Perhaps the assumption that markets are still anchored by predictable economic policies needs to be challenged. For the first time since the fall of the Berlin Wall, political volatility – once background noise – is potentially reshaping investment risk at a structural level.
Despite authorities taking their foot off the environmental, social and governance pedal and recent volatility in equities and bonds, the benefits of Artificial Intelligence and improved investor transparency are just beginning.
It’s the unknown unknowns spooking investors in private credit funds
Investment trends, like fads, can often take on a life of their own. But investment fads, like emotions, are ultimately driven by our primal emotions: greed and fear, two emotions that can have us acting irrationally.
Fundamentally, we understand how this isn’t logical, yet seeing others profit handsomely from yesterday’s decisions can often influence us to lower our standards, telling ourselves, “they must know something that I don’t”.
When it comes to the financial markets, sadly, history is littered with such examples where we emotively override our fundamental principles from “fear of missing out”.
More recently, and I appreciate that this is contentious, a possible example lies in an asset class called private credit. To explain, let’s first start by defining what it is.
Businesses often need to inject working capital and, more often than not, use debt that is accessed three ways: bank loans, bonds and, increasingly, directly through the private market, AKA private credit. The latter is invaluable to the economy as businesses often can’t access borrowed capital via the first two because banks won’t lend to them or the dollar amount is too small to offer debt securities.
As an asset class, private credit benefits lenders and borrowers. In this case, lenders typically aggregate capital through investment funds managed by investment and banking professionals.
As with banks, typically much of the debt is secured and short-dated, which is a more defensive debt vehicle when compared with some corporate bonds. The number of debt offerings can often extend beyond the 100s, meaning the impact from any one default on the total portfolio is minimal, or at least that’s the expectation.
Just as with other fund offerings, the risk spectrum in private credit can vary from low- to high-risk, where risk is usually defined by either credit quality, term of loan, and/or asset backing levels. Naturally, the higher the embedded risk, the higher the expected return.
Investors also need to be conscious of how liquidity within the fund will impact their ability to claw back their money. Some have daily access while others are less liquid with one to three-month fund claw-backs.
Private credit fund providers are compensated via management fees and, in some cases, performance fees. Some managers, albeit not all, additionally capture “origination fees” as part of their overall compensation.
Think of the “origination fee”, per se, as a fee paid by the banks to your mortgage broker for you borrowing their money. Some private credit funds even capture 100 per cent of this origination fee while others split such fees with their clients.
Nothing attracts a moth faster than bright lights, and the returns from this “defensive” asset have not only matched higher-risk growth assets but have left other defensive assets for dust.
While the investment community sought CPI+ returns during our previous quantitative easing (QE) world, private credit funds had delivered high single-digit to low-teens net returns. With this increased attention from the institutional, wholesale and retail worlds, the proliferation of funds grew rapidly.
Indeed, the demand for private credit grew almost as rapidly as did their offerings. So, is private credit a fad or is it a viable and more capital-secure alternative to other traditional defensive interest assets?
My answer is in three parts.
First, what I call the “secret sauce”. When one asks providers how they’re generating low double-digit returns off a low-duration, well-diversified portfolio when even junk bonds are only delivering high single-digit returns, the answers are often filled with platitudes, historical results and the platitude, “trust me, we know what we’re doing”.
Behind this veil of secrecy lies an investor’s greatest enemy: the unknown unknowns. It’s the vagueness around portfolio construction and risk management that raises the hairs on the back of my neck, not the asset class per se.
Double-dipping is my second point. Mortgage brokers are compensated through origination fees/trailers and not by their clients. A trailer received by a financial planner is rebated to their clients. Fund managers can no longer do “soft dollar” arrangements. But in the private credit world, it seems that some believe that origination fees, or part thereof, belong to them. But were it not for their clients’ money, origination fees would not exist. I call this the OPM principle – Other People’s Money.
Finally, there’s use-or-lose. Every asset has a capacity issue, and with private credit being relatively new, do we know what this figure even is? Like the other private asset class, private equity, if the manager doesn’t find a home for the asset, the manager misses out on prospective revenue (and origination fees).
Coupled with the “secret sauce”, it’s difficult for clients to monitor if their manager is sliding down the quality pole to invest the capital. Like other credit assets, the demand for debt doesn’t always match the supply of funds.
The recent public scrutiny of one private credit manager was unfair as the issues raised were not unique to that manager but typical of the asset. There is little doubt that within the pool of private credit offerings are some well-credentialed and diligent managers.
All private credit funds are not alike when it comes to risk, but because of our inability to properly segregate the sound from the hounds, the risk of the unknown unknowns haunts them all. I suspect it will take for the tide to go out to see who’s swimming naked.
Full disclosure: I hold a small allocation to a private credit fund, albeit recently cutting my investment in half as these aforementioned unknowns concern me more than the strong returns.
