Episode 27 – Private Credit 101

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Welcome to Market Perspectives, a Mercer Advisors podcast. Today’s episode is Private Credit 101. I’m Josh Zumbrun. I’m the Director of External Communications here at Mercer Advisors, and I’m joined today by Don Calcagni, our Chief investment officer. Don, thanks so much for being here.

Josh, thank you. It’s great to be here again.

So, Don, we’ve talked a few times about private markets, but we’ve usually focused on private equity in these conversations. And so we were thinking it would be good to step back and take a deep dive into the other side of private markets, into private credit.

So, Don, start us off. Give us just the high-level overview of private markets and explain a little bit the difference between private equity, which is what we’ve focused on most often, and this world of private credit.

Well, Josh, private markets broadly refers to investments that are not publicly traded, things that you’re not going to find on the New York Stock Exchange. Naturally, we can buy stocks and bonds, and mutual funds and ETFs through the different public stock exchanges. Private markets are indeed exactly that. These are private investments not subject to all of the regulations that must be met in order to trade in public markets.

But within private markets, we have private equity, which, as you rightly point out, we’ve discussed many times. And private equity is most analogous to owning stock, owning an interest in a private company. You’re an owner. You’re not a lender. You actually own part of the company.

What’s the difference between private credit and just traditional corporate bond that pays a fairly high interest rate?

Yeah so corporate bonds that are what we call below investment grade. Josh, you rightly point out those are high yield bonds. That’s the nomenclature that we use on Wall Street. These are firms that typically have BB rating or lower.

And the key difference is that publicly traded bonds are pretty standardized. They have a stated interest rate, they have a stated maturity date, and that’s pretty much it. They’re pretty straightforward. Private credit, on the other hand, is an entirely customized transaction. So for example, many private credit loans have what we call debt covenants in place.

So for example, there could be a prohibition against the company, the borrower, from taking on any more debt without permission from the lender. So that would be a classic debt covenant. There could be debt covenants that require them to maintain a certain EBITDA, or in layman’s terms, a certain profit level in order for them to continue to borrow capital from the lender. So totally a customized transaction in the private markets.

Typically, private credit loans are also what we call floating rate. So typically it would be some sort of base interest rate, let’s say U.S. treasuries plus 200 basis points or plus 300 basis points. So if interest rates were to rise, well, the interest that we would earn on our private credit loan would also rise. If they decline, likewise, the interest we earn would go down.

When you own a bond that has a stated interest rate of six or seven or 8% — Ford Motor Company or whoever — they have to continue to pay that interest rate no matter what happens to interest rates in the broader market. So there’s some really material differences between private credit and publicly traded high yield bonds.

So I see there’s different interest rate risk characteristics. If rates change, they affect these in different ways. And then there’s also just the fact that these are more complicated to evaluate in a lot of ways. And that’s probably why traditionally these were the domain of ultra high net worth investors or the domain of institutions that had the ability to go in there.

But why is it that we’ve been hearing a lot more about this asset class in the world of retail investors? We’ve seen more offerings that are aimed towards retail investors, and we’re hearing concerns about this reaching retail investors. So what’s going on there?

Josh, there’s been a lot of things going on really since the global financial crisis from 07 through 09. And private credit really had its Genesis in the financial crisis, and it certainly existed before then, but really began to take off in the wake of the financial crisis.

That’s because coming out of the crisis, there were a number of regulations that were passed. Part of it was the Dodd-Frank bill that was passed in the aftermath of the crisis that really severely limited the ability of more traditional commercial banks to make certain types of loans to private companies.

And so private funds, private credit funds, began to step in to fill that void that was left by of these regulations that effectively pushed commercial banks out of the lending business. Now, we can debate whether that was a good thing or a bad thing. That’s a topic for a different day.

But what we saw here over the past 15 years is really the growth of a very popular asset class. And initially, it was institutional investors and ultra high net worth investors that we’re most interested in this asset class. But it is increasingly appealed to a broader set of investors.

And I think the reasons are pretty obvious. Private credit loans offer the prospect of higher returns. It’s not uncommon to earn 9%, 10% yield on a private credit fund. It’s a very lucrative yield, even in today’s market, where interest rates are higher than they were several years ago.

So number one, it’s returns. Investors are responding to the higher return profile that private credit offers. Doesn’t mean it’s guaranteed, naturally, but offers. But number two is that investors are rightly looking for ways to continue to diversify their portfolios beyond public markets. I think look, I mean, you talk to any investor who’s been investing for 20 or 30 years. There’s a sense that the diversification within public markets has become increasingly limited over time.

And so I think investors are looking naturally to invest in private markets. And in this particular context, private credit, to better diversify their portfolios, but to do so in a way that isn’t necessarily compromising returns.

And there’s pockets of the financial service industry that are eager to accommodate this. Like there’s new offerings coming out trying to push these products to retail investors.

Absolutely right. So another reason that investors are increasingly interested in private credit as an asset class…on the one hand, we’ve seen more innovation in terms of the vehicle structures that investment firms can use.

There’s now something called an interval fund, which takes a fundamentally illiquid investment and makes it semi liquid. They offer some very limited liquidity, perhaps on a quarterly basis. So we’ve seen a lot of innovation coming out of investment organizations to create better vehicles for retail and individual investors broadly.

So that’s number one. I think number two, on the other hand, is what we’ve actually seen a significant amount of marketing by these firms. Every conference I go to, I am constantly bombarded by wholesalers pushing whatever private credit fund they’ve recently come to market with.

So part of it is marketing. It’s created awareness by individual investors, and they are naturally asking their advisors about this asset class and whether or it’s something they should consider.

And now as this has gone mainstream, we’ve seen people raising concerns about this. Moody’s, the ratings agency, wrote a piece warning about the risks of private credit. And I know you wrote a piece over viewing those risks and talking about what you think Moody’s got right and where they might have missed the mark. So let’s dig into that a little bit. What are some of the concerns that Moody’s has raised about this rise of private credit, especially as it pertains to going into retail investors’ portfolios?

I think anytime you get an asset class or an investment strategy that has grown enormously in popularity, by itself that should set off red flags. There certainly should be caution. We have seen private credit grow by over 500% here just in the past decade, just in terms of its popularity. The assets under management and so on and so forth. And again, that’s for all the reasons we just discussed, that investors are interested in the asset class because of the return profile and the diversification opportunity.

Now, with that, certainly there are risks. And Moody’s recently wrote a paper highlighting some of those risks. And look, I think some of those risks, I think Moody’s got it right. I think some of those things they perhaps missed out on, missed the boat on. First and foremost, it’s an illiquid asset class.

Yeah.

Right. It’s illiquid. These are private investments. These are not ETFs. You can’t go into your Schwab account or your Fidelity account and just click the sell button and redeem your interests in these types of investments. So they’re illiquid.

The risks that Moody’s raised is that, it’s an asset class that has a lot of high fees. That is absolutely true. So you have to be very aware of what you’re investing in and what those fees are. One of the bigger concerns–

it’s a concern that I actually share–

is that there’s only so many quality assets in the marketplace.

And you run the very real risk that the very best private investments are gobbled up by the biggest investors in the marketplace. And that the table scraps, the stuff that’s left over, is what’s going to find its way into private funds, private credit funds for smaller investors.

Big institutional investors, insurance companies, ultra high net worth investors they are certainly going to have their pick of the litter, so to speak, when it comes to private investment. So there’s only so many quality investments in the marketplace. Making sure that investors have access to quality investments as a concern.

Making sure that they have access to those investments at a reasonable price is also a concern. It’s not uncommon for a private fund to charge 2% per year plus 20% of profits as their fees, and so those are high fees that are very different from what most retail and individual investors have become accustomed to.

Certainly, investing in public markets, where ETF costs and mutual fund fees have come down over the past 20 years. The biggest risk that Moody’s highlighted that I’m not sure that I actually agree with, is they argued that there was a liquidity mismatch between these investments, which are inherently by design, illiquid. They’re private, they’re going to be illiquid. And the expectations of the investors who are investing in those assets.

And when you think of a liquidity mismatch, at least I do. Having for the financial crisis was a formative experience for me. And one of the problems there was that these big investment banks had borrowed money on a very short term basis and were using it to finance long term assets.

And so when the short term financing disappeared suddenly, they had no way to finance this and their whole business model blew up. And that’s why we had the big investment bank collapses. But this is a different scenario. Walk us through the liquidity situation.

It is very different. So what’s that Christmas movie It’s a Wonderful Life with Jimmy Stuart, right.

Yeah

Perhaps for some of our older listeners who’ve seen that, perhaps they can relate to that. But if you think about it, think back to the global financial crisis. You had firms had commercial banks where folks like you and I would use them for our checking accounts and our savings accounts.

And what banks fundamentally do is they borrow short term out of your checking account. My checking account. They pay us some really, really low interest rate, if at all, to take our checking account dollars, our savings account dollars, and invest those in longer term assets where the capital is effectively locked up. That’s a classic liquidity mismatch, and that’s how you can have a run on the bank, right. Which we saw.

In fact, we just saw it a few years ago with Silicon Valley Bank, where there was a collapse of that bank that had lent capital long but had borrowed capital over very short horizons. The difference this time around is that when you invest upfront in a private fund, most private credit funds are very clear that you are locking up capital for anywhere from 5 to 10 plus years for a more traditional fund structure.

And so if you’re lending capital to a company for 5 years and it’s coming from a private credit fund, I would actually call that a proper liquidity matching. Because now we’ve actually committed the capital. We all know as investors going into the fund ahead of time that we cannot redeem our interest. We know we’re going to be paid interest payments during this 5 or 10 year window.

Most private credit funds will pay interest on at least a quarterly basis. So I actually think the liquidity mismatch argument, at least legally speaking, is off base. I don’t agree with Moody’s. I do agree that we could have an expectations problem.

Maybe as an investor you’re really frustrated that you can’t get your money back.

Correct And you’re calling your congressman or your congresswoman and you’re upset saying, hey, I can’t get my money out. But that doesn’t change the fact that you signed a legal agreement. Committing capital for, let’s say, 10 years.

The expectations issue is that we live in a world where most investors today have had an investment experience in a world that has created more liquidity. We went from mutual funds to ETFs that trade throughout the day. And so I think there could be a mismatch between investor expectations and how the funds are ultimately designed.

I wanted to go back a second to the point about there’s a limited amount of quality assets. In your piece there’s this great chart right where it shows the dispersion. It shows the difference between how well the best managers in an asset class do and how well the worst managers in an asset class do.

And it illustrates this point. It shows that if you’re able to identify the very best investors in private credit over the past 10 years, and by best, it means the top 25% you would have had a return of over 12% which is quite good.

However, if you had failed to identify the best managers and got the bottom quarter. It would have only been 7 and 1/2%. And when you add on the fact that there would have been fees and stuff, you very well could have done worse than just investing in the S&P 500. And so it speaks to the fact that there really is like this risk that you could end up with the bad part of the asset class.

Very, very true. And perhaps a more dramatic example would be think of private equity. The average private equity fund over the past, let’s call it 10 years, has returned about 12% per year. Now that’s the average.

The top 25% of private equity funds returned about 22%. Well, that’s a 10% spread to the upside that if you actually had access to the very best funds, the very best managers, you could have really earned quite a handsome spread. Now, the other side of that is that the bottom performing those bottom 25% private equity funds only returned about 1.6% annually for a decade. That is pathetic. And that’s coming at a time when the S&P 500 index clocked 10% 12% 13% returns over that particular 10 year period.

So manager selection, the quality of the assets in that private investments part of your portfolio is absolutely critical. And so you want to make sure that you’re getting access to high quality assets, and not just the table scraps that happen to be left over after the big institutions had their pick of the litter.

And if you’re a do it yourself investor trying to navigate that on your own, how confident should you be that you’re going to be able to assess that.

Well, I would say you should not be confident at all. Yeah, I’ve been investing in private equity for close to 30 years. I can tell you that this is not an asset class for the do it yourself investor. That may not be what most people want to hear. I know that we all want to see markets democratized, but this is an asset class where information is gold and information high quality information is very hard to come by.

That’s why these private investments tend to do well better than their public market counterparts is that private investors, private equity fund managers are going the extra mile to do their research to get information that is not publicly available on the types of investments that they’re putting into their funds.

If you think about it publicly traded stock, all the information is out there. The SEC has requirements, audited financial statements every quarter. We have U.S. generally accepted accounting principles. There’s accounting requirements for how we have to present our financial statements for publicly traded companies. None of this is true for private companies. And so I think for a DIY investor, private markets, frankly, is not a place where they should try to go it alone.

So put these insights together for us. On the one hand, there’s things that are appealing here right. This is a great diversification option. The returns can be very strong, especially if you’re able to identify good managers.

On the other hand, I think you’re saying that these risks raised by Moody’s, a lot of these are pretty legitimate. So how do you put those two points together and think about how to approach this asset class.

Well, what I would say is that all investing entails risks, whether you’re investing in public or private markets. And so we like the asset class. We like private markets. We like private credit. We think that there is a role for private credit in investor portfolios, for those investors that meet the requirements and have certain financial goals and objectives where private credit could be advantageous.

And so the way we think about all investing, Josh, is it comes back to really just rightsizing the allocation, understanding what are the risks, what are the potential rewards. How do we prudently enter the asset class without taking undue risks.

I see too many investors, for example, getting too excited about a specific fund or a specific asset class, and they end up over allocating, putting too much capital, too much of their liquid investments in a certain asset class. We think that that’s dangerous.

So while we like the asset class, we think that a more prudent allocation to the asset class, something that’s right sized with the rest of their balance sheet, makes a lot of sense. And so that could be 5% that could be 10% of their broader portfolio. And that’s probably the upper limit, at least in my view, in terms of how much you would allocate to it. But it really comes back to also doing it in a diversified way. You don’t just pick one private credit fund and plow all your capital into just one fund.

I’m in private credit now.

Exactly. This gets back to the different managers and that spread in performance that we were talking about. When we invest in private credit we are diversifying across a number of underlying private credit managers, anywhere from four to six to sometimes as many as 10 or 12 underlying private credit funds in the portfolio.

That way, we diversify that risk away that perhaps we selected a bad manager. We want to make sure that we’re doing everything in our power to focus on those top 25% of managers, but to also make sure we’re diversifying the downside risk.

And, Don, one of the things that you always say, and it’s a line that I love right is that the only returns that matter are the returns you get to keep.

If you are investing in a way that you’re incurring a large tax bill, even if you’re like return is good before the taxation, you really need to think about what happens after the tax bill comes. What’s the tax consideration here. Basically.

There’s the challenge. This is the biggest Achilles heel of private credit. Is that private credit despite the fact that it offers very high yields. Is that all of that yield in most instances is taxed as ordinary income. So these are the highest income tax rates in the Internal Revenue Code. So you’re talking 37% federal plus whatever your state income tax liabilities would be.

Now, there are ways through very sophisticated diversification where you can actually design a private credit strategy where most or perhaps even potentially all of the yield could effectively be tax exempt. And this gets back to our diversification comment by pairing it with the right other types of investments in your portfolio. You could conceptually capture 8%, 9%, 10% yields on a tax exempt basis.

That is a very different topic for a different day, but it is important to always keep in mind, like you said and I’m often reminding our advisors and our clients, is that the only returns that matter are the ones you get to keep. So if you’re going to allocate to this type of higher returning asset class, then my only advice would be make sure you do it in a way where you get to keep the returns and you don’t end up ultimately just giving the returns to the IRS.

Don, I think that’s a great overview of private credit for people who are just of starting to think about whether or not this belongs in their portfolios, what to make of all these reports. So thank you so much for being here for this discussion.

Thank you Josh.

If you’re already a Mercer advisors client, don’t hesitate to reach out to your advisor and talk about where this fits into your approach and your financial plan. If you’re not a Mercer advisors client, but you’re interested in more information, check out our website Mercer advisors.com. It starts with a phone call. Thank you so much for being with us today. This has been market perspectives.

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