Dear Valued Clients and Friends,
Our annual money manager week a few weeks back inspired a number of topics for me, and there is no question that the impact of AI on investment markets and the impact of AI on jobs were two of them (hence the recent coverage). But while those two topics probably dominate your thoughts and concerns more, the issue that was an even bigger deal amongst asset managers and various financial elites in the city was private markets. Depending on who you talk to these days, private markets (think private credit and private equity, with more clarification on the vocabulary offered below) are the greatest opportunity in the current environment we have ever seen, or, especially if you are in financial media, they are the biggest risk we have seen since Las Vegas dancers were buying four condos with no money down in 2006. You will be shocked to hear that all the polar extremes are idiotic. You will be further shocked to hear that I think I can add nuance to the subject, which I consider to be aligned with truth and prudence. And you will be thrilled to know that this is what we are doing in today’s Dividend Cafe!
I want most of this week’s nuggets to be in the actual Dividend Cafe, so I will avoid overdoing the introduction. There are trillions of dollars in the world of “private markets.” From money lent outside the traditional bond world and banking system (private credit) to money invested in the equity of companies whose ownership interests do not trade on a public stock exchange (private equity), this is a massive universe vital to the well-being of our overall economy. And, much as our “parents’ index funds” are not the same as those available today, what people once meant by private equity and private credit has changed a great deal.
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The Easiest Part of This Week’s Bulletin, or any Commentary You Will Ever Read, Anywhere
If someone ever tells you, “There is a debt fund that pays you 9% (or 8% or 10%) and it has no risk, so you should buy it because Treasuries or municipal bonds only pay 4%” you need to lose their phone number, pronto. Now, it is entirely possible that the person is not a con artist – they may very well just be a simple idiot, and there are plenty of those in the world, too. But only con artists or morons say that something has a return at least twice that of the risk-free rate, without a commensurate increase in risk.
But I don’t much care about the people who say such things. Our practice exists to take the clients of people who say such things, or at least to protect our clients from those who may say it to them. Those who vocalize such falsehoods are easy to contend with; my concern is with those who hear them. You know – people like all of you. Because on one hand, there is a certain gullibility in the public square that could cause someone to believe something like, “you won’t believe it, but I was getting 4% in a CD, but now I have a private debt fund paying me 9% and it is like, the same thing,” but much more than gullibility is the problem of people’s propensity to believe things they desperately want to be true. Human beings can and do go to great lengths to make things seem true if they want them to be true (and, in some cases, almost need them to be true).
Now, a debt fund paying 9% may be a wonderful investment. In fact, I happen to believe many of them are. But they are not “the same thing as treasuries.” They pay more because there are risks that require the investment to offer a higher expected rate of return as the trade-off to whatever that risk may be. It may be illiquidity risk, it may be higher default risk, or it may be any number of risks, but the premium return is compensation for a risk premium. And if anyone on God’s green earth doesn’t know this, they have absolutely no business advising anyone about money, ever. And if anyone on the other side of the table doesn’t know it, they need (and would be wise to pay for) some truth-teller in their orbit who will steer them honestly and wisely.
The truth is that public equities (think: stock market) also offer a return premium, only because they offer a risk premium. That risk premium is most commonly driven by high volatility and severe drawdowns, and in less diversified cases, it may reflect the non-systematic risk of a given company failing. The trade-off for those risks has been a return for patient and disciplined investors that vastly outperforms the risk-free rate.
So if all one wants to say about private markets is, “hey, they have risks, too!” then let’s end the conversation right here. That the superior return investors are pursuing within private credit and private equity comes with risk, which is necessary to make that superior return possible, is a tautology. It is not news. It is inherently true. And it is not helpful.
The questions before us are whether there are systemic risks in private markets that we ought to consider, and whether there are particular risks in private markets relevant to us as investors. To these ends, we work today in the Dividend Cafe.
What is Private Credit?
Let’s start there. What is it? Essentially, and I will be very clear that I believe this is an overwhelmingly positive thing, many capital market functions moved outside the banking system after the 2008 financial crisis. At a high level, “private credit” means that non-bank lenders are extending debt to borrowers. The money being lent is generally coming from investors who have a longer timeline (duration) for the money to come back, whereas the duration of bank funding is whenever their depositors ask for it back. Banks are not supposed to absorb losses in their loan portfolio, are supposed to be collateralized, and are supposed to meet regulatory standards that keep their ability to lend somewhat constrained (especially post-GFC). Private lending markets function by matching risk-takers (investors seeking higher yields) with borrowers who can pay that higher yield.
So differentiation #1 is private credit being outside the banking system. But we have always had a BOND MARKET as well, and that, too, competed with the banking system using investor capital. Those bonds were registered securities, publicly available, subject to all sorts of disclosure requirements, and were liquid (public markets bought and sold them). Private credit involves loans that are not registered securities, may offer a premium yield (meaning the borrower is paying a premium), and are often (not always) “floating rate” (versus bonds with a fixed rate).
So private credit is basically an asset class that has taken off since the financial crisis, where the benefit to investors has been a higher yield and protection against rising rates, and the benefit to borrowers has been access, ease, privacy, speed, and strategic value from their capital partners. The benefit to society has been more money available to fund good businesses and good projects than a post-GFC banking system could provide, but also less systemic risk because the credit risk of this lending was held by wealthy investors (who I will repeat, are risk-takers) and not the unwitting depositors of our nation’s commercial banks.
What is Private Equity?
This one is effectively easier to answer: It is an equity (ownership) investment in a company that is not publicly traded. Traditionally private equity investments were made by talented asset managers who raised money from institutional investors, bought equity in companies that could be fixed, improved, or presented some other path to value creation, and who used the equity raised and the assets of the business to collateralize the borrowing of money for the remainder of the purchase (what were known as “leveraged buyouts”). Companies that sell a partial or complete interest in their equity to “private equity” might be small, medium, or large, but the defining characteristic is that the equity is not registered, is not traded on a public stock exchange, and is theoretically illiquid.
Private companies often bought and sold for much lower valuations than public companies so often the path to value creation was not merely improving the new business (new management, new strategy, a new set of eyes and ears, and yes, new growth capital), but also the arbitrage that came from buying a company privately for 10x earnings and selling it in public markets for 15x earnings.
The private equity industry has exploded over the years. From $100 billion in total industry assets in the early 1990s to $500 billion in 2000 and $2.8 trillion in 2010, the private equity space now manages $7.6 trillion in total assets. Is this a feature or a bug? Yes. It is a great feature if you own a business you want to sell – there are many more asset managers with a lot more capital that need a lot more details. This competition drives up demand for your business. It is a bug for investors if they are with the wrong asset managers – more money and more managers chasing more deals means fewer good deals than when there were fewer deals. This last point is probably overstated, but it is certainly true enough in the most elementary sense.
This explosion of PE capital has coincided with a crazy drop in the number of public companies over the years. There were 7,500 publicly traded companies in the United States in 1999, and there are basically 4,000 now. Did all the available private equity money take some companies out of public markets? Sure, there have been some private take-outs (not a ton, but some). But the biggest impact has been the lack of new issues. Some companies get bought by others, and some go out of business, but that organic consolidation has generally been offset by gazillions of new companies wanting to go public. Not any more! The strong desire to be public in the 1990s has been replaced in the post-2010s by the strong desire to “stay private as long as possible!” Why? Being public is a lot of work. Your business’s secrets are made available to the world. If your accountants make mistakes, a bunch of people go to jail (Sarbanes-Oxley). Investors can take over your company and throw you out. Analysts and reporters can say bad things about you. Regulators are all over you. It is just a lot. Well, why did anyone ever do it? Simple – they needed the money, or at least they wanted the money. It was a path to monetization and liquidity, plus growth capital that many (most) capital-intensive businesses needed. Now, many (most) companies can avoid the burdens of public ownership either for a very long time, or possibly forever, without having to delay monetization. Private equity has abundant resources to create monetization and access to growth capital. The consequence has been a very different opportunity set for public companies, as many big and successful companies have already been around for 5, 10, 15 years and have seen their most significant growth trajectory take place well before they ever go public. It simply wasn’t that way before.
The benefit has been great returns for private equity investors and great optionality for private business owners and operators. The downside has been fewer great companies coming into public markets for investors who only buy public companies. And out of that downside has come a strong desire among investors to increase their private equity exposure. Simple enough.
My First Philosophical Caveat
Let me just say, as someone with very strong beliefs about investing, the whole issue of “private vs. public,” “listed vs. unlisted,” and so on is almost entirely immaterial for me. There are profoundly important issues of liquidity to consider, of portfolio functionality, of cash flow distributions, of transparency and reporting, of a company’s maturity and stage in its life cycle, and all of those things matter a great deal when considering what is appropriate for investors. We have billions of dollars more invested in publicly-traded dividend equities at our practice than we do in private equity assets because we have clients who have goals that often require a cash flow, a liquidity, a rebalancing flexibility, and a risk profile that are far more appropriate in that public marketplace than the private equity space. But philosophically, if I believe in the human person producing goods and services that meet human needs and wants as the fundamental driver of value creation, I have no rational reason to believe that private markets do that worse than public markets. In fact, I believe the opposite if the right caveats are in place (for example, there will be a much higher dispersion of returns in private markets, more failures, and less information available to drive decision-making). But I am in a lifelong love affair with entrepreneurialism, and there is extraordinary business savvy and wealth creation in private enterprise, even the kind that doesn’t trade on the New York Stock Exchange.
But as fiduciary wealth advisors, one of our jobs is to evaluate the appropriateness of different investment categories for different investors. Liquidity, cash flow, transparency, and divisibility are common needs for many, many investors, and public markets provide us with much more of these things than the private equity world does. So both spaces provide investment opportunities, but one democratizes better than the other.
What is the Concern Now?
Essentially, while there is much more granularity that could be unpacked here, the major concerns I see right now about private markets are:
- The explosion of new assets raised in private credit raises concerns that there is too much money chasing too few good loans, and that means subpar returns, more defaults, and more problems (mo’ money, mo’ problems, as B.I.G. once taught us) …
- The heavy volume of private equity transactions from 4-6 years ago has created a bottleneck of deals needing to exit, and the increase in interest rates between when the purchases were made and now has made it harder to profitably effect these exits.
- While it is investor money (risk-takers) that has fed the increase of assets in private credit and private equity, the banking system has lent money to the non-bank lenders, and therefore, there may be more systemic risk here than people realize
Let’s take a look at the legitimacy of each of these concerns, and where legitimate, the right approach, solution, and mitigation.
Are There Time Bombs in the Loan Book of Private Credit Funds?
The recent collapse of a single (but large) issuer, First Brands, has amplified calls that there is more risk out there than people realize. Of course, one could argue that this is the case that proves the point of many private credit managers … Indeed, this situation looks like an unmitigated disaster, and most likely one of fraud, not mere “poor credit quality.” But since so many asset managers avoided it, isn’t that evidence of “ummmm, underwriting matters”? Since they did blow up and their loans are priced right now to almost no recovery value, but the rest of the space continues to perform and function, isn’t that evidence of a healthy space with some defaults always in play? I suppose it depends on how you look at it.
I would say this: If you are getting 8%, 9%, or 10% by lending money to corporate borrowers, then some of those borrowers are going to default, period. It is virtually impossible to command that kind of return premium and have no defaults or impairments. Can diversification mitigate that risk? Certainly. Can tremendous resources for recovery out of default help? Absolutely. Does being senior-secured in the capital structure matter? Very much so. But some loss rate is inevitable. What to do?
Limit exposure to this space to those who, wait for it, have a diversified loan book, maintain standards for underwriting, have a history of low loss and default ratios through really bad cycles, and have a track record of great recovery when there is impairment. Oh, and yes, resist the temptation to squeeze extra basis points of yield by taking a more subordinated place in the capital structure. Be senior, be secured, and be with the best managers in the space who are not desperate for loan volume and are not susceptible to compromising the integrity of underwriting.
Is this risk-free? No. That’s what the money is for.
Is the history of this, when practiced as described above, a very good return profile that diversifies some other elements of one’s portfolio, particularly for yield/income-focused investors? Yes.
What about Liquidity?
This is the part that drives me most bonkers, and has for quite some time. When people bring up the illiquidity of an illiquid investment as if is a problem with the investment and not the investor, they are really confusing things. Are private investments intended to be illiquid, with a long duration assumed, allowing the investment to play out over multiple years as intended? Yes, they are. Are some structures or vehicles intended to offer liquidity in one’s investment in an illiquid asset class, deceiving investors into thinking that they can have the illiquidity premium in their return without taking on the, well, illiquidity? Yes. But here is the solution: Don’t believe it. Now, could some theoretically be in a private credit investment that offers more liquidity than the underlying investments do and still get the return and an exit without incident? Sure. But no investor should be assuming that to be the case.
A mismatch between asset and liability duration is not a problem with the underlying investment; it is a problem for the investor who believes they can eat ice cream and not gain weight. It is akin to believing you can own public equities without taking on price volatility. To be more precise, this is usually a problem of the investment advisor, not the investor. But I will say it very clearly: The possibility of limited liquidity when investors thought they had liquidity they don’t really have is only a problem if an investor actually expects such liquidity. Don’t expect it. View the asset class as it was intended to exist —and has existed for institutions for many, many years —as a bespoke asset class that offers a return premium for a longer duration (illiquidity).
Are Companies Having a Hard Time Selling?
Yes, they are. Period. Fewer realizations are happening because many deals were done 4-6 years ago, and there are not as many buyers right now as sellers. Will this hurt returns on those transactions? Well, if the sellers force transactions to happen sooner rather than later, I would say that is pretty likely to make the problem worse, don’t you think? Two things impact the internal rate of return as a percentage for the underlying investor:
- The dollar gain, and
- The time it takes to get there
These two things are at odds with one another: accelerating the timeline is supposed to enhance the % return, but if it comes with a lower dollar gain, it hurts the % return. What seems evident to me for higher-quality sponsors is that they are essentially seeing exits and realizations happen at a slower pace, over a longer period of time, but at the dollar levels and valuations they have targeted. That can change, but with interest rates coming down and some of the cyclical challenges of the last few years having peaked, it may not. I have to believe an exit that takes one, two, or three years longer than expected to materialize absorbs a lower percentage return, but one that maximizes value (even if patiently) is the superior option. Yes, there is a tension here.
What is the solution? To allow the sponsors who have skin in the game (carry) to affect exits as the opportunities organically play out, and who require future fundraising for the sustainability of their own enterprise. Some managers have earned this confidence. Some have not.
Is There Systemic Risk?
U.S. banks now have $300 billion lent to non-depository financial institutions that are private credit providers. These loans sit on top of everything else—the credit risk of a given loan, the various mezzanine and subordinated loans in any specific deal—and are basically the LAST loss to be incurred. An entire loan in a private credit portfolio can go to zero cents on the dollar, but the banks only lose money if the entire private credit enterprise fails (and equity is zero). They provide warehouse-style loans and help private credit managers syndicate loans. They are liquidity providers, not risk takers. The risk here is not with defaults or credit impairments.
So why bring it up at all?
Because I do not believe we can be assured that the timing mechanisms, the transparency, and the real exposures are fully known and understood. I guess you could call it PTSD, or just healthy skepticism from a lifetime of watching institutional FOMO from certain banks. Now, $300 billion is about 1% of total U.S. bank assets, and I imagine the losses here are most likely to be 0%, but even if they went to 100%, it would not be earth-shattering. However, that is a systemic answer (as it was a systemic question). Does that mean there can’t be isolated incidents of squirrely results for individual banks and institutions? No, it does not.
Conclusion
I see private market investing as a legitimate diversifier for some (not all) investors’ portfolios. A precondition for that suitability is comfort with illiquidity. Where that criterion is met, there are elements of value creation, yield, and return that are entirely attractive. When they offer risk and reward that is somewhat different from those of conventional public markets, this can amplify returns for an investor when done well.
But the surge in popularity here means more dollars are competing for the same deals. That is not entirely true; more dollars can also mean more deals, but that may mean lower-quality deals. The increased popularity of this space means diligence and selectivity are more important than ever. I should add, if anyone doesn’t believe that applies to public markets, too, I have a bridge to sell you (financed by a mezz loan from an Uber driver). Diligence and selectivity push us up the quality curve when choosing the managers we work with.
The systemic concerns are largely not understood, but do have adjacent legitimacy. Financial innovations drive economic growth, but also come with bumps and bruises along the way.
Investors are wise to ignore the media on this, but not ignore common sense. Risk and reward are never, ever getting divorced.
Chart of the Week
The amount commercial banks have lent to non-depository financial institutions (like asset managers) has increased in recent years, but not in a systemically concerning way (or anything close to it)
Quote of the Week
“A lot of financial debates are just people with different time horizons talking over each other.”
~ Morgan Housel
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Next week, we will be looking at China in great depth, particularly the latest developments in the U.S. deal(s) with China. I can’t wait. And speaking of “can’t wait,” our entire company will be in Dallas the second half of next week for our annual offsite. It is going to be special.
Have a wonderful weekend, and fight on!
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
