Volatility Laundering in Private Credit

Why It Matters

The mis‑pricing risk created by volatility laundering could erode investor returns and shift capital toward more transparent public credit markets.

Key Takeaways

• Private credit lagged public credit since 2022.
• Illiquidity hides true volatility, inflating Sharpe ratios.
• Higher concentration and lower credit quality increase default risk.
• Mark‑to‑market omission enables “volatility laundering.”
• Public credit likely to outperform on risk‑adjusted basis.

Pulse Analysis

The leveraged finance landscape has undergone a rapid transformation over the past five years. During the pre‑2022 boom, private credit attracted capital with promises of higher yields and bespoke structures, but the subsequent credit cycle slowdown exposed structural weaknesses. Compared with public bonds, private loans now exhibit longer settlement periods, tighter covenants, and a higher concentration in a few distressed sectors, which collectively diminish their relative attractiveness and increase portfolio drag.

A core driver of the perceived performance gap is the practice dubbed "volatility laundering." Because private credit funds typically value holdings at quarterly or even less frequent intervals, short‑term price swings are smoothed out, producing deceptively low volatility metrics. This accounting choice inflates Sharpe ratios, making private credit appear more efficient than it truly is. In contrast, public credit markets price assets continuously, offering investors a clearer view of risk and return dynamics. The disparity raises concerns about hidden exposure and the reliability of performance reporting.

For investors, the implications are clear: re‑evaluate allocations to private credit and prioritize transparency. As public credit demonstrates more consistent risk‑adjusted returns, capital may flow toward liquid, mark‑to‑market instruments, especially for risk‑averse institutions. Portfolio managers should incorporate stress‑testing that accounts for latent volatility and consider diversifying away from highly concentrated private loan positions. Ultimately, heightened scrutiny and a shift toward publicly traded credit could reshape the competitive balance, rewarding assets that deliver genuine, observable performance.