The Panic in Private Credit: For Investors, It’s Complicated

The incentive fee? I suspect that there's not a fee cut. If their value goes down 20%, do they get a fee cut, shareholders? You're right. You do not get a return of that. Sometimes there'll be a high watermark, which means they have to make back the money that they lost in a previous period before they can charge that incentive fee. But there's not a reimbursement per se as you're describing it for that answer. You knew the answer to that question. How do you feel about that, Jake? You knew the answer to that question. You've been in this business long enough. Welcome to the Informed Investor where we break down the latest financial headlines bringing in research and insights to help you separate the news from the noise. Private credit, what is it and should I own it? That is the topic today on Informed Investor. Thank you for joining the show. I'm Mark Gochnour. I'll be joined today by Jake DeKinder and Kevin Greene. Kevin, great to have you back on the show. Mark, good to be here. You were back here I think for the Bitcoin episode, right? Yeah, we talked about Bitcoin. We also talked about IPO, so, nice to be back and talk about private credit today. And you do a great job with this stuff. And just for the audience's perspective, PhD, you head up our investment solutions analytics group as well. That's right. So integral part on a lot of the research we do around these type of topics. Absolutely. Keeping topical, what matters to investors and helping communicate what they need to know. All right. Listen, I got some headlines here and you guys weigh in and just to give a little warning to the audience, some of these headlines are a little bit long and I got four of them, but they're integral to today's conversation. Okay. Way to set expectations, Goch, that was good. Yeah, it is setting expectations. That's right. All right, first one, "Why BDCs and REITs Should Be Cornerstones in Every Income Investor's Portfolio." And we'll come back to BDCs. That's a vehicle for private credit. Yeah, we'll explain what those are. Number two, "How the Software Panic Hit Private Credit and Why Some BDC Stocks Might Be Worth Buying." Number three, Once The Hottest Bet on Wall Street, Private Credit Has Started to Crack." Number four, "Private Credit Investors Are Cashing Out in Droves." All right, there's a lot there and kind of a lifecycle around private credit. A lot of headlines for investors to try to make sense of is, "Hey, is this something I should be investing in?" Is this something I should be avoiding? How do we think about that? And that's what we're gonna dive into on the show. All right, Kevin, let's dive into it. Give us a little background on private credits, kinda what it is and then we'll dive dive into sort of the BDC aspect of it. Yeah, Mark, I think it's important. We hear a lot about private credit, whether it's in the news or I'm sure you're having conversations with clients, they talk about them often. It's important to know kind of what is private credit and it's generally described as the loan market made by private investment funds to small to mid-size companies that may not have access to traditional banking lending opportunities. So they can provide more bespoke lending arrangements or simply capital that these companies may not otherwise have access to through this private credit market. Typically there are gonna be loans that are floating rate loans, often senior secured, but also unsecured loans. So, a pretty wide range of what types of loans they can be making. And generally a pretty wide range across different industries that they're accessing in terms of providing loans to individual companies. And then are these typically more short-term in nature? Yeah, commonly more short-term in nature, very similar to kind of like the bank loan market, if you will, just made by these private investment funds. Okay. So it might be a way for an investor. They could go buy, you know, a bond, government bond or corporate bond, but then here's an opportunity set potentially for maybe higher returns into the future and we'll dive into that, right? Yeah, absolutely. It's similar but different in the sense of it's providing access or providing loan arrangements to a segment of the market that may not be getting captured by our traditional banking institutions. And one of the characteristics private credit, usually it's for accredited investors, you have to have a certain amount of net worth and I guess be eligible to buy into some of these private credit funds, which sort of was the rise of then what we call BDCs, business development companies I think. Yeah. Is that the right BDC? Yeah, you're right. So historically this market has been limited in terms of who can access these vehicles and there's some change potentially to that. There's a few vehicles out there that do allow for retail investment and there's a broader initiative of some have described of trying to make private markets in general, including private credit, available to investors through their 401k plans. And I think when you hear those headlines, it's important to first ask of why do I want this in my portfolio to begin with? What are the benefits of private credit? And we've hit on some of it already. There's certainly a part of the market that you can access that may not be available to you if you're only invested in public markets. And anytime you're investing in a different segment of the global marketplace, you can think of there being a diversification benefit to that. It may not perform exactly as your public market investments do and therefore you may get some benefits in terms of diversification where that segment does well when other areas may struggle. And conversely it may not do as well when other segments of your portfolio are doing really well. The other potential benefit is the idea that oftentimes the returns in this segment will outpace some of their more conservative, if you will, public fixed income market peers. In other words, they can deliver higher returns in the private market segment by accessing, by loaning money to some of these smaller mid-size companies that aren't a part of the public investment universe. Now, I say those two characteristics, being diversification and higher expected returns and both of them have trade-offs. One of which is on the diversification side. Oftentimes what investors may see or point to is the low volatility or low correlation characteristics of private credit versus what they see in a public market. And it's important to remember when you look at public markets that's getting priced and updated every single day. And you can't compare that volatility characteristics or how the price dispersion works in that market to a market like private credit or privates in general where the pricing is updated far less frequently and is often done through an internal mechanism where the fund managers are evaluating what is the appropriate valuation of a particular loan. And so, you really can't compare the volatility of that asset class to something that's getting priced every day in the public market and treat them as apples to apples. Well and just to be clear, when we're talking about those price wings, the volatility, it's, hey, if I've got, you know, a hundred bucks in publicly traded securities, you know, it might be up and down 20% any given year. Right. Right, where private credit might just be very small swings. That's kind of what you mean there. Right, it looks stable and smooth, but in reality it's not subject to the same pricing mechanism we see in public markets. So you have to take it with a little bit of a grain of salt as to what that volatility looks like. And I think for us here, certainly in this conversation and for investors in general, when you think about the other aspect, that higher rate of return being offered, we fundamentally believe that risk and return are related. So there has to be a trade off. You're not just getting a free ride of higher returns without assuming additional risks associated with making that investment. And so investors need to be aware of that while they might be getting higher rates of return, there has to be a trade off and that trade off has to be some form of risk in terms of how those loans perform. Well, Jake, that's something you'd love to get into there is this idea that, oh yeah, you can go out there and get higher returns. And that's the same level or that's risk- No risk associated with it, right? I mean, but it's, you know, look, you can go and buy a short-term high quality bond fund or you can go invest in emerging markets value stocks. I can tell you which one has a higher expected return because to Kevin's point, risk and return are related. So, I think with an investment like this, you just have to sort of again, go in kinda eyes wide open of oh hey, it's got a higher yield. Hey maybe they're going after these companies that couldn't get loans from other places. Like just ask yourself some fundamental questions of would that potentially be a riskier investment in some form? And that's the reason I'm getting the higher return. And the other thing I wanna pick up on, and you said it too, Mark, was, you know, you talk about these BDCs and now we're opening it up to the retail space. I always have a little bit of skepticism when I start to see these types of trends, you know, I think over the last couple of years and when we're out talking with financial professionals, we're out talking with investors how many questions on private credit have we started to get, right? And when I see things go from that sovereign wealth fund to institutions, to foundations endowments. to financial professionals, to packaged up for retail, I always have a little bit of skepticism and a red flag goes up. And that's actually the reason that I brought this book here. Are you ready for me, Mark? Yeah, absolutely. It's been staring me down the whole time. It's "Pioneering Portfolio Management" by David Swensen and he was head of the Yale endowment. And the reason I bring this up is this book's back from around like 2000 and you're heading up the Yale endowment. He starts talking about all of these traditional asset classes, but then all alternative asset classes and hedge funds and raw land and timber. And I remember back then we started to get a lot of questions, a lot of retail investors were like, "Do I need to own acres of timber? Do I need to go into hedge funds?" And it's sort of this classic thing that you see of these new investments come out, people get really excited about it, the institutions get excited about it. And as it starts to flow down, retail investors ask questions. It may not be necessarily the best thing for your portfolio because you're not managing the Yale endowment, you don't have access to those deals, you don't have the staff to analyze it and you also may not have the horizon to hold it for that period. So there are different types of investors that are out there. You don't have to sort of like match up what this part of the market's doing with what you may be doing. Yeah and going back to that point about making it available private credit and 401k plans, I mean most of those participants aren't gonna understand the intricacies of private credit or BDC. So, that's why we're doing the show. That's right. Gonna bring some of these things to light here. One thing I wanna go back to, Kevin, we're talking about again, sort of these volatility swings you might see in publicly traded securities versus private credit. And we've given this example before, but you know, think about a REIT, publicly traded real estate versus let's say private real estate. And you got, let's just call it the equivalent building one side of the street, same building's on the other side of the street. In a REIT, I call it market to market from my accounting days but that's getting price adjusted every single day, right? Depending on what's going on with interest rates, the economy, rental income, all those different things. Yet in a private holding, you don't see those swings because it's not getting market to market every day. It might be quarterly or annually or whenever they go back and revisit those valuations. So, that's kind of an example though of what we're talking about there of how these loans that may not necessarily getting market to market every day. Yeah, absolutely and I think underlying kind of both the points you're making here is this idea of we have a lot of data on public markets. In the US we go back a hundred years now of data on equities and we can draw a lot of insights of how these securities might perform, the range of outcomes, how they might perform in different market environments. We do not have that same type of data for an area of the market like private credit to draw those inferences to understand what are the potential outcomes if the market goes through another challenging period, what could performance look like? And that can be a challenge for investors to understand what are the implications of making an investment in this space and what, in reality, might that turn into for my investment allocation. So very important concept of just limited information that we have to really inform the potential investment outcomes that we might expect to see. That's a good reminder just kind of about private markets in general, right? Which is sometimes you have less data, sometimes you have less transparency and really understanding what the true risk return trade off is, forming an appropriate expected return and then how that fits into a financial plan for somebody. It's just a little bit harder to do. Absolutely. So, let's talk a little bit about the tradeoffs. You mentioned some of the benefits potentially around the higher expected returns and this diversification, meaning you're getting exposure to something that's not necessarily in publicly traded markets. The tradeoff side of that. What are some of the implications we have to think through that may be challenges when it gets into some of these BDCs and private credit? Yeah, we've mentioned BDCs a few times now, so let's just define what that is for the audience here. When we say BDCs, we're referring to business development companies and these are closed in funds that invest and make private credit loans and that are available to retail investors to invest in the marketplace. They have a traded price that we can observe every day and they also have other characteristics about the fund that we can observe to draw an inference of kind of what this market segment looks like. And so, a few things that you wanna be aware of, probably first and foremost for investors is there are pretty high fees associated with making an investment in this space. In general, what we see from these business development companies is they charge about 2% flat management fee on gross assets. And I say gross as opposed to net because these funds are also introducing leverage to their investment portfolio and they're charging those management fees on the total assets being invested, not just the capital contributed to the BDC. So, a high management fee associated with that. They also have what we refer to as an incentive fee on top of their basic management fee associated with investing in these BDCs. Now those incentive fees, sometimes they'll have a hurdle rate or requirement that they return a certain rate of return, but that incentive fee is applied to in general whatever profits or positive rates of return that BDC collects. They're gonna take a portion of that as an incentive fee for their services. Now often we'll see those incentive fees come out to around 15 to 20% of those positive returns, which for the top BDCs in the last calendar year came out to around 2% of the overall assets under management. So you think about 2% of of management fee plus an additional 2% of your asset management of incentive fee. Right there we're in a different ballpark in terms of the fees compared to what we see in the public marketplace. All right, so a couple things. First one, real important point about the fees being assigned to the gross value of the investment. So, let's just say a fund gets a million dollars from investors, they go out there and get exposure to $3 million of loans. They're charging on the 3 million bucks, right? Even though they only really have equity of a million dollars in there. Yeah, that's right. And leverage is a common characteristic across these BDCs. They're authorized under SEC regulations to go up to two times leverage. So, two times that two equity ratio, which means that at maximum for every dollar contributed, they could be investing $3 in capital as a part of their investment strategy. So that leverage characteristic is consistent across the BDCs. It's something that investors should be aware of. The other thing, Jake, the incentive fee. I suspect that there's not a fee cut. If their value goes down 20%, do they get a fee cut, shareholders? You're right. You do not get a return of that. Sometimes there'll be a high watermark, which means they have to make back the money that they lost in a previous period before they can charge that incentive fee. But there's not a reimbursement per se as you're describing it for that answer. You knew the answer to that question. How do you feel about that, Jake? You knew the answer to that question. You've been in this business long enough. But I mean you do start to think about that and you were talking earlier about, you know, risk and return are related, right? Well, not only do we have potentially loaning to companies that might be riskier. Now inside of these funds, now I'm putting leverage on there and you have to understand, look, that can be a good thing on the upside, but it also can hurt you on the downside. So now you've sort of got another layer of risk that you're putting in there and you've got pretty high fee. I mean, think about that, right? Think about the average expense ratio if you go out and you buy sort of a broadly diversified equity fund or a bond fund. It's not 2%. I mean, right off the bat, man, you're really starting at a disadvantage to try to capture some decent returns. Yeah, that leverage piece, you're right, it can amplify positive returns and it also amplify returns in the other direction. And when we look at the volatility of just these BDC funds, we see volatility characteristics very similar to equity markets. And if you look at the fixed income market, you see volatility characteristics very similar to junk bonds, even in the triple C-rated segment of the universe in terms of how volatile those BDCs have been and their public market prices. So an important thing to consider, the other aspect of that leverage is that the cost of that leverage, right? These BDCs are issuing bonds to get money to lever up their investment portfolios. Those costs are passed on to the ultimate investors. And when you look at the cost of those, we found about 5% of assets managed on average for some of the top BDCs. And so you add that to the incentive fee, you add that to the management fee, you can get at times eight to 10% fees for assets being managed for some of these BDCs, which is just a different kind of realm of fee levels compared to what most investors are accustomed to in investing in traditional mutual funds or ETFs. And let me ask you a question there. So, I'm just an average retail investor. I start looking into this. I mean, how easy would it be for me to determine that eight to 10%? I mean you've got the data, you do this for a living, you sift through this stuff, but if I'm just out there like trying to buy one of these things, like what would I... Would I be able to see any of this stuff? It can be, it depends. If you're investing directly in the BDC, you will have, you know, SEC filings that you can look at and you can understand what fees are being charged. There are also ETFs out there that will invest in BDCs and they have a net expense ratio associated with them. So you can see them. Hey, let's go back to some of those headlines. One of them was around, hey, you're starting to see some cracks coming into play with private credit and you have some performance numbers. I think that article was going into looking at some of the performance particularly around these BDCs, which is public information. So, give us a sort of a feel of what performances looked like over time with these BDCs. Yeah, Mark, I mean one of the reasons we're talking about the segment, there's been headlines about fraud, president and some of the loans being made, the underlying borrowers and fraudulent activity that brings into question, you know, whether or not the either assets being used, declares the loans are there or available. There's been concerns around exposure to certain segments of the market, in particular software companies as that company has been in the headlines of whether or not AI is gonna have an impact. And some of these BDCs have had a significant weight or exposure to companies in the software industry. As a result, we've seen in aggregate this BDC market decline rather sharply relative to other segments of the market. And again, we talk about having a long history of data in the US market. What we see right now is over the last year, US equities are up. They're fixing a market. If you look at something like the Bloomberg US aggregate, it's also up healthier over the last year. When you look at these BDCs, over the last year in aggregate, this group has fallen by just under 20% in the last 12 months. And that is again, related to some of the headlines you're seeing, but you see that what is otherwise appear to be a very healthy market. I've seen strong performance from both equities and fixed income and now we're seeing this group declining by a substantial mark just under 20% over the last 12 months. So it's pretty eye-opening as to kinda what the return outcomes can look like in the segment of the market. Well if you go back a little bit further though, the returns were pretty decent for this segment of the market. Is that correct? Yeah, if you look back historically they've had strong returns relative to other fixed income segments and many cases outperforming, which is maybe not surprising given the type of companies they're making loans to. But recently we've seen significant underperformance. Well, I guess that's the reason I bring it up. I mean, one, you bring up a good point there of the outperformance, risk and return-related, we've talked about that. But I mean, why do you think we're talking about it? Why do you think we get a lot of the questions? I mean, it's sort of that classic, you've got an asset class that did well, right? And we've sort of hashed out all the reasons why maybe that was the case. But then you get a lot of people that kinda see those returns and they, it's maybe a little bit of performance chasing. And the tough part is, is a lot of times when you're performance chasing, then you get a run where, what'd you say you're down almost 20% in the last year. You know, that's a tough one. It's a tough one. You know, those kind of strategies, they sound good and they work when they work. Right. And then there's at some point they're gonna have some challenges, you know, and you saw that in the last 12 months or so. But one of the other things related to that is if I'm an investor and say, "Okay, well, I don't like where this is going, I wanna get my money out." That's a little bit challenging as well. The ability to get money out when you want to, you're kind of limited in some of these different portfolios. Yeah, you're right. We've seen headlines on the private segment. So apart from the BDCs of some of these private investment funds are kind of restricting any type of redemption activity from investors altogether. But oftentimes they even, in normal periods, they have a restriction or a limit of how much you can redeem at any point in time, and that's often comes at quarterly intervals or something similar. So, you go through one of these periods and maybe you think, oh man, I need to have liquidity, I need to access that money. And if the manager is restricting access to being able to redeem that, that's another concern you have to think about of a trade off of if you're investing in this space, you may not be able to access liquidity at the point in which you need it. And now in the BDC market, there's a publicly traded form in which you can access liquidity, but the question is at what cost, right? And you may have to trade at a deep discount to the net asset value of those loans in order to access liquidity at the time in which you need it. And what we've seen during this downturn for BDCs is many of these funds are trading at a discount to their NAV, which brings up that point of what the costs are to access liquidity even in a publicly available vehicle like a business development company. You know, I was on a panel at an institutional event about a year or so ago, and there were a number of private credit managers that were there and they were operating more in the institutional space, don't get me wrong, but a lot of the conversation was basically, "Hey listen, some of these loans that we've done are reaching maturity. We need to figure out basically how to get some of these investors paid but we also don't know if these loans are really gonna pay off." So now they're out sort of seeking more investors to come into the fund to pay off some of the investors that have been in the fund, right? And I think that's a little bit of what you're talking about right there. I mean the BDC is maybe a different space there, someone sell off the loans and figure out how to meet the redemptions there. But again, what you're seeing is, is that maybe these things didn't pan out and now the returns that people expected weren't there, how the funds are gonna be managed gets a little bit more challenging. And so, it was a very interesting conversation to watch these private credit managers have a conversation on how they're basically trying to take care of investors, but the market's changed on them. Yeah. Well you know, one of the things too, I think on private credit, and we've talked about this before, Jake, about there is a valuable role that's being played. Completely. By these private credit managers, right? They are providing liquidity to some of these companies that may not have been able to get it traditionally through a bank. So, it's a valuable part of the economy. It's just as an investor, how do I think about that and does it belong in my portfolio? And so, what are you guys' thoughts on that? You know, is this something I should own in my portfolio? What are the things I gotta be thinking about if I do put it in my portfolio? Yeah, I think you probably wanna think of this as maybe being a little bit different than traditional fixed income where we see historically it's served as kind of a ballast for equities of on average and down equity periods. We've seen fixed income generate positive returns. And it's also been a great way to reduce the overall volatility of your portfolio by allocating some of your investor capital into the fixed income market. With this market, again, there's an incentive there from a diversification standpoint of you're accessing a segment that you might not otherwise have exposure to in your public markets. There's an ability to generate higher rates of return because of the types of loans being made in this market. But the trade-offs are, it has volatility characteristics similar to your equities and we don't have a hundred years of data, if you will, to understand exactly what types of outcomes we might expect to incur. We also mentioned the fees and the liquidity as additional trade-offs that someone might wanna consider when making investments. So it may not be the best fit for everyone and even for those that it is a great fit for their understanding of the trade-offs, we have to think about what type, what size of allocation. And this market makes up about 1 1/2 to $2 trillion in aggregate. And you compare that to the many, many trillions that are available in the US equity and fixed income spaces. And that probably suggests that you should have a relatively small allocation to this segment as a part of your global asset allocation strategy. I come back to a framework that we've talked about a lot of times, which, you know, and Kevin kinda walked through it there, but what's the goal? Like what's the point of me owning it, right? And what role does fixed income play in the portfolio? What should I expect to make on it? And having a lot of data, by the way, is really helpful for that, especially if you're gonna do financial planning around that. Yes. What's the risk associated with it? And I think we've talked about some of the potential risks with some of these. And then the fourth one is what's the cost? And we addressed that as well when you told me about a lot of the fees and you actually hit the fifth question, which is, if I answered those four, what's the goal? What do I expect to make? What's the risk and what's the cost? How much money am I gonna put into it? And it is a relatively small segment of the market compared to the broad fixed income and equity markets. So again, it's not to say it's a good investment, it's not a bad investment, just ask the right questions before you go after it because the performance was good or you think it's interesting or you heard your friend talk about it or whatever it is. Yeah, that's a great summary and I'm gonna go back to your book there too, Jake. You know, you go back to that, some of the comments that were being made in the book there about, hey, this is for very sophisticated large pension plans, endowments, things like that. You know, for the average investor, I think it's even in the book there, the average investor is probably better off in just a very, very low cost, diversified, publicly traded markets of stocks and bonds, right? I completely agree with you. And look, we did an episode on 60/40 and to me this is almost like an example of like that sort of just that classic 60/40 that keeps moving towards their goals. And don't get me wrong, this could be, you know, part of the 40% of fixed income there if you wanna go into it. But it's just, to me it's another example of just have a little bit of skepticism and ask the right questions. Yeah. Well, and even you mentioned maybe it's part of the fixed income, maybe it's part of the equity too based on how volatile it is Oh yeah, sure. We talked about that, yeah. Is it stocks or is it bonds there that I'm getting. Hard to answer, right? Yeah. So you don't have the data to really get a good tell for it. Yeah, you're right. It's a good question. I think just being aware of the trade offs is first and foremost, the most critical aspect of trying to evaluate the decision you're looking to make. And hopefully what we've been able to articulate today is what those trade-offs look like. You know, the high fees, potential volatility, the potential situation where you might face liquidity constraints, all of those are pertinent to understanding is this a good fit for you? And if you can't answer those in a way, then you probably still have more work to do before you can come to a conclusion. Great to have you on the show. Great comments as always. Thanks for joining us here today and thanks for all of you for joining the Informed Investor today. One of the things that we talked about today are price swings and we're going to come back on a future episode and talk about earning seasons and how we see that impacting the price of stocks and bonds. So thanks again, everybody. Be sure to check out the survey and give us any ideas you have on future topics. Have a fantastic rest of the day.