Dear Valued Clients and Friends,
In this week’s Dividend Cafe:
- We look at the numerous stories raining on the parade of private credit and other alternative asset classes.
- We offer a mature reminder about the nature of liquidity (and illiquidity) and how investors ought to think about such things.
- We suggest an actionable framework for thinking about private asset managers, private asset investments, and your own portfolio.
Let’s jump into the Dividend Cafe …
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When it Rains, it Pours in Financial Media
I do all this for a living and feel I have a pretty good sense of how to compartmentalize and properly categorize stories in financial markets that have numerous layers. I believe there is a story about where AI may or may not impact certain software companies. I believe there is a story about how particular loans to particular software companies will perform. I believe there is a story around the liquidity dynamics of investment products made up of “direct lending” loans (private loans extended outside the banking system). I believe there is a story around the quality of loans outside the banking system, the demand for such loans (by investors), and the demand for such credit (by borrowers. On that latter point, I believe that there are three different stories. I believe there is a story about how limited partners in the investment products of private asset managers do. I believe there is a story about investors in the management company of a private asset manager. I believe there is a story about the wisdom, nuances, and ramifications of making private markets investment available to retail investors. I believe there is a story around indigestion in capital markets as it pertains to the imbalance of sponsors looking to sell companies, versus strategic companies or financial sponsors looking to buy such companies. I am getting tired of typing this paragraph, and I have just identified ten stories, and can assure you that in the Venn diagram of these various subjects, I could easily add four or five more.
But these are ten different stories – not one single story – and the desire of the financial media to treat all these things as one does a huge disservice to the investing public. It blurs categories, it confuses people, and it fails to deliver truth in a discernible and actionable manner. I would argue that even one of these stories (AI impact on software) requires a dozen or more points and sub-points to be understood correctly. By treating these things as “all part of the same tale,” investors end up understanding nothing at all.
I do not believe the dozen stories out there have been “consolidated” by the media to try to simplify things for readers, listeners, and viewers. Rather, I think these things are not parsed out properly because blending them all together creates more hysteria and hype, and hysteria and hope drive clicks and ratings. In other words, the business model incentivizes a narrative that is sloppy and sometimes outright inaccurate.
None of this is to say that story #1 is good, or story #4 is bad, or story #9 is excellent … Perhaps all these various issues and categories for discussion all lead to a horrible place. My only point is that whether they are all bad or not, they are not “all the same.” They are different stories that require parsing if a good understanding is to be obtained (Prov. 4:7), and if a proper response is to be pursued.
What is the Single Narrative You are Referring to?
I would say the media coverage looks something like this right now as it pertains to the private asset markets:
“A lot of private credit companies have lent money to ‘software’ companies, and AI may do things that make people not need those software companies anymore. And if that happens those loans may not get paid back. And also, the private credit companies have raised money from investors and made these loans but if those investors ask for their money back and these loans are in trouble they may have to give them less money than they lent out (because the value would be less than it was). And also, why are managers in asset classes like private credit and private equity making their investments available to regular people? Insurance companies and pension funds have long-term timelines but regular people use their investments to buy boats on a whim and now the liquidity might not be there! And also, there were two companies that no high-profile asset manager had lent money to last year that went bankrupt, but still, some people lent them money, and are there more cockroaches out there? Also, we found competitors of these asset managers who said their investments might be in trouble, but didn’t say what investments or what managers. But it sounds bad. And also, a lot of these companies have bought equity of companies that they have not been able to sell yet and there are a lot of sellers and less options to buy. And in the meantime they keep raising money. But did we mention AI and software, and also, that their illiquid strategies are not liquid and some investors may not like that?”
I think the only problem with my diatribe in capturing the vibes out there is that my diatribe is more articulate and sensible than most of what I am encountering.
But this is what the Dividend Cafe exists for – to parse out the inarticulate and not sensible into something comprehensible.
So, Where Do You Want to Start?
Before we go into the fundamental nature of loans made to software companies, let alone the business prospects of those software companies, let alone the threats they do or do not face from AI – and before we get into who has made such loans to these companies, let’s talk about that liquidity issue. Because it is driving me batty, and it will be cathartic for me to set the record straight.
I do not have any doubt in the world that some investors have bought assets that have a different liquidity profile or timeline than is appropriate for their own goals. I also have no doubt that many have done this because a wealth advisor or financial professional steered them to do so with a poor appreciation for that investor’s objectives and profile. I also have no doubt that many investors have said, “yes, I understand this building, company, or loan (or fund of buildings, companies, or loans) is not readily available for sale, but I do not need the money and I have a longer-term horizon for the money I am putting into this investment,” and then, upon hearing something, changed their mind. What they heard may have been their spouse selling that they want a boat, and it may have been their TV saying, “oh, private credit is in trouble,” but regardless, their desire for liquidity (in many cases) comes despite the fact that they once acknowledged the intended illiquidity of the asset class.
I believe three things at once here and do not find these to be complicated or remotely incompatible:
(1) An investor who needs liquidity (an easy ability to buy and sell at then-current market prices) should not buy assets that do not offer such assured liquidity. Feel free to copy and paste this whenever you’d like.
(2) An investor who is told there will be liquidity when there may not be was lied to, and lying is unacceptable
(3) There are many investors with patient timelines who are great lenders to borrowers for various private market needs. The liquidity profile works for both.
Risky Business
This is a superior funding model to traditional banking channels for many borrowing situations. The potential winners in this include the borrower, the lender, and the overall financial system that does not hold the risk inside its bank depository system. This, of course, does not mean there is not risk in it, because if there weren’t, the yields would be about half of what they are, and investor appetite to be the lender would disappear. When the media makes hay out of certain defaults or busted loans, it is essentially the same thing as them lying through their teeth with impunity. No one has ever invested in private credit, structured credit, corporate credit, mortgage credit, or any other spread-based lending without there being a reality of default. The media knows this &*^% well. Default rates are presumed to be at a certain level, and that has been true of high yield bonds, bank loans, and last time I checked even first lien mortgages since time eternal. Yes, some assets being lent against are more secured and collateralized than others, and recovery rates will vary across different lending structures, and that gets reflected in the YIELD. But this is not complicated, it is not mysterious, and it sure as heck is not new. How do risk-taking investors account for the reality of some defaults? By diversifying the portfolio of loans. What a concept.
In macroeconomic distress, defaults generally pick up across all categories of lending. The reason for that is tautological. If borrowers were not struggling to repay, it wouldn’t be a period of macroeconomic distress. In periods of reasonably healthy economic conditions (non-recessionary), there are still some defaults (event-driven, company-specific, and even cases of fraud).
In recent months, the two high-profile defaults the media have focused on (First Brands and Tricolor) were, ironically, shunned by most private credit investors. Yet somehow they have been used as poster children for “risk” in private credit. It is gross.
Power of the People
So here is where we are: Private credit (pooled investment vehicles centered around loans extended to businesses outside of the commercial banking system, generally at attractive yields, generally first lien and senior-secured, and generally floating rate around a wide spread to a reference rate) has two defining characteristics for investors: (1) Illiquidity – the loans can’t be sold like a money market or a public stock, and (2) Risk – some percentage of the loans may go bad, because of how things work in the world. Why do people invest in an asset class with illiquidity and risk? Because of the return (you can cut and paste that if you want). Or, as Don Draper so artfully put it, “that’s what the money is for.”
If you are a highly sophisticated investor, a pension fund, a hedge fund, or some category of investor who accepts and understands illiquidity and wants and understands risk, none of this is an issue, and we wouldn’t be having this conversation. But what has become the latest mania of news coverage is the horror of this asset class finding its way to the hoi polloi.
It is hard for people who had no reason to pay attention to this to appreciate how severe the pressure has been, for a long time, to allow more investors access to investment strategies they were previously prohibited from buying. Whether due to leverage, illiquidity, or other risks, an outright ban on many investment categories and strategies was long the norm for many investor types. People fought for greater democratization and largely got it, and now many are saying, “Oh wow – how awful that these investments have limited liquidity and some of the people who bought them are too dumb to know.” It is condescending and patronizing, and feeds the crisis of responsibility in our society. But that is not to say that no investor was ever misled – it is simply to say that if the investment was mis-sold, that is not the fault of the investment. You can copy and paste that, too.
For years, the demand was that various institutional-caliber private markets investments be better democratized. That was successfully done, and now the demand is that they be un-democratized. It’s a head scratcher. Now, one solution is that people in my profession take seriously their obligation to utilize investments that are suitable for their clients, and to, you know, actually know their clients. But I am sorry – I cannot get to a place where I blame an asset manager who creates an investment product intended to offer illiquidity and risk for a return premium and makes it available to investors who then get mad that the investment had illiquidity and risk. The asset managers are culpable when they cannot deliver on what they have promised, and some promises are legal, while others are what I like to call part of a “social contract” (not in the prospectus, but part of what decent human beings know to be true). The hysteria of the last month has not centered around any violation of these obligations whatsoever. Perhaps there are cases of investor misalignment, but not something structurally flawed with the investment solutions themselves.
What about Those Investment Solutions?
Some software companies will be disrupted by Artificial Intelligence.
Some will be disrupted but adjust, adapt, pivot, and avoid.
Some will be disrupted, and not adjust, and still pay their loan payments, because their loans were underwritten with massive protections and “loan to value” cushions (for what it is worth, I suspect this is the “worst case” scenario for the “majority” of situations – the worst case).
Some will not face disruption at all – but rather opportunity, and will use the technology as a feature in their underlying business. Their value proposition will prove to have always been not the coding itself but the customer service, the implementation, the consultation, the integration, and other components that transcend the mere software application.
And in each outcome I enumerated above, there are numerous sub-outcomes available. And in each sub-outcome, there are thousands of examples, nuances, and particulars.
The idea that “software is dead” is maybe the dumbest thing I have heard since the AI moment began (of the contenders for that award!).
Loans are underwritten to earnings. And they are senior to the equity. And they have recovery options in the case of default. It is just a non-sequitur of perverse proportions to go from “AI is disrupting software!” to “Private credit is in deep trouble.”
Which, by the way, the narrative did not stay as “mass defaults are coming.” That contention cannot be intellectually defended by any credible person, so the well gets poisoned with non-correlated talk of First Brands and AI/software and someone in their basement’s new substack article – then pivots to “oh that illiquidity problem!!”
The quality and future performance of the loans matter for investors in loans. And liquidity (or lack thereof) matters, relative to the need and expectation around such, for a given investor. But the two things are not connected, and every honest person knows it. Now, in fairness, what some may be trying to say is “the loans may start to show signs of trouble, and then investors may want to sell because of that, and then may not be able to.” Got it. Liquidity may prove to be the worst thing you could imagine in that scenario (allowing price-takers to benefit from the irrational incoherent panic of others), but I do take the point: In times of panic sales, illiquidity either provides no exit, or a very bad price.
I reiterate my earlier points about suitability.
So, Are All the BDC’s from These Asset Managers Fine?
First, a BDC is a Business Development Company, which is a basket of loans that passes along the interest it generates (less fees) to the shareholders of the company in the form of a dividend. Some trade on a stock exchange (a permanent vehicle), and some do not. Those that do not are generally interval funds with limited liquidity (but still registered with the SEC). Those that trade on exchanges can be sold day by day, but at whatever price someone else is offering.
Some are better than others. They can all be very different from one another. The leverage. The PIK exposure. The sector allocation. The underwriting in the loan book. The ability of managers to manage recoveries in the event of defaults.
Oh. And some are publicly traded … and some are not. So there’s that. The liquidity profile is intrinsically different.
The loans in the portfolio can be quite different, too. Some offer loans to companies that do $10-50mm in EBITDA. Some are focusing on companies with $200- $500mm in EBITDA. These are apples-to-carburetors comparisons. The enterprise value of the companies can range from $100-150mm at the small end to multi-billion at the larger end. Talking about this monolithically is irrational.
I am not going to forecast where defaults go from here because I believe each BDC is different, and the risk of the BDC performance is held by investors in BDC’s.
Caution That is Prudent
There is a big difference between being invested in a certain private credit fund, or private equity fund, or BDC, and the underlying asset manager itself. Now, if a particular asset manager manages a lot of private credit or private equity funds like a dog, then I have to think that manager may run into trouble generating carried interest (profits) and gathering new fee-related assets for the future. So yes, being invested in the operating/management company of a bad manager can be a bad thing. This Dividend Cafe does not make the argument that all managers are good, let alone that they are created equal. In our portfolio, we are invested in one that we believe is very good and another that we believe will either prove they are good or not. But my belief that private credit matches duration better than the banking system does, or that it creates the possibility of risk premium for risk-takers, has nothing to do with believing that every loan, or even every fund, will do great. The capital that has entered the system over the last few years has surely created opportunities for bad managers to allocate funds to bad deals. The sentiment shift as of late is not driven by evidence of this, or even fear of this (even if such fear is sometimes stated as a rationale). Right now, it is driven by incoherent and incomplete concerns that do not call for the conclusions that have been found, and it is driven by a dust-up over liquidity and redemption questions.
If an investor is on the wrong side of that redemption question, they may not like what happens. But you know who probably will? The person who buys from them.
In a Nutshell
A conflation of different narratives, many of which are just wrong on their own merits, and all of which are wrong to be conflated with each other, is creating a sentiment shift that is, all at once, absurd and exciting. I would not guess that it ends in 2-3 days (though I wouldn’t guess that it won’t), but I would guess that it will end. And when it does, I hope we can have a more rational conversation about all the things we are supposed to be talking about:
- What is the right way to underwrite private loans?
- Who has the right resources for recovery when a loan becomes impaired?
- What structures exist that reflect the best alignment between investors and managers (see the Conclusion below)
- How can we democratically make private investment opportunities available to investors in a liquidity-appropriate manner?
- Is it better for private equity companies to force sale events at less-than-optimal prices in a logjam of deal flow or to patiently exit performing investments in the best interests of their LPs? And are efforts to create options there – separating those who want to hold a good investment longer for a better price vs. those who want to redeem sooner – commendable to condemnable?
- How can “retail” investors be best served and protected in terms of access to investments they may want, while maintaining a true awareness of liquidity realities? And how can we treat all investors like grown-ups once we have done that?
Conclusion
Here is how I would summarize the state of private asset markets:
- Creditors are going to relentlessly look out for their own self-interest, as they should
- Borrowers are going to relentlessly look out for their own self-interest, as they should
- Limited partners (LP investors) in private equity deals are going to relentlessly look out for their own self-interest, as they should
- General partners (private equity sponsors and managers) are going to relentlessly look out for their own self-interest, as they should
- On that last front, the GP’s who plan to stay in business and be around for more deals, more funds, more loans, more buys, more sells, more asset gathering, more transactions … they are also going to look out for the interests of the creditors (lenders), borrowers (companies), and limited partners (investors), because it is in their self-interest to do so.
- Where there is alignment of incentives, it is worth paying attention. Where there is no shared alignment, caution is warranted. But those private asset managers who desire longevity will have a long-term focus that may align with your own long-term investor focus.
And it should be said: A long-term focus and short-term media/investor sentiment are not in alignment. Some of us are thankful for that. In fact, to that end, we work.
Quote of the Week
“The purpose of capital markets is to transfer capital from those who have it to those who can use it most productively.”
~ Michael Milken
“Capital is not the scarce commodity. Vision is.”
~ Michael Milken
* * *
Two quotes for the price of one this week. Milken was a treasure.
I am very happy to report that this will be the first weekend all year that I am not spending 12-18 hours writing my new book. My brand-new book on dividend growth investing, Profit from the Profit: The Past, Present, and Future of Dividend Growth Investing, has landed with my editor and will soon be sent to the publisher with a planned August 25 release date. I feel a huge relief. I love, love, love writing about investing, but writing a 2,500-3,500-word Dividend Cafe commentary is very different from writing a 50,000-word book. And writing on Thursday and Friday mornings at 4:00 am is very different from dedicating an entire Saturday to it. So I am looking forward to this weekend.
Enjoy yours. And for those counting, we are two months done with 2026 …
With regards,
David L. Bahnsen
Chief Investment Officer, Managing Partner
The Bahnsen Group
thebahnsengroup.com
This week’s Dividend Cafe features research from S&P, Baird, Barclays, Goldman Sachs, and the IRN research platform of FactSet
