Fear of contagion has some investors pulling their capital from private credit funds.PPAMPicture/iStockPhoto / Getty Images
Alarm bells are ringing in the $2-trillion private credit industry, with investor concerns about the growing risk of default on private loans to software businesses, which may be disrupted by artificial intelligence and higher interest rates.
Fear of contagion in an increasingly interconnected financial system has some investors heading for the exits, pulling their capital from private credit funds from Blue Owl Capital Inc. OWL-N, BlackRock Inc. BLK-N, Blackstone Inc. BX-N and others.
Yet, the broad private credit sector is in better shape than the headline news presents, says Philipp Soummer, who manages the private credit fund at Chronicle Wealth, a Toronto-based multi-family office and asset management firm.
“It’s important to disambiguate the two key risks in private credit: liquidity and valuation,” Mr. Soummer says. “The second risk is far worse than the first. Right now, I’m not seeing anything regarding a deterioration of valuations or from a default perspective.”
What he sees is a gap between retail investors’ liquidity expectations and the way the funds are structured.
“These funds have effectively democratized access to both private equity and private credit for non-institutional investors. As an advisor or investor, you need to understand the terms of the fund you are buying,” he says.
“Investors want both the upside from the illiquidity, and they want the yield premium. You have to pick one.”
Victor Kuntzevitsky, portfolio manager with Stonehaven Private Counsel at Wellington-Altus Private Counsel Inc. in Aurora, Ont., sees the current anxiety in the sector as a sign of a maturing market, not a reason to run for the exits.
“The current turmoil in private credit is visible, but it’s orderly, and exactly what the structure of semi-liquid private credit markets was built to handle,” he says.
However, Mr. Kuntzevitsky faults the way these investments have been marketed as offering an attractive yield while “being like an ATM, where funds could be withdrawn at any time.”
He points out that some Canadian legacy credit funds had excessively liberal liquidity terms in which investors could request their money back within two weeks to a month.
“There was a mismatch between the loans the funds held compared to the redemption terms they offered,” he says. “When these funds were overwhelmed with redemptions, they didn’t have enough cash on hand and were forced to gate, preventing further withdrawals.”
Mr. Kuntzevitsky says the risk of contagion in private credit funds is higher in Canada because of the large overlap of advisors and investors in these funds: “If one fund gates, the advisor might think, ‘If this fund has issues, I’m going to submit redemptions in the other funds, too.’”
Another contributing factor to contagion is career risk, Mr. Soummer says. If an advisor thinks there’s even a 1 per cent chance of a broader problem in private credit, “they will take liquidity now, earning less for their client but not losing their job.”
Whether the average investor should even own private assets is debatable.
Steve Balaban, chief investment officer of Mink Capital and founder of Mink Learning, at which he trains family offices and advisors globally on private equity and debt investing, says there are some long-term benefits to having “something steady in a portfolio,” which private markets can provide.
He also points out that most of the world’s companies are privately held and exposure to them offers portfolio diversification at a time when the S&P 500 is increasingly concentrated among large technology companies.
However, Mr. Balaban questions the high fees of private credit funds. And while family offices and other institutional investors have the assets and expertise to make direct loans to companies they understand, retail investors lack transparency on the borrowers and loan structures, he adds.
Because private investments are more opaque by nature, the amount of due diligence and ongoing monitoring tends to be labour-intensive, Mr. Soummer says.
Investors must understand the types of loans and where they sit in the capital structure – including the amount and type of leverage and the collateral backing the loan, the nature of the borrower’s business, and the covenants and other legal documents.
Mr. Kuntzevitsky disputes the marketing pitch that multi-asset-class portfolios are essential for every investor.
For those looking to invest new capital, he prefers the expected risk/reward of publicly listed credit funds, some of which have similar holdings to private funds but carry market valuations currently 30 to 50 per cent lower.