea, they represent a significant step forward  in mitigating the risks associated with subjective assumptions. 

However, the adoption of these technologies is not without challenges. Implementing blockchain  solutions requires industry-wide collaboration and significant upfront investment, while AI models  must be carefully calibrated to avoid perpetuating existing biases. Moreover, the use of technology  does not eliminate the need for robust regulatory oversight; rather, it should complement  traditional safeguards to create a more transparent and accountable ecosystem. 

Recommendations for Strengthening Investor Protections 

Given the systemic risks posed by opaque valuation practices, a multi-pronged approach is needed  to strengthen investor protections. First, regulators should mandate more detailed disclosures  regarding the methodologies used to value Level 3 assets. These disclosures should include  sensitivity analyses that illustrate how changes in key assumptions, such as discount rates or  recovery projections, impact NAVs. Such transparency would enable investors to better assess the  reliability of reported valuations.

Second, the role of independent auditors must be expanded. While annual audits are a standard  requirement, their scope often excludes a granular review of valuation methodologies. Regulators  should require auditors to conduct periodic, unannounced reviews of Level 3 asset valuations,  focusing on the consistency and rationale behind discretionary adjustments. This would provide an  additional layer of oversight, deterring opportunistic behavior. 

Third, investor education should be prioritized. Many retail investors lack the financial literacy  needed to critically evaluate private credit funds, leaving them reliant on marketing materials that  often downplay risks. Educational initiatives, supported by both regulators and industry associations,  could empower investors to ask more informed questions and demand greater accountability from  fund managers. 

Conclusion: A Call for Collective Responsibility 

The challenges facing private credit markets are not insurmountable, but addressing them requires a  collective commitment to transparency and accountability. Fund managers must recognize that their  long-term success depends on cultivating trust rather than exploiting opacity. Regulators must strike  a balance between fostering innovation and safeguarding investor interests, while investors themselves must approach private credit with a critical eye, resisting the allure of superficially stable  returns. 

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The practice of discretionary upward valuation demonstrates how structural incentives within  private credit fund management can lead to distorted reporting. By exploiting flexibility in fair value  accounting principles, fund managers may classify transactions as "not orderly" to justify ignoring  observable market prices. This allows them to rely on Level 3 inputs, such as proprietary models and  recovery assumptions, to inflate asset valuations. While this practice can enhance reported NAVs  and accrue performance fees, it creates risks for investors who rely on these valuations for decision making. The systemic implications of such practices have drawn regulatory scrutiny, including calls  for enhanced transparency and oversight from the SEC. As SEC Chair Gary Gensler noted when  proposing the private fund adviser rules, "Private fund advisers, through the funds they manage,  touch so much of our economy. Thus, it’s worth asking whether we can promote more efficiency,  competition, and transparency in this field." (SEC, Feb. 9, 2022). Investors must remain vigilant and critically evaluate reported returns, recognizing the potential influence of structural incentives on  valuation practices. 

Figure 1. Anatomy of a secondary-market transaction: the valuation gap 

This visualization illustrates the core mechanism of discretionary mark-ups. It shows how a  distressed asset, acquired at a significant discount (70 cents on the dollar), is subsequently revalued  upward by the acquiring fund using Level 3 inputs. This creates a 'valuation gap' between the hard  transaction price and the reported Net Asset Value (NAV), artificially inflating perceived  performance. 

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Figure 2. Valuation opacity by asset classification (ASC 820 / IFRS 13) 

This chart demonstrates the escalating degree of managerial discretion and valuation opacity as  assets move from Level 1 (market-priced) to Level 3 (model-priced). The heavy reliance on Level 3  assets in private credit provides fertile ground for the discretionary mark-ups that obscure true  economic performance and mislead investors. 

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Additionally, a growing body of academic and policy research has examined valuation and return smoothing in private credit markets, generally finding that funds holding more illiquid assets tend to  report smoother reported returns than the underlying credit conditions would imply. Financial-press  coverage of the sector, including reporting by The Financial Times, has likewise scrutinized how  some funds apply subjective valuation adjustments and report smoothed returns. Taken together  with the academic literature and the regulatory findings below, this coverage indicates that the  concerns described earlier are not merely hypothetical but reflect patterns observers have  documented in the industry. 

Public filings and regulatory disclosures offer further insight into the valuation methodologies  employed by private credit funds. For example, in a Risk Alert issued by the SEC Office of Compliance  Inspections and Examinations (SEC OCIE, June 23, 2020), the staff observed that some private fund  advisers did not value client assets in accordance with their disclosed valuation processes, in certain  cases leading to overcharged management fees and carried interest based on overvalued holdings.  These findings underscore the systemic nature of the issue and highlight the need for greater  transparency in valuation practices. 

Consider, as an illustrative scenario, a fund that disregards observable market prices in favor of  internal models that consistently produce higher valuations. Such a pattern—marking a book away from recent transaction evidence without adequate support—would expose a manager to  enforcement risk for misleading investors about the fund’s true risk and performance, and it  underscores why robust oversight and disclosure matter for market integrity. 

The combination of permissive accounting standards and limited regulatory scrutiny creates an  environment where opportunistic valuation practices can thrive. While not every fund engages in  such behavior, the documented cases and regulatory findings make it clear that the risk is far from  theoretical. Investors and regulators alike must remain vigilant to ensure that reported returns  accurately reflect underlying economic realities. 

Case Studies of Valuation Failures 

To further illustrate the challenges of private credit valuation, we turn to the case of the Abraaj  Group. Although the Woodford Equity Income Fund is sometimes cited in discussions of fund  failures, that episode is best understood as a cautionary example of liquidity mismatch from holding  illiquid assets in an open-end, daily-dealing structure rather than a direct private-credit valuation  analog (Financial Conduct Authority, 2019); the Abraaj Group is a more relevant example of  valuation misrepresentation within a private fund context. Abraaj’s collapse was precipitated by  allegations of misappropriated funds and inflated asset valuations; the SEC charged founder Arif  Naqvi and Abraaj Investment Management Limited with misappropriating money from a private  fund and making misrepresentations to investors (SEC, Litigation Release, Apr. 11, 2019).  Investigations revealed that the firm used aggressive accounting techniques to mask liquidity issues  and maintain the appearance of steady returns. This case highlights the potential for valuation  practices to obscure financial instability, ultimately leading to significant losses for investors. 

In a comparable scenario, a fund that overstated its loan portfolio by selectively excluding lower  transaction prices from its valuation models would produce materially misleading NAV calculations,  harming both investors and broader market confidence. Together, these examples underscore the  importance of rigorous valuation standards and greater accountability in private credit markets. 

Disclosures 

This document contains discussions related to private credit markets, valuation practices, and  investment risks, which are financial topics requiring disclosures. The content may be interpreted as  commentary on investment strategies, asset valuation methods, and risks associated with private  credit funds. Readers should note that this document does not constitute financial or investment  advice. Private credit investments involve significant risks, including valuation opacity and reliance  on discretionary accounting practices, which may not align with observable market data. Investors  are strongly encouraged to consult with a qualified financial advisor or conduct independent  research before making any investment decisions. Past performance is not indicative of future  results. Additionally, the document references accounting frameworks such as ASC 820 and IFRS 13,  which are subject to updates and changes; readers should verify the current applicability of these  standards as of the publication date, June 1, 2026.

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