“We can complain because rose bushes have thorns, or rejoice because thorns have roses.”
~ Alphonse Karr
As we have expressed via numerous updates and perspectives, today’s quote nicely embodies the media’s ongoing muckraking of private credit; it has primarily been (and continues to be) an exercise in focusing on perceived thorns amongst the roses. Regardless of the reporting inaccuracies, the stories have been powerful enough to drag down the minds of many retail investors, along with the stock prices of even the most robust private investment firms.
Every rose has its thorn
To ensure this is all perfectly clear: I am not encouraging anyone to blindly focus on the roses and pretend the thorns do not exist. Rather, we can confidently enjoy the beauty of the roses because we understand and accept the thorns that are innately inseparable from them. More overtly, we cannot (or should not) invest in private credit if liquidity is required; these sorts of tradeoffs have existed since the dawn of time and will exist for all eternity. Today, we will continue with the evolution of alts structures, and I will share with you how and why we can easily tune out the noise of the negative press and be thankful we’re even having this ongoing private credit conversation. Here we go!
Speaking of tradeoffs…
In Part 1, we briefly covered Liquid Alts strategies. Many of these still exist and I assume are widely used, but I think they really had their day in the sun when many investors were still freshly scarred by the 2008 Financial Crisis and were seeking solutions to dampen volatility. “You’re telling me you can give me a fund that provides market-like returns with much less volatility, so I don’t have to go through that again?” Sign me up. But as I also mentioned – instead of delivering market-like returns – the many long/short moving parts of those strategies often felt like watered-down equity, rather than real alpha generation (e.g., performance was akin to holding a lot of cash and a small allocation to stocks).
Even managers who had posted impressive risk/return numbers in the years prior to or during the crisis were unable to replicate those results post-GFC – potentially due to the lack of volatility and especially the lower interest rates that were pervasive thereafter. Again, there are some exceptions, and manager selection always matters a lot, but it became clear there is only so much one can expect from a daily liquid investment wrapper.
The middle ground
For those who were qualified purchasers (QP) and really didn’t need liquidity (which I’d estimate to be about 1% of investors), liquid alts presented no issue, as they could use “real” alternatives. Still, the investment managers were limited to a small fraction of investors, and that market could be easily saturated. Most of those investments – particularly anything related to private markets, like real estate, private equity, and venture capital – came in the form of drawdown funds, which require a series of capital calls before (ideally) returning all of the money along with profits over 7-10+ years.
Investment managers realized that if the restrictions were reduced, the number of potential investors would expand immediately. Anecdotally, I’d say this really happened in the mid-2010’s, as many more strategies began being offered to accredited investors – a far easier hurdle to reach, based on either net worth or income thresholds [for an overview of these requirements, check out Nouveau Accredited from the archives].
Some even started to offer “evergreen” structures, in which they would continue to invest over time rather than return capital to investors after a predefined period. Some also began providing a) regular opportunities for limited liquidity (annually, semi-annually, quarterly, etc.) and b) an income stream along the way, thus making the illiquid nature of the investments more palatable. These are known as “interval funds.”
Another, similar notion was that of the private/unlisted BDC (business development company); the difference is that those BDCs eventually had to “go public,” and this is where a lot of the bad press for Blue Owl began late last year. Since then, perpetually private BDCs have been developed to alleviate that particular issue.
Up until this point in the story, all of these investments require completing subscription documents with the investment managers, wiring cash to fund them, and performance reporting that ranges from “fairly automated” to “entirely manual.”
The retail evolution
Taking the above concept a step further, what if managers could offer these investments to retail investors (i.e., everyone)? That became possible with the interval mutual fund structure; these look exactly like any other mutual fund in an investment account, but they can limit liquidity, which is a monumentally important difference.
For me, Stoneridge was a pioneer in this space, originally using it to launch a reinsurance strategy, and then, soon after, a direct consumer-lending strategy in the interval mutual fund wrapper. Since then, many more managers have brought offerings to the market and captured the attention (and assets) of the retail crowd.
It’s the end of the world as we know it…and I feel FINE!
I would like to take this opportunity to remind everyone of a long, long time ago (like 3 years), when it was the end of the commercial real estate industry and there was a barrage of negative press about Blackstone’s BREIT interval fund, focusing on its ability to limit investor redemptions (implying this was a bad thing), and calling into question its valuation processes (see here and here for a couple of examples).
Do you know how that all turned out? It turned out COMPLETELY FINE! Headline after headline for what was ultimately a non-event. Why? Because, for BREIT, liquidity restrictions protected investors, valuation practices were sound, and the underlying assets were strong (and even conservatively valued vs. eventual sale prices). Did some commercial real estate landlords lose money? You bet. Did the entire commercial real estate industry melt down? I’ll let you be the judge.
I have a feeling that we are seeing the exact same thing play out in private credit today. Just like our kids are now wearing the pants I was rocking back in junior high, we’ve been here before, and journalists are recycling clickbait from only a few years ago. At least the fashion industry waits a decade or two between the cycles (I’m really being generous to those of us who spent our teenage years in the ‘90s).
It’s not the size of the liquidity, it’s how you use it
For those utilizing well-managed, private credit (or any less-than-daily-liquid alts) appropriately, the gating of redemptions is a non-issue, and these headlines are just noise. In addition, if there is an uptick in loan defaults, it will very likely work to your advantage over the long term. And if you aren’t in it for the long term, then you aren’t investing.
Knowing what the options were before interval funds were so widely available leaves me with nothing but gratitude for these modern marvels and for our ability to help clients benefit from them. Thorns protect our beautiful rose bushes, just as structural illiquidity protects our investments, and we are fortunate to have them both. Rejoice!
Until next time, this is the end of alt.Blend.
Thanks for reading,
Steve
