Private credit has seen significant growth in the last decade, attracting both institutions and retail investors searching for yield and portfolio diversification. Its appeal often lies in a perception of stability, with quarterly valuations and contractual cash-flow profiles creating the impression of muted volatility. In reality, that smoothness largely reflects appraisal lag rather than genuine insulation from market cycles. Furthermore, many private credit lending strategies also behave differently from public assets. Understanding what drives those differences is essential as allocators look to integrate private credit into their total portfolios.

The illusion of low volatility

Empirical evidence from long-term private credit data shows a consistent pattern. The annualised volatility of private credit rises as the return horizon lengthens. Shorter horizon returns, such as quarterly figures, show artificially low variability due to smoothed valuations. However, when returns are measured over longer horizons, volatility steadily increases and converges toward that of public high-yield bonds. 

This convergence highlights a key insight. Smoothing can delay the recognition of volatility but cannot eliminate it. Over time, unrealised fluctuations in credit quality, spreads and collateral value are eventually reflected in the data. Private credit’s reputation for low volatility, in other words, is largely a function of slow-moving valuations rather than inherently lower risk. 

^{Source: MSCI Research}

Different lending strategies, different risks

Private credit encompasses a wide range of lending strategies, each with distinct return and risk drivers. The differences arise from a combination of factors, including its position within the capital structure, deal type and collateral dynamics.

Senior direct lending typically provides first-lien exposure to middle-market borrowers with predictable cash flows. These loans usually feature floating rates and relatively low default risk, with returns driven by credit spreads and modest fund level leverage. Historical loss rates tend to mirror those of broadly syndicated loans. This is largely supported by collateral coverage and covenant protections, although those protections have loosened in recent vintages.

In contrast, subordinated or opportunistic lending targets higher yields through mezzanine, second-lien or hybrid instruments. These loans sit deeper in the capital structure and absorb more downside risk, making them more sensitive to macroeconomic downturns and borrower stress. Returns can include equity-like components, such as payment-in-kind interest or warrants, introducing greater dispersion and fatter tails in performance outcomes.

Asset-backed lending brings a different set of risk drivers altogether. These strategies rely on the performance of specific collateral pools rather than on a borrower’s enterprise fundamentals. Their credit behaviour stems from collateral valuation, asset liquidity or structural complexity rather than from corporate default cycles.

Leverage as a key amplifier

Leverage is a defining feature of private credit funds and an important driver of both return and risk. Many managers borrow against committed capital to enhance yield and improve efficiency in capital deployment.

MSCI Private Capital Solutions data shows that safer lending strategies often employ higher fund-level leverage because their underlying assets generate more predictable cash flows and exhibit lower loss severity. For example, senior real estate backed debt funds frequently operate with higher leverage than subordinated real estate debt funds. Similarly, senior direct lending funds typically use more leverage than subordinated or opportunistic credit funds. 

As a result, investors assessing private credit risk need to consider the fund’s use of leverage. Two funds with comparable borrower risk may have very different volatility profiles once financing structures are factored in.

Decomposing total risk: a factor-based perspective

Much of the discussion around private credit risk remains conceptual. Yet new analytical frameworks, can help investors measure these dynamics more systematically. The new model breaks down total risk in private credit into three intuitive components: leverage, public market risk and pure private risk.

This factor-based approach reveals clear patterns across strategies. Senior direct lending exhibits the lowest overall volatility, driven primarily by its correlation to public leveraged loans. As strategies move down the capital structure toward subordinated, opportunistic or distressed lending, risk rises sharply and becomes increasingly shaped by private market-specific factors.

In asset-backed segments, such as real estate or infrastructure lending, the model finds that most of the total risk originates from pure private factors. This reflects the unique characteristics of their underlying collateral. Public market betas explain only a modest portion of total risk in these cases.

^{Source: MSCI Research}

This decomposition, together with the correlation heatmap, highlights an important insight. Private credit derives its diversification value from two sources: its modest correlation to public credit and the unique risk factors embedded in its different lending strategies. By isolating these drivers, models such as MSCI’s give allocators and risk teams a more accurate, forward-looking picture of how private credit behaves within the total portfolio.

^{Disclaimer: Private equity is valued infrequently, may not be priced on a secondary market, and any reliance on fair value estimates and non-market input introduces potential biases and subjectivity. Internal Rate of Return metrics are not fully representative without full disclosure of cash flows, assumptions, and time horizons.}