The big idea and why it matters: Private credit is beginning to make its way into markets previously dominated by public solutions, and technology is being created for private loans to trade more freely in a marketplace (i.e., more like bonds). We can only expect the lines between these asset classes to continue to blur, but rest assured, it will not change the importance of manager selection in Alts.
“Isolation is a blind alley….Nothing on the planet grows except by convergence.” –Pierre Teilhard de Chardin (French Philosopher)
To the point of today’s quote, everything is constantly changing in the world around us. That’s probably not news to anyone. And – while I love (yes, I think “love” is a fair adjective) private credit in its current form – I suppose I can’t expect it to remain “as is” forever. Private markets are not immune to the unstoppable forces of competition, innovation, and evolution; on the whole, they will benefit from these forces over time, regardless of whether some tradeoffs are involved. Even the incredible restaurant in The Bear has to innovate and evolve, and it may be entirely unrelated to the quality of their food and service deliverables (not a spoiler, but season 4 was delightful, and thankfully, a 5th season is coming!).
With that in mind, a few things have come to my attention in private credit that scream “change is coming!” and warrant an update on this topic. Perhaps unsurprisingly, they involve competition, innovation, and evolution, and that’s what we’ll cover today in a Private Credit roundup. Here we go!
Bonds vs. Loans
To ensure I haven’t lost anyone already, a brief reminder on what is meant by “private credit.” Most people are familiar with bonds. Bonds are a way to borrow (or lend) money in public markets. If a large public company wants to borrow money, it can issue bonds. Investors can purchase those bonds in public markets, essentially lending money to the company. It is essential to note that the bonds are issued with specific terms (including interest rate, maturity, and other features) that the company has predetermined. If you’re interested, this link has a brief rundown of the bond issuance process.
Private credit (aka “private loans” or “direct lending”), on the other hand, occurs directly between a borrower and a lender. It’s very much like when someone gets a mortgage from a bank (though mortgages are highly commoditized). In a private loan (using a private company borrower as an example), the lender can thoroughly examine the business and negotiate the terms on which they will lend the business money, often including conditions that allow them to seize the company’s assets in the event of default; the entire risk/reward construct of a private loan hinges upon that underwriting process. [As a reminder, we covered the “what and why” of private credit in Behind the Façade, if you’d like a quick refresher.]
Thus, private credit is constructed on the lender’s terms, in contrast to bonds, which are issued at the borrower’s terms. Obviously, bond investors still have to believe those terms are reasonable, and so do private-credit borrowers, or else no deals would ever get done; but they are two different animals. Now back to the fun…
Competition
A hat tip to our friend Jon S. (a man who appreciates a good hat, I might add) for sending this article from the Wall Street Journal. The title is “A Pioneer in Private Credit Warns the Industry Is Ruining Its Golden Era.” On the one hand, it’s about the competition that has entered private credit – a story of pioneers being at least partially displaced by new players entering the space. But I also view it to be largely about how Private Credit (and Alts in general) has evolved in recent years.
Evergreen funds have become much more prominent. As the name implies, these funds are available on an ongoing basis; most accept lump-sum investments and offer some degree of liquidity. That is opposed to closed-end or drawdown fund structures, which may have a fixed life, offer no liquidity, and take in capital slowly via a series of capital calls. We covered this evolution in a more in-depth way here, last fall. At the same time, evergreen funds typically offer less arduous investor qualifications, simplified tax reporting (1099 vs. K-1s), and seamless portfolio reporting.
To me, the message is straightforward: if you want people to buy more of something, make the process easy. Drawdown funds can be perfectly good, but they are inconvenient; this is in large part why our investment team has put a lot of time and effort into building internal structures to help mitigate operational, reporting, and tax issues that these investments create The newer, more convenient, evergreen funds are unsurprisingly getting increased amounts of traction with advisors and their clients. Managers with competitive advantages and the ability to innovate will win business, and, as McKinsey points out, there’s reason to expect private credit to expand into more assets, with a broader investor base, new use cases, and all of it to receive a boost from technology.
Liquidity without liquidity?
Earlier this year, Bloomberg unleashed this topical headline: Apollo Plans to Build the First Marketplace for Private Credit. The idea of investments trading in secondary markets is nothing new (for more on secondaries, check out this pun-laden adventure from the Summer of 2023), but the way it works now is usually at the fund level; i.e., a buyer for an illiquid fund is matched with a seller, and a one-off transaction takes place at a discount. There are even secondaries brokers who specialize in those types of transactions. But what Apollo is talking about sounds more like the way that bonds trade today: a marketplace of buyers and sellers of private loans facilitated by some standardized platform/connectivity. And this quote from the article makes it a shoo-in for today’s discussion: “The biggest trends in the next five years are the convergence of public and private markets and the changing role of financial institutions.” Get your extra-large tub of popcorn ready (like big enough to last for five years).
In a completely different vein of liquidity seeking, a reasonably well-known real estate interval fund (aka “mutual fund with limited liquidity”) has announced that it is seeking shareholder approval to convert the fund to an exchange-listed closed-end fund; i.e., they are trying to take the private fund public. If you’re reading that and thinking you missed this chance to be part of this fund’s “going public,” just take my word that you can kick that FOMO right to the curb; this is NOT a good development. As one analyst put it, “The Bluerock share redemptions are outrunning fund raising. I can’t imagine it will be treated kindly in the public markets.” Current investors are going to be held captive and taken along for the ride – and popcorn may help, but I’d advise keeping the tissues close by, too.
What’s old is new
This quote (yet again from Apollo and Bloomberg) says it all: “We think investment-grade capital solutions are the next frontier of private credit.” As we’ve discussed many times, and as the aforementioned McKinsey article points out, manager selection will continue to be at the core of successful Alts investing: “As private credit’s footprint expands into additional, larger subsectors, possessing a certain scale may well be the cost of entry. Only the largest lenders are likely to compete for multibillion-dollar financings of investment-grade companies, major infrastructure projects, and the largest commercial real estate financings.” Does that mean we’ll see a lot of small managers acquired by the most prominent players to stay relevant? Perhaps, but only time will tell.
And speaking of large companies and private credit, this recent WSJ headline also tells quite a story: Jamie Dimon Says Private Credit Is Dangerous – and He Wants JPMorgan to Get In on It. He is quoted as saying, “Parts of direct lending are good. But not everyone does a great job, and that’s what causes problems with financial products.” That, and human nature, perhaps. Overall, I agree with his sentiment that there remains a good opportunity in private credit, and we want to participate. However, access to deals and the underwriting process – which, again, are driven by manager selection – will be vitally important.
Blurred lines
The groundwork is being laid for private credit to make its way into markets previously dominated by public solutions (e.g., bonds), for private loans to trade more freely in a marketplace (like bonds do), and we’re seeing at least one example of a private credit fund going public (which is hopefully very much the exception, as this becoming widespread would be a real cause for concern). We will watch the evolution unfold, navigate it prudently, and keep you updated on anything of interest.
Embrace change, but be selective
Until next time, this is the end of alt.Blend.
Thanks for reading,
Steve
