As super funds seek enhanced yields, often more complex assets such as private credit and asset-based lending are emerging as a yielding strategy and increasingly the ‘go to’ option.
Whilst the assets might meet investment requirements in terms of target returns, the operational complexities and challenges that are facing investors today are numerous and are best understood from a historical context.
Credit and loan assets gained momentum in the mid-2000’s primarily in the US, as banks exited traditional lending in favour of more exotic methods of generating returns, most infamously of course, trading residential mortgage back securities. With banks focused on big fees from selling RMBS and other customized derivatives, the humble US small to mid-size enterprise (SME) needed somewhere to go for credit lines. Funds stepped into the void, christened by the press with the ominous moniker of “shadow banking”, initially known as asset-based lending or (ABL) in the funds world.
An American SME is somewhat different to an Australian one, with US SME’s having up to 500 employees and up to US$150 million in revenue, meaning there was more room for hefty loans to be made. As the banks exited this space, a number of funds came through that structured and packaged the assets into privately offered vehicles.
As financial markets started to creak, a number of ABS funds failed amid allegations of poor valuation governance and sadly fraud, most notably the “Madoff private credit” world of Tom Petters. Petters ran a US$5 billion fund empire with global clients and now resides – courtesy of the US government – at The United States Penitentiary, Leavenworth after being found guilty of fraud.
Like today, many private credit funds did not benefit from equivalent governance controls to their long only or hedge fund counterparts. In an environment with limited governance, Petters fabricated retail orders from department stores he owned and used them as collateral to borrow more money through the funds.
Fast forward to 2019 and many investors are investing in private loan funds, under the more prestigious title of private credit. They are also incorporating other complex and illiquid assets to make up for low (and negative) interest rates in government bonds. However, accessing these strategies can provide operational challenges.
In a pure operational sense, many international funds are structured as limited partnerships. These funds are not unitized, so investors are ascribed a partnership value and, in many cases, have to work out a unit price themselves. This creates operational risk for the investor, as often striking a unit price isn’t something they do in-house, instead outsourcing to custodians and specialist fund administrators. Thus, spreadsheets are often the go-to tool for a work around with users needing to put in place strong controls (such as locked formulas) to ensure the integrity of the sheet. Often investors sensibly request that their auditors also review the models before going live.
From an operational due diligence perspective private credit funds require in-depth and specialist review. With many managers offshore, the challenge of visiting them is evident and moreover, analysts reviewing these funds should have adequate international experience in the space.
Valuations also prove challenging. With many super funds requiring a daily asset value, typically these funds are priced quarterly and hence there is a pricing and liquidity mismatch to consider. Redemptions, if they are permitted at all, are only able to be made infrequently (quarterly or annually) on long notice periods. Accessing these strategies through open ended structures is not for the feint hearted, not least due to the issue of ensuring that applications and redemptions are done at the correct value.
For many investors, accessing private credit provides much needed yield boost to the portfolio, however, accessing these assets isn’t a simple answer to what is a complex problem. Investment operations and operational due diligence are not one size fits all.
Investors taking the same approach as they make a break for liquid and transparent mandates open themselves up for exposure to the next Tom Petters currently lurking somewhere in the banking shadows.
