High hopes for private credit

Good morning. I guess we’re killing time and waiting for the Federal Reserve at this point? Well, while you wait for next Wednesday, here are some thoughts on private credit and cryptocurrencies. Email us your thoughts on either: robert.armstrong@ft.com and ethan.wu@ft.com.

How does private credit beat the bond market?

Often I write headings or section headings that end with a question mark, even though I know the answer. This is not one of those times. I don’t know how private credit beats the bond market, or even if it does, on risk-adjusted terms. However, it is quite clear that a lot of other people believe it is right, and it will continue to be.

We can see confidence in the fact that money is flowing entirely into asset classes, with the clear expectation that it will beat the dismal performance of the public debt market. Stories about this appear regularly in the Financial Times and elsewhere. The most recent in the Wall Street Journal on Monday, which describes how Ares Management has raised $8 billion for a new private debt fund that will invest primarily in loans that support leveraged buybacks. It set out to raise just $4.5 billion, but what the heck. Where do all the needs come from? It’s not complicated:

“More than anything, it’s about low interest rates,” said Kipp deVeer, head of Ares Credit Group. “Many investors are frustrated by the low returns on fixed income that they have traditionally allocated, whether it is loans, government bonds or senior companies.”

Disappointed investors include California’s Public Employees Retirement System, announced Last month, it was so frustrated, it added 5% leverage to its portfolio and changed its asset allocation as follows:

Calpers’ return target is 6.8%. Junk bond indexes are yielding 4.5%. The Triple-C Bond Index (which includes bonds that are “currently vulnerable and subject to favorable conditions to meet financial commitments” in the words of S&P Ratings) are just above target. of Calpers 115 basis points. Discouraging! So here we come to the private market, with a large portion of it being private credit. The Ontario Teachers’ Retirement Plan is doing same thing, for the same reason.

With private equity, we have a pretty good idea of ​​where the profits beyond the public market have come from. They come from high leverage and from managing that leverage skillfully so that it doesn’t cause a downturn during a downturn. I used the past tense here for private equity as an industry didn’t work any better public markets over the past decade (something that comes with high leverage in a constant, bullish market, but with the right fee structure, the upper limit is heaven).

Both hedge funds and private debt funds say that part of their excess returns come from illiquidity discounts. I’m not sure, but I suspect this is wrong. The main clients of private equity and debt funds – pension managers – really like illiquidity, because it comes with consistently steady returns unrelated to other asset classes. , which is consistent with the portfolios of retirement managers. In other words, I believe that managers pay more than they want for the illiquidity of the private market, because it brings unmarked returns to the market. My work has made me skeptical.

If not illiquidity, then what is the secondary source of profit? The executives at Apollo Global Management have something to say about this. Here’s Marc Rowan, Apollo’s chief executive officer in charge of the company’s credit business, saying during the investor call:

“This is a fixed income alternative business. This is not an opportunistic credit business. Our goal in [private debt] segmentation is to generate 150 to 200 basis points of profit beyond parity [publicly traded bonds] on the entire capital structure. We want to get paid. . . because of illiquidity and complexity and origin, not to accept additional credit risk or assume other risks. ”

So higher returns, less risk, because finding high-quality private loans to make or buy is difficult, and Apollo is very good at this. Here’s another Apollo executive, Christopher Edson, at a conference:

“No more residue in liquid [public] market, so we believe we need to be rooted [these loans] direct. It is essentially the production and creation of the factory to generate these assets continuously and periodically in order to drive excess spreads and effectively create these assets at wholesale prices. . . What are these starting platforms? They are companies that live and breathe. They have a management team. They have dozens or hundreds of employees.”

These Apollo-owned companies lend money to small companies, and lend against airplanes or companies that rent out cars, houses, and other properties. Apollo was able to earn an extra 200 basis points on these loans with the same risk because it was clearly too difficult for anyone else to provide credit to the same customers at the lower interest rates currently available in the market. bond market.

There are many examples of complex, niche markets that reward bold investors with superior returns, but it is often argued that these are reward for risk, not for brains. The idea that there’s an inefficient market big enough to stuff hundreds of billions of dollars in doesn’t naturally appeal to me, but at this point, I’m not sure if I’d buy a private credit story. I’d love to hear from readers with experience in the industry or investing in the field.

Revolution as the use case of cryptocurrencies

What is cryptocurrency good for? A question with many answers, most of which are unsatisfactory. On Sunday, a new one was added to the list. Are from Bloomberg:

“A parallel government led by supporters of ousted Myanmar leader Aung San Suu Kyi has recognized Tether as an official currency for local use after the group started fundraising for a campaign to overthrow the military regime.

NUG Finance Minister Tin Tun Naing said: “The Government of National Unity officially accepts tether, a cryptocurrency meant to be a dollar, for ‘domestic use that eases and speeds up the system. current commerce, services and payment systems’. post. No details have been given.”

Tether, you will recall, is a stablecoin, which means it appearance is pegged 1-1 to the dollar. Some have cast doubt on tether’s peg, but it has remained the same so far. And that makes it useful, potentially, if you’re an anti-government rebel group without access to the formal financial system. chaotic.

Cryptocurrency enthusiasts have long boasted that bitcoin and its brethren are independent of established systems, which is an exaggeration. Cryptocurrencies depend, to varying degrees, on centralized exchanges, fiat currency convertibility, internet infrastructure, etc. But the Myanmar episode suggests that cryptocurrencies have a degree of independence system setting. Tether, or another stablecoin, may just be independent enough to help a protest movement despite a policy of disorganization.

Eswar Prasad, a Cornell professor and author of a new book on digital currency (disclosure: I’m a researcher on the book project), tells us he thinks a bigger shift is underway:

“I think angle is important [on the Myanmar story] easy access to a dollar-equivalent payment instrument that has the benefit of being non-physical, not traceable in principle, and allowing transactions to be carried out without the need for the proximity of the transacting parties . All for a good cause for a change.

“This development goes hand in hand with a prediction I make in the book – that the currencies of small countries and those with unreliable central banks or currencies will face threats. existential threats from digital versions of major currencies and from stablecoins.”

That is to say: even though the cryptocurrency is not a dollar, the right thing could cause serious trouble for the Burmese kyat, especially if the currency is devalued by the government. If a stablecoin is stable enough, easy to trade, and resistant to state blacklisting, it could start to look better than the official currency. Emerging markets with fragile currencies should watch out. (Ethan Wu)

A good read

A great Bloomberg Piece about the fundamentally deceptive nature of environmental, social and governance ratings from MSCI and others. The ESG industrial complex is horrible.