Private credit isn't safer than banks - it's just better at hiding losses

By Robert Pozen

Investors have no idea that fund returns can reflect clever accounting instead of investment skill

Private-credit funds need more transparency.

Accounting rules allow instant markups that mislead investors - changes are needed.

Imagine buying an asset for 85 cents on a dollar and immediately telling your investors that it is worth $1. Although this sequence seems illogical, it is arguably allowed under current accounting rules. Moreover, this sequence is happening every day and distorting the $2 to $3 trillion global market for private credit.

Private credit is lending made to companies that happens outside of banks and the public bond markets. During the past decade, Wall Street aggressively sold shares in private-credit funds to retail investors with the promise of higher returns than stocks and bonds.

The catch: Unlike public securities traded on every business day, investors in many of these funds can only request their money back once a quarter, subject to a total redemption cap equal to 5% of the fund's assets. If too many people want out at once, investors get back a prorated amount of the redemptions they requested.

Within the last six months, retail investors have become quite worried about private loans to software companies, fearing this business might be replaced by AI coding bots. As a result, retail investors have flooded private-credit funds with redemption requests. At the end of the first quarter of 2026, for example, two funds managed by Blue Owl Capital (OWL) received redemption requests exceeding 20% of net asset value (NAV).

To raise cash for redemptions, some private credit funds sell their loans at discounts. Here's where the creative accounting comes into play. The buyers of these discounted loans - so-called secondary funds - do not value them at the purchase price; instead, the buyers immediately mark up the loans to their NAV on the books of the selling fund. These instant markups boost the returns of the buyers and mislead their investors.

The buyers justify these instant markups under an accounting rule called ASC 820, which defines "fair value" as the "exit price" a loan would fetch in an "orderly transaction" as opposed to a distressed fire sale. ASC 820 also permits a buyer to use a loan's NAV as a "practical expedient" if that value was calculated in accordance with generally accepted accounting principles.

A secondary fund buying discounted loans from a private-credit lender hitting its 5% redemption cap has a plausible argument that it is not buying the loans in an "orderly transaction." Nevertheless, do the investors in the purchasing fund realize that its returns are artificially boosted by an accounting gimmick instead of investing expertise? And may a purchasing fund rely on a loan's NAV as a "practical expedient" if it knows the actual price is lower in a contemporaneous transaction?

The problem is even more acute in transactions between affiliated funds. For instance, an "old" fund sells a portfolio of loans at 85 cents on the dollar to a "continuation" fund run by the same manager; the continuation fund immediately marks those loans up to 100 cents. That accounting maneuver can turbocharge the early returns reported by the continuation fund to its investors - who have no idea that these returns reflect clever accounting instead of investment skill.

The SEC recently brought an enforcement action against an investment adviser that sold loans to an affiliated fund. Although the adviser did not assess the changed market conditions between the origination and sales dates of the loans, the adviser certified that the affiliated fund was acquiring the loans at fair value. The SEC found the adviser had violated its fiduciary duty and the antifraud provisions of the Advisers Act.

Now that private-credit and secondary funds have sold shares to millions of retail investors, the pricing of loan transactions should be more transparent.

While this enforcement action is helpful, the SEC should issue a broader warning against the immediate markup of purchased loans to their NAV when they are acquired at a significant discount. Advisers should always disclose to their clients any material differences between the actual purchase price and the new carrying value of a loan. When an adviser sits on both sides of a transaction - as is common with continuation funds - the SEC should require an objective valuation of the purchased loans by a qualified independent appraiser.

In addition, the Financial Accounting Standards Board should clarify that a loan purchaser may not use a loan's stated book value as a "practical expedient" when it knows of a contemporaneous transaction at a materially different price. That shortcut should be reserved for situations where there is no observable transaction between a willing buyer and a willing seller.

Private credit has opened new borrowing channels to companies that otherwise struggle to access capital markets. But now that private-credit and secondary funds have sold shares to millions of retail investors, the pricing of loan transactions should be more transparent. If the value of a fund's purchased loans is inflated by an arcane accounting rule, investors may suffer significant losses when these loans become due.

Robert Pozen is a senior lecturer at MIT Sloan School of Management and a former president of Fidelity Investments.

More: Private credit not only won't spark a financial crisis - it may be more stable than your bank

Also read: These investments promise high yield with bond-like safety. But what looks too good to be true often is.

-Robert Pozen

This content was created by MarketWatch, which is operated by Dow Jones & Co. MarketWatch is published independently from Dow Jones Newswires and The Wall Street Journal.

(END) Dow Jones Newswires

05-02-26 1155ET