Episode 305 - Is Private Credit Special?

0:03This is the Rational Reminder Podcast, a weekly reality check on sensible investing and financial decision-making from two Canadians. We're hosted by me, Benjamin Felix, and Cameron Passmore, portfolio managers at PWL Capital. Welcome to episode 305. This week, we have a nice, tight, but important episode. Ben, why don't you queue up the main topic today? We're going to talk about private credit for our main topic, which should be lots of fun. I think it's an interesting topic. I will be repeating myself, but this is the asset class by far that I've been pitched the most in the last few years, which is interesting.

0:40Yeah, it's becoming very popular these days. I'm getting lots of questions about it as well, and definitely from the wholesalers and those types as well, but as well as from clients and the public. So it should be a good one. May 22nd, we have a webinar coming up that's getting lots of interest. Mark, you're involved in this event. Why don't you queue that up? I'm involved now. Thanks, Cameron. I wasn't involved as of yesterday morning, and then I got a message from Cameron saying, hey, you want to help out with the webinars? Yeah, sure. I'd be happy to. It's on optimal compensation strategies for business owners.

1:09And that would extend to professionals or anybody with a corporation who has a choice to pay themselves by different means, salary versus dividend. But it's going to get a lot deeper than that for anybody out there that also listens to MoneyScope. I know Ben and Dr. Mark Soth have done some really deep dives on this topic. I think Ben, you said it's episodes 12 and 13, if I'm not mistaken. So we are going to present myself, my colleague, Brady Plunkett, and Spencer from Hendry Warren, our friends at an accounting firm that we work very closely with. And are we at 500 registered guests yet? We were at 450 yesterday.

1:41I think we're flirting with 500 now. It's amazing. Flirting with 500. Yeah. And there'll probably be a late push before the webinar. So it should be a good one. It's going to be very detailed. And if you're a business owner or incorporated professional, it's going to be for you. So we'll put a link in the show notes, but there's also a link on our homepage, pwlcapital.com. It's on the first page. It's going to be good content. Spencer is one of the two tax accountants who reviewed the notes for the MoneyScope episodes. He's brilliant on this stuff. Beautiful. Okay, guys, ready to go to the episode?

2:11Let's do it. Let's go.

2:18Okay, 305. Let's get going, Ben. All right, so private credit. So in my role as a portfolio manager, but also because I have the title head of research, that one of the implications of that is that I get pitched a lot because people look through a website or whatever and decide that I'm the guy to pitch their product to if they want to get it on our. It explains why you get so few pitches now they're going right to you, which is awesome. Yeah. Makes me want to change my title. But like I said in the introduction, private credit is by far a long way the asset class I've been pitched on the most in the last couple of years.

2:51So what is private credit? It's loans. I like bonds, like a bond is a loan. But in the case of private credit, they're not publicly traded, not created by banks. They're created by non-bank entities like a private credit fund or a business development company to fund private businesses. So the name implies like bonds, but in private markets and also sort of not like bonds, which we'll talk about. Now, this asset class gets promoted to retail investors and other investors for its high yields, see a 9 % yield and stable returns. And that's the part that I have more of a problem with. But as you can probably guess, I'm skeptical of the asset class.

3:29And it's pretty new. Is it not that it's being opened up to retail? I think for a long, like it's new to the retail class. It's not a new asset class necessarily, but the proliferation of publicly available funds and institutions that are offering it now is growing very rapidly. And I think that's obviously why we're here talking about it today is because it's growing fast. Some validation. Listen to a Provchi interview as well as Demodaran, the valuation expert from I know you, Stern, and he was talking about it on this week's podcast that he's actually looking at credit and he's a long devoted equity only investor.

4:02So you start hearing more and more in other types of channels. And it's not a bad asset class. I don't want to be the guy out here disagreeing with Demodaran and you got to look at what are you actually getting. And if you're Demodaran, maybe you can find good opportunities in the asset class, but in aggregate is what I want to talk about, whether there's anything special there. Now, this is one of the fastest growing asset classes. I think in terms of growth in total AUM, private equity is the fastest growing. Private credit is in second place. Incredible. Papers that I've read on why that's happening, it's intuitive when you hear it, but that growth has largely been driven by investor demand for high floating rate yields because we've been through this long period of low interest rates, although they've come up now.

4:45But we went through a period of low interest rates and then people were worried about rising rates. Private credit tends to be floating rate, which protects you a little bit from rising rates, and it's got higher yields than publicly traded fixed income. That's one side of it. Then the other side of it is tightened capital requirements for banks, which pushed small and mid-sized companies to find alternative non-bank sources of credit. Those two things happened in the last 20 or so years, became increasingly prominent factors. That is what I have seen argued in any way, as the reasons explaining a lot of this growth.

5:22We've got investors seeking yield and then companies needing non-bank lending. Then boom, we get this big, fast-growing new asset class. Now within private credit, the fastest growing part of that market is private credit funds. These are funds that raise money from investors and then make direct loans to private firms. typically firms, and this is important, that can't get bank loans due to their creditworthiness. Now, another interesting point that I've seen this as an argument for why this is an interesting asset class, and we'll get to that, to whether or not it does make it interesting. But one of the arguments is that loan terms are negotiated individually with each borrower.

6:03And the terms often contain features that traditional fixed income would not, like a structured equity component, like warrants or something like that as part of the overall deal. So more answer, are they not like a long-term call option in a way? That gives you a version of equity exposure in the borrower. An important thing, and this shows up in the high yields, the interest rates on these loans are high. The borrowers are too risky for banks, which means that the loans already command a higher interest rate. But then the other thing is that private credit funds have to build their own fees into the rate that they're charging these borrowers and their fees are high.

6:39A typical fee structure is 1.5. I've seen 1.25, as low as 1.25. I have not seen lower, although I haven't surveyed the whole market. That's just my casual observation. Call it 1.25 to 1.5 % plus a performance fee of 15 to 20 % over a hurdle. All in, it ends up being 3 % to 4 % in total fees that you would expect to pay. That ends up getting reflected in the pricing of the loans. That performance fee is widespread in private credit? From what I've seen, yeah. Interesting. So you take those two pieces, we're lending to higher risk borrowers in the first place, and there's equity-like features in the loans.

7:17I think private credit, and I don't just think this is what the data suggests, private credit can start to look a lot more equity-like, or at least have a meaningful equity component than bond-like. But the tricky thing is that due to its nature as a private asset class, that equity-like risk is not going to show up as volatility. On paper or in a pitch deck, the result is what looks like high returns, low risk, and low correlations to public assets like public stocks and bonds, for example. Now, of course, all of those things, if you can get them, if you can get an asset with high returns, low risk, and low correlations, that is the holy grail of portfolio management.

7:59Everybody wants that. But of course, private loans are not valued daily. They don't have a secondary market to establish a price. So their reported returns are not always going to reflect the true volatility in the value of the underlying assets. The price is what the value is a different thing. Who values them in a credit fund? It would be similar to private equity. I don't know the exact details, but I'm sure they would have some third-party valuation, which is fine. But we'll talk about some of the research on the relationship between net asset value of private loans and market value of private loans.

8:31There's some really interesting research on that. I saw an article somewhat recently, like in the past few months, it was arguing about valuations on private credit. And I guess they had different evaluators looking at the same, not a bond, but the same loan. And there was no agreement on what the actual value was, because I guess measuring the risk and the credit worthiness of the issuer is a challenge. So you had different shops evaluating it at 75 cents on the dollar, 50 cents on the dollar, 82 cents on the dollar. So without market pricing, you're just accepting the valuations that are being given to you by whoever's evaluating it for the fund.

9:02I think I saw that article too. Yeah. So we don't have market pricing. If you took all of the private valuations, like you were just talking about market, if you took all of them together, you might get something like a market price, but I don't think that the private credit funds are usually doing that. When private credit assets are marked down, and this part's important, and there's some of the research we're going to talk about is on this, the marks down will tend to be a lot more muted. They won't be as deep. They won't be marked down as much compared to an otherwise comparable publicly traded asset.

9:32That again, becomes really important when you're looking at these things and asking questions like what is the volatility? What is the downside risk? What is the risk more generally speaking? That's super important. The smoothing effect is similar to what we talked about with private equity. But you take return smoothing and generous valuations, especially during bad times on private loans. And it can make the asset class look a lot more attractive than it is maybe if risk is evaluated properly, if we can call it that. So all this kind of starts to touch on the question that I think every investor should be asking before allocating to an asset class, which is what underlying risks, what economic risks am I taking?

10:10And how do I expect to be compensated for those risks? We know about systematic and non-systematic risk, an individual stock, you're taking stock-specific risk. So you've got to know what risks am I taking in the case of private credit? A fundamental truth is that financial assets represent discounted future cash flows. The value of a financial asset is going to change when one of those two things changes. Discount rates can change, cash flow expectations can change. That's why we see price variation day-to-day in financial markets when assets are valued by the market. That's always true. The value will change.

10:45But in the case of something like private markets, we don't have live valuations and we don't have market valuations. Even if you had a private valuation, like you talked about earlier, Mark, even if you did get a private valuation every day, that's not going to represent the value that you could sell it for if you went to the market. So one really interesting perspective on this that I found in a paper in the Financial Analyst journal titled Direct Lending Returns, this 2023 paper. They look at publicly listed business development companies, BDCs. These are closed end funds that engage in direct lending and they themselves trade on the public market.

11:22It ends up being a really cool laboratory and I'll explain why. They're relevant to private credit because they're required to invest at least 70 % of their assets in non-public equity and debt of US corporations. They've been shown in other research to be good benchmarks for the returns of private credit funds, a decent proxy for private credit. In the paper, what they do to evaluate BDC performance is they build a benchmark consisting of small cap value stocks and leveraged loans because those public assets end up explaining most of the variation in BDC returns. They take some public assets and they just did this empirically.

11:57They looked at what package of public assets are representative of the returns of BDCs. And so they found this mix of small cap value stocks and leveraged loans, which are both publicly traded and mirror the returns of the publicly traded BDCs. That equity bond mix as a benchmark is quite important. And there's another paper on this that we're going to talk about in a little bit. So this is the important part of this paper. They find that when BDC performance is evaluated based on net asset values, and this marked your earlier point is when they're valuing the assets themselves. It's an on-paper valuation when they do their regulatory filings, not a market valuation.

12:34Measured from that, measured from net asset values, BDCs outperform the liquid benchmarks by 2.74 percentage points per year, and they have very high sharp ratios. That looks really good. It looks like what we talked about earlier as the pitch of private credit. It looks like you can take risks similar to publicly listed assets, similar to risky stocks and bonds, while earning a big alpha. Is that before any fees are considered? This is the net return of this security. So it'd be after the fees of that security. But then of course, the issue is that BDCs don't trade at their net asset values, particularly during times of market stress.

13:10They'll tend to trade at a discount. And we know the market is this pretty efficient pricing machine. It's taking in lots of information and outputting a price. And so you can think that when the market assigns a price below the reported net asset value, we could take that as meaning that the net asset value was not accurate. You could also take it as meaning the market price is not accurate. You could say the market overreacts. That's the argument, right? Is the market is irrational. The market underprices and overprices stuff all the time. And our valuation is more accurate. You get that in all private asset spaces, right?

13:43Like private real estate, private equity, and obviously private credit as well. So either the market's wrong or the firm who's evaluating the price is wrong. And there could be some validity to that. I would tend to trust market prices more. I think from an investor psychology perspective, one of the most interesting aspects of private equity and private credit is that it allows investors to take more risk and have higher expected returns, even net of fees, while feeling like they're taking less risk. There's a paper from Antti Ilmanen talking about how the premium for illiquid assets may be negative.

14:18You'd expect to earn a premium for holding illiquid assets because they're riskier, but he's argued that it may actually be a negative premium because people have a high demand for the smoothing effects of illiquid assets. So it's not obvious that there's a benefit to holding illiquid assets from a financial perspective, but from a behavior perspective, there could be, which would actually drive down the expected returns of the assets anyway. Oh, it's interesting. I was talking to a friend of mine who works for a firm that does a lot of private assets, like private equity, private real estate, and private credit.

14:44And we were just chatting yesterday about it. And he was talking specifically about those behavioral benefits for retirees and the psychological comfort they get from withdrawing from a portfolio that looks very stable on the surface. You pointed out the high sharp ratios and the lack of volatility, and that's really cliff-assness would say volatility laundering. They're just not pricing it frequently, and it's not being priced by the market in aggregate. But there may be a behavioral benefit to that, and I could see that for somebody retiring and drawing from a portfolio. It's not a crazy argument.

15:12No, I don't disagree. You look at private equity and you look at private credit, net of fees, we can make the argument that the returns are not better than public assets, but they're also not terribly worse. I think the bigger issue you have to deal with in private markets is dispersion, where the difference between picking a bad manager and picking a good manager is huge. And it's not so easy to just buy an index fund like we talk about with public markets. So there's that dispersion piece can really hurt you or help you depending on whether you pick a good fund or not. But if we just look in aggregate, I don't know, man, net of fees, the performance is sure.

15:43Say it's the same as public assets, so there's no benefit financially to owning these things. But if you get a big behavioral alpha from smoothing, who are we to say it's a bad idea? And some cool stories to tell. This is all before tax too, right? So presumably private credit is taxes, interest income primarily. Assume so, but that's not something that I've looked into in any detail. But that would make sense. Yeah. So on an after-tax basis, depending on the situation, of course, and whether you're holding it in a non-registered or a corporate account, you might get equity-like returns gross of tax, but net of tax would probably be significantly worse.

16:15Okay. So back to BDCs, we talked about how on a net asset value basis, they outperform the liquid benchmark on a market value basis, because remember, we're talking about securities that are publicly traded. We've talked about their net asset values, which are the reported asset values, which is like what you would get with an unlisted private credit. But in this case, we get this additional layer of insight because these securities actually do trade in the public markets. Using their market value, the BDCs do not outperform the liquid benchmark. That suggests that when they're properly benchmarked and properly priced, the apparent excess risk-adjusted returns goes away, at least in the case of BDCs.

16:50Although we're going to talk about private credit funds in a second, private credit funds specifically. There's a 2024. It's a pretty new paper titled, it's a working paper. The other one was published in the Financial Analyst Journal. This one is a working paper. This one's called Risk Adjusting the Returns of Private Credit Funds. What they do is they apply a cashflow-based method to form a replicating portfolio that mimics the risk profiles of a large sample of private credit funds. Roughly similar to what we just talked about. They're looking at the private credit funds and figuring out which public assets they can use to benchmark.

17:22And they find using an equity and debt benchmark to measure risk that a typical private debt fund produces an insignificant abnormal return to its investors. So again, back to the idea, if we properly measure risk, there's nothing really special going on here. That means that investors are not getting any alpha. They're just getting compensation for the risk that they're taking in the funds. Their risk-adjusted excess return is indistinguishable from zero. Now, they do note in this paper that if you remove equity from the benchmarks, private credit looks really good. If you benchmark private credit against public fixed income, it looks very attractive.

17:58I think that highlights the importance of proper benchmarking. It also suggests that anyone adding private credit to their portfolio as part of their fixed income allocation may really just be increasing the overall equity exposure while feeling good about it, which like we talked about earlier, maybe that's fine. I don't know. And this is similar to other corporate bonds, is it not? Where there is some equity risk in the issuer? I think it's a little bit more explicit in this case because of the structured equity component to the loan contracts. But yeah, if you go into high yield, it'll start to look like there's equity exposure in there as well.

18:30It's completely unreasonable to not have some equity exposure in the benchmark then, is it not? I would argue so, yeah. People are probably using this as a bond alternative. That I'm not sure about. I'd have to survey people that do this, but if they are, they're taking more risk than they realize. You wouldn't substitute this for bonds unless your intention was to increase the amount of risk that you're taking. But given how many retail investors are getting interested and how easy it is for them to access it now and they're seeing it as stable fixed income allocation in their portfolio, to your point, many of them are likely taking a lot more risk than they thought they were.

19:06And just replacing this with like their bond allocation with something like this is significantly different than what they thought they were doing potentially. That would be my hunch. It's only a hunch, but that would be my hunch. And that's one of the reasons that I think this is an important topic because there are firms in Canada that very explicitly target low investable asset retail investors who are marketing this fairly aggressively, I would say, in terms of just showing off the high yield and the stability. It's not like it's not affecting anybody and it's not like it's only being pitched to ultra high net worth investors who can afford to take a little bit more risk than they maybe realize that they're taking.

19:43So there's no free lunch. There's no free lunch is what the research that we're talking about suggests. Now, we also know that in theory, skilled fund managers will attract assets to their fund up to the point where they're no longer able to generate excess risk-adjusted returns. None of this stuff should be too surprising. That's Burke and Van Binsbergen, who we had on, I don't remember which episode, 200 and something. Jonathan Burke had the original theory on this in the Burke and Green 2004 paper, and then Burke and Binsbergen have continued to develop it. Basically, assets will flow into managers up to the point where all of the benefits of their skill are absorbed by the manager in the feeds that they collect, and the investors and their funds earned returns that are in line with the risk that they're taking.

20:24Episode 220. 220. That was a great episode. The argument there is basically that there's an efficient market for manager skill. Some research on private equity, this is a paper from Ludovic Falapu, who we also had on to talk about private equity. His paper has a cheeky title where he refers to private equity as the billionaire factory because private equity managers generate large fees for themselves while delivering net returns that are similar to public equities to their end investors, which is exactly what you'd expect in an efficient market for skill. It's important here because this means that there's nothing wrong with the opposite.

21:00Private equity and private credit managers are extremely skilled because they're able to earn net returns that are in line with the amount of risk they're taking while charging 4 % or in the case of private equity, 6 % total fees. That's a lot of alpha to generate, but the problem is it gets absorbed by the size of the fund and accrues to the manager, not to the investors. The investors just get the expected return in line with the risk that they're taking. Ludovic Fallopu is episode 210. That's another good one. I think in the case of private credit funds, it looks like the managers are able to apply their skill in identifying, negotiating, monitoring private loans.

21:37This is no joke. This is serious due diligence. They're working with companies that couldn't otherwise raise financing. It's all impressive, and I'm sure that people running these funds are absolutely brilliant. But the thing is, they charge a fee rate, they charge a lending rate to the borrowers that approximately equals the risk-adjusted borrowing rate for them plus the fees that the private credit fund is charging. And in the end for the end investors, and in line with what theory would predict, the fund managers absorb the benefits of their skill as fees. And the end investors, as I've said a couple of times now, end up taking a whole bunch of risk in this case, probably more than they realized, paying high fees, which maybe that's not so bad if you're getting a net return that matches public markets with lower fees, I guess.

22:20But the big piece is they're getting returns that they could get much cheaper and something we haven't mentioned yet with better liquidity if they just use publicly listed assets. I think it's perfectly fine. We've said this a couple of times now. If investors are fully aware of a lot of the stuff that we've talked about and they go into private credit anyway, they say, yep, I got all I get that I can replicate it with public assets, but I want private credit because it feels good, or it lets me take more risk without seeing volatility, or I can tell my friends about it or whatever. I think that's fine.