In Cliff Asness’ latest missive, a fictional asset allocator from the future looks back on the decade to 2035 to figure out which assets helped their performance and which hurt it.
Higher starting valuations usually lead to lower returns, but the most important part of a bubble is “highly skewed psychology” – and investors remain anchored to sanity.
The four-letter word private credit investors have forgotten
The private credit frenzy that’s gripped local and international markets has earned the asset class plenty of proponents – and plenty of detractors. My view is that private credit is neither universally good nor universally bad. It’s just money lending, plain and simple, and just like every other form of money lending there are a number of private credit strategies that range from the very good to the very bad.
After all, private credit is mostly just a gentrified term for lending to riskier, unrated borrowers. The situation its investors find themselves in reminds me of this old nursery rhyme.
There was a little girl who had a little curl, right in the middle of her forehead.
And when she was good she was very, very good but when she was bad she was horrid.
We have been living in a Goldilocks environment for a long time. In this fairytale world, a world with few defaults where whoever buys the highest returning debt wins the most, it’s no surprise that good and bad strategies alike have been attracting investors’ capital.
My only issue is that forgotten four-letter word: R-I-S-K.
To return to the world of cliches, “a rising tide lifts all boats” – but only when the tide goes out can we see who isn’t wearing a bathing suit! One day we will see a more normal level of defaults and then we will be in a better position to judge which strategies can stand the test of time. As I have warned before, credit’s day of reckoning is upon us.
Until then, I suggest that one method by which private credit strategies can be judged is by which of them are money-good (i.e. you get your money back) and which are not. Credit investing is an asymmetric bet where the best one can hope for is a return of capital with interest. This is to be contrasted with equities where the upside is unlimited.
Before we think further about private credit, let us have a look at some of the tenuous reasons given to entice investors into private credit.
Reason one: private credit is better than so many other investments because it is ‘senior secured debt’
Technically this is sort of true because most private credit is ‘first lien senior secured private debt’. But so what? The chance of the investment-grade subordinated debt of a large capital stable company defaulting is considerably lower than that of most private credit strategies. A better way of looking at private credit is that old fashioned notion where one assesses whether the return compensates the investor for the risk undertaken.
So, quelle surprise! Unrated, illiquid debt pays more than safer conveyances.
Reason two: private credit gets equity-like returns at bond-like risk.
As my mum would say, “nonsense and fiddlesticks”. All high-risk, high-return credit has elements of equity risk embedded within them. Credit spreads have a high correlation to equities whereby the higher the credit risk, the higher the correlation with equities. So it is no surprise to me that with elevated equity prices Hi-yield credit spreads at around 2 per cent over the risk free rate are very low by historical standards. I would no sooner buy high-yield debt for such a tiny margin over swap than fly to the moon.
The best work I have seen on this was by James Waldron of the Future Fund, who looked at many credit strategies and assessed their EEE (effective equity exposure). Even though some are not a fan of EEE, or say that EEE is not the only way to look at private credit, the historical relationship between non-investment grade debt and equity prices is certainly enough to refute the notion that ‘first lien senior secured private debt’ should be seen as either pre-debt or as a predominantly defensive asset.
My back of envelope methodology suggests that most private credit is approximately 50-70 per cent correlated with equity. If it walks like a duck and talks like a duck, then it probably is a duck. Bottom line, private credit is part debt risk and part equity risk, and likely more equity than debt.
Reason three: private credit has a very low chance of default
As I mentioned previously, the above may have been the case in recent history. But is the last 35 years the norm or an outlier?
As a card-carrying believer in mean reversion (and a reader of history), the most recent past is clearly not a good representation of normal conditions, and neither is it likely such low defaults will be the case going forward.
In normal times BBB debt (still investment grade) has nine times the chance of default of AAA debt. Who knows what the expected default rate will be for all private credit? It will not be “very low”. I am looking forward to finding out how each private credit strategy performs when defaults mean revert to more normal levels.
Reason four: private credit lends to great borrowers whose only reason for not getting funding from banks is regulatory reasons.
In a few unusual situations this may be the case, but it is hardly the norm. No rational borrower would pay 10-12 per cent if funding was available at lower rates.
Additionally, many of the strategies used by private credit (e.g. lending to speculative real estate developments) was rarely undertaken by major banks.
So before investing in any credit strategy, whether private or public, one must determine whether the return is commensurate with the risk. At the end of the day, all roads lead back to these simple guiding principles.
What now?
Some private credit strategies (and managers) are very good. Some private credit strategies (and managers) are not. Some private credit strategies charge fair fees. Most private credit strategies charge too much. The way to tell the difference between them is by seeing how they perform over a full cycle. We have yet to see that.
So, in the meantime, rather than praying that your capital is returned, I suggest investors conduct rigorous due diligence with a focus upon ascertaining which strategies will hold up best in a downturn. All strategies work… until they don’t.
Whatever metrics one uses to evaluate private credit, it is clear to me that risks are unfairly being borne by investors in this space. I am an investor in private credit, both personally and professionally, and am sticking with those strategies that I perceive to have a high likelihood of returning my capital.
The total fee (including origination fees) that I am comfortable with is around 10-15 per cent of value added above an appropriate hurdle (adjusted for gearing), usually a margin over cash.
So until my next article, stay safe and vive la révolution !
