“There is no success without sacrifice” -Tonic Motihala
In this fifth and final post in our miniseries on portfolio longevity, we’re continuing with our overview of the B-squad – various components that can play a role in the fixed income portfolio of the future. We’ll cover more of the credit spectrum and even touch on private real estate, including strategies that can and should require some degree of liquidity sacrifice for proper execution. Here we go.
As the financial services industry has evolved in recent years, there have become more ways to invest in private credit transactions. Instead of lending money to the government or corporations by purchasing the bonds that have been made publicly available, private credit involves loaning money directly to businesses, individuals, real estate transactions, or a host of other potential borrowers. Although it comes with less liquidity than typical public fixed income, private credit can reward investors with higher yields and, in some cases, additional upside potential.
As the lender, the investor (typically via a private-credit fund) dictates the loan terms, including the interest rate, fees, what happens if the borrower doesn’t pay, etc. From the borrower’s perspective, even though a private loan may be more expensive than traditional lending (which may or may not be available to them), there are several reasons why it can still be desirable:
- Information Protection: issuing bonds that trade publicly also means sharing information publicly; this has implications that the borrower may not find appealing, so private markets are more attractive.
- Easier Process and Certainty: private lenders typically can make decisions more quickly than large financial institutions, which can be critical to the borrower’s success (e.g., winning a bid for a real estate transaction). Bank loans may also come with “flex” rates that ultimately price based on market conditions at the time of closing, adding to uncertainty.
- Greater Flexibility: private lenders commonly build in commitments to assist the company with future growth/acquisition with limited underwriting and are more apt to accommodate “revolving loan facilities” (aka revolvers or lines of credit).
- Partnership/Alignment: private lenders may be very involved in helping the borrowers through in-house expertise and resources to help drive better growth; the lender may even directly participate in this growth by including warrants as part of the loan terms.
As with any investment, private credit is not without risk. We believe an institutional-quality due-diligence process should be followed to help evaluate managers and that strict underwriting standards are essential to managing risks related to underlying loans. Our preference is also to mitigate risk through diversification, as not every loan or strategy will work out as expected. There will be some defaults, but by investing in many quality loans via an experienced investment team, the number of defaults can be minimized, and recovery of funds (in the event of default) can be maximized. Further, by limiting exposure to a given fund (e.g., 5% or less of a portfolio allocation), it can be a meaningful component of income/returns but not overly detrimental if it doesn’t work out as planned.
Suppose the reduced liquidity is acceptable and appropriate for a given portfolio; in that case, private credit may help to target either higher yield, lower volatility, and/or better growth potential (ideally all three) vs. publicly traded fixed income or even other asset classes. In fact, in this recent article, Why Lagging Pensions Should Consider Private Debt, (part of the All About Alpha series from the CAIA Association), author Zack Ellison provides an overview of the Cliffwater Direct Lending Index vs. many other asset classes from 2004 through 2017. The annual net return of 9.7% even bested the Russell 3000 equity index (9.3% annual return), but with less than a quarter of the volatility (3.5% vs. 15.1%) and only about 17% of the maximum drawdown (-8% vs. -46%). To be fair, this comparison is only over one particular timeframe, but it does imply that private credit has the potential to be a powerful component of one’s portfolio.
Credit Hedge Funds (liquid to semi-liquid)
In one of the earliest alt.Blend posts, Framing the Solution, we touched on the idea that “hedge fund” has become a very general term, mainly implying that something should be hedged. Thus, “credit hedge fund” provides very little insight as to the strategy or holdings of that fund, though you’ve likely already guessed that it should involve both credit and hedging. Anything credit-related is likely fair game for inclusion. There may even be opportunistic equity exposure if the manager believes it can add value; it just comes down to what flexibility the fund terms/agreements allow.
Credit hedge funds can range from a fund-of-funds structure (i.e., several different managers packaged into one fund) to multi-strategy (several different strategies all run by one firm) or single-strategy approaches. Liquidity also varies from daily-liquid to more limited liquidity (e.g., quarterly, semi-annual, or annual, typically with gating).
Because the composition and methodology can vary so wildly, it’s essential to know what you own (tired of hearing this yet?) and what associated risk/return/income characteristics you should expect. Given the current opportunity set in credit markets, it’s likely that credit hedge funds will have significant exposure to the asset-backed securities (general ABS and more specific RMBS and CMBS) discussed in the previous alt.Blend post. But even amongst funds primarily focused on those segments, the variation is substantial.
In the below table, I’ve outlined three funds from the same credit hedge fund manager, all of which focus mainly on ABS, RMBS, and CMBS, along with a small sleeve of “opportunistic” holdings. This manager runs a daily mutual fund, an interval mutual fund, and a limited partnership (i.e., a “real hedge fund”). While the general approach/mindset of the team is the same across the strategies, some things can be done within less-liquid structures that cannot be done in a daily liquid structure. Some things can also be done in an LP structure that cannot be done in an interval fund (e.g., charging incentive fees and using more leverage), even though both may offer similar liquidity.
|Fund||Liquidity||Net Expense||Current Yield||Duration||Leverage||# of Holdings|
|LP||Quarterly||2 and 20*||14.5%||1.26||0.6x||314|
Current yield, duration, and holdings stats sourced directly from the manager. *“2 and 20” indicates 2% management fee and 20% incentive fee.
Isn’t it amazing how substantially different these strategies are?! To be fair, the interval fund is very early in its life, so I expect the number of holdings to ramp-up over time. That aside, briefly comparing these funds makes it very apparent that there are different yields available in less-liquid areas of the markets for those willing to look there.
There are also costs beyond just sacrificing liquidity, as there may be higher investment minimums, additional investor qualifications, and more significant risks to consider. In the case of the LP fund, we can plainly see that it has much higher fees and utilizes leverage; thus, the yield is magnified by the leverage. That leverage will also increase both risk and return (positive or negative). The investment can still make sense for certain investors, but it takes a lot of due diligence to arrive at that decision.
In the context I’m going to discuss here, peer-to-peer lending is a pretty recent and exciting (to Alts nerds) development in the world of private credit. At this point, I’d be surprised if you haven’t heard of at least one tech-enabled direct-lending platform that has emerged over the past ten years or so. Examples include Lending Club, Square, SoFi, Upstart, and many others, and you may have noticed many related offers in both your mailbox and inbox.
Using Lending Club as an example, its platform matches people who want to lend money with those who want to borrow money. In the past, those borrowers probably would have turned to a bank or credit card company for a similar loan, and the lenders may have resorted to buying bonds. Instead, now individual investors can go to a platform like this to review potential borrowers and directly (via the platform’s technology) make loans to one or many of them. By cutting out the institutions, investors can earn higher yields, and borrowers can get lower rates and better terms than what was previously possible. Individuals can now act as a simplified version of a private credit fund by:
- Employing their own underwriting process: researching applicants’ financial situations to determine which are the best credit risks.
- Managing balance-sheet risk through diversification: Instead of giving $1000 to one person, ten loans of $100 can be made to ten different borrowers, reducing the risk of significant loss.
Alternatively (pun intended), it’s also possible to invest in alts funds that do all of the work for us on a far more diversified and sophisticated basis. The fund can dictate the credit/characteristics of borrowers they will accept while making hundreds of thousands of loans across multiple platforms that include personal loans, small business loans, mortgages, student loans, etc. By funding entire loans (not just pieces of loans), funds like this can also build-in backup servicing (i.e., continuing to collect loan payments) for those loans in case one of the platforms were to fail. Thus, with scale, the potential to manage risk is far greater than what individual investors can do on their own.
I am most familiar with dedicated peer-to-peer lending strategies in an interval fund formal (e.g., a mutual fund with quarterly gated liquidity). However, loans like this may be found in any credit funds that can afford to have less liquidity (e.g., hedge funds or even small pieces within daily-liquid mutual funds).
“Middle-market” is loosely defined as companies that fall between small businesses and large businesses. That generally means this space involves loans made to companies ranging in annual revenues from about $50 million to a billion dollars. Because the range of target companies is vast, the funds that play in the middle-market vary immensely.
The lower-middle market (smaller companies) allows for low double-digit yields with additional upside potential through warrants, and these attributes can be found at relatively low debt/leverage ratios. Usually, the funds are used for growth purposes, making the relatively high yields worth it to the business owner, as it’s still cheaper than giving up equity.
On the upper end of the spectrum (the upper-middle market), the companies demand more favorable terms; thus, we should expect lower yields (7-8% range) at higher debt ratios. These loans are often related to private equity transactions, where a private equity fund takes on debt to buy companies (aka “leveraged buyouts” or LBOs).
Funds involved in middle-market lending range from semi-liquid BDCs (business-development companies) with quarterly liquidity (and gating) to illiquid structures that employ a more traditional private-equity style (drawdown approach with a fund life of ten or more years). Expect that the more liquid structures will be available to more investors, while the less-liquid funds will be restricted to those who meet certain income or net worth requirements. Failure to make timely payments can result in the lender getting better terms (via restructured terms) or even taking ownership of the underlying business. If the underwriting is done well, defaults can potentially increase the total return of a fund, even if the current-yield is reduced.
Private Real Estate
While many investors have exposure to a single piece of real estate (their home), there are also opportunities to either lend to or own real estate in a more diversified manner. In real estate credit funds, money is lent to real estate transactions, while in real estate equity funds, money is used to buy (and sell) real estate.
As with every other segment of this discussion, the approach of each fund, along with its structure, liquidity, and risk/reward characteristics, will vary significantly across factors including:
- Geographies/regions or market tiers (Tier I cities vs. Tier II or Tier III cities)
- Tax or ownership mandates: e.g., opportunity zones or triple-net leases
- Development: land improvements or ground-up construction
- Management/light improvement of already occupied properties
- Property types: one or more of office, medical office, student housing, self-storage, industrial, retail, workforce housing, single-family homes, etc.
- Quality of properties: e.g., A, B, C grades
- Using any of the above (and more) as a single-strategy or multi-strategy fund that may be more strategic or tactical (changing as the environment changes) in its allocation.
On the equity side, real estate structures range from daily-liquid REIT mutual funds and ETFs to interval funds and PE-style illiquid drawdown funds. However, some funds focus on lower-volatility mandates with some liquidity and reasonable/consistent yields (e.g., targeting 5-6%, paid monthly or quarterly), making them good candidates for long-term fixed income replacements. [As an aside, make yourself a mental note that a REIT (real estate investment trust) is a very general structure, so all REITs are not created equal, and I will dedicate a future post to this topic.]
On the real-estate credit side, the options are far more limited, but a profile that exhibits high single-digit yields with relatively low volatility is achievable in this space. However, expect real estate credit to be less liquid than equity options, as the opportunity set is smaller and loan terms can be more restrictive from a liquidity standpoint. Like middle-market lending, failure to make timely payments can result in the lender getting better terms (via restructured terms) or even taking ownership of the underlying property. If the underwriting is done well, defaults can potentially increase the total return of a fund, even if the current-yield is reduced.
Decentralized finance, or “DeFi,” is the next frontier in which we can search for yield to help replace the bonds of the past. This topic is part cryptocurrency, part blockchain, very much tech-based, and I expect it will be revolutionary in allowing certain investors to generate additional income from their assets. Not only can loans be made in cryptocurrencies, but some platforms will pay holders a yield on their existing crypto assets (e.g., earning a 3% yield on Bitcoin holdings, kind of like a high-yield savings account). As with other topics included above (middle-market lending and real estate), DeFi deserves a separate alt.Blend post in the future, and I’ve made a note of this. For now, know that it exists, and don’t be surprised if you hear more about it going forward.
Long Live Your Portfolio
By combining many strategies across various specializations (businesses, real estate, peer-to-peer, hedge funds, etc.), sectors, size, and fund structures, a robust fixed income portfolio is still possible in today’s environment. While the 60/40 (aka “balanced”) portfolio may very well outlive us all, investors can be rewarded by taking a different approach to constructing the fixed-income portion vs. the publicly-traded bonds that have worked so well for decades.
Creating dependable portfolio longevity for the future likely means rethinking our fixed-income allocations, planning for more consistent income generation across asset classes, and embracing less liquidity where it is appropriate. If we can more closely align our portfolio’s longevity with our potential life trajectory, this will serve our families and us better over the long term.
Until next time, this is the end of alt.Blend.
Thanks for reading,