Private Credit Boom or Bubble? What Investors Need to Understand Today

Hello, and welcome back to another episode of blue Chip NOW!. You have Daniel Dusina, chief investment officer, Matt Mondoux, senior financial advisor, and Erin Goss, chief operating officer. So I will provide a very brief, high level overview of what’s what’s going on in financial markets right now.

Before I turn it over to our esteemed Chief Operating officer, Erin Goss, to unpack what’s happening in private credit right now and what is private credit. So, I want to be brief. Also because I think the headlines are are, well, capturing what’s going on and what’s stoking market volatility at current and over the last month. Realistically, certainly a lot of this volatility we’re seeing in equity and fixed income markets, both in the US and around the world, is due to conflict in the Middle East.

More specifically, you know, US action in Iran. A lot of individuals and investors are starting to price out. What does it look like if energy supply disruption stokes higher inflation? What does that mean for interest rates in the Federal Reserve and so on and so forth. So, with all that in mind, you have US equity indexes down, let’s just call it, you know, for the S&P three, 3.5% over the last two weeks, more severely for your higher growth, more prone to volatility names like the Nasdaq.

So certainly we’ll be watching very closely as developments emerge. It’s very challenging to number one, try to call a bottom with how, volatile the, the Oval Office can be. You saw that at days over the last couple of weeks with massive, you know, opening gains higher because of constructive news flow and whatnot. At any rate, plenty to unpack.

We’ll be releasing our quarterly outlook in, in the next week or so. So we’ll be unpacking that at scale. Very soon there. But let’s jump into the, what I, what I want to have be the meat of this conversation. And it centers around private credit, which has really taken center stage over the last. Let’s just call it month or two.

Erin is very well equipped to have this conversation. For those of you who don’t know, she’s our chief operating officer today, managing a ton of different aspects within our business. But in her prior life, she was deeply involved in illiquid assets, alternative investments. She helped to build Plant Moran’s alternative asset platform, over almost a decade.

Erin. Is that right? So I think there’s no nobody better. Certainly at blue Chip if not in the southeast, metro Detroit or, sorry, southeast Michigan area to to have this conversation and provide some education and intelligence. So without further ado, Erin, I think I’ll let you start wherever you want, but maybe it makes sense to to start thinking about or discussing what even is the background on private credit, what is it and where did it emerge from?

Absolutely happy to be here. So I think even if you don’t invest in private credit, there’s a lot of important lessons that can be learned from what is going on right now. Lessons about liquidity, which means, you know, when can I get my money out of an investment? Investor behavior and really knowing what you own, not just do I own stocks, but how do I own stocks if I invest in a fund, what does that look like?

And how does that operate mechanically? So, the headlines are surrounding private credit. A little background on the space. After the global financial crisis, banks became much more restrictive in the loans that they could make, in particular to small and midsize companies. So that really did create a gap in the market for those who had capital to lend.

So, the asset management industry stepped up, to fill that void and really sought to tap private investors to pool together their capital to make loans to companies and private credit, positioned themselves as being able to make loans to companies faster than banks, maybe on more custom terms, and just allowed more flexible financing. Which again, made it attractive to, companies from an investor perspective.

Private credit also offered a lot of benefits. They offered higher return potential. These loans, often mature and maybe 5 to 7 years. So usually if there is some, illiquidity to an investment, you want to make a higher rate of return. So these were pretty attractive interest rates compared to other publicly traded fixed income, alternatives.

There were also relatively low default rates, at least with the data that, that we’ve had weren’t a majority in to like asset backed. So they were collateralized at least in the beginning. Exactly. You know, ten years ago. Yes, yes. So, a defaults if on a loan means that the borrower does not pay it back, as you know, the, the, lender expected you didn’t have a lot of that in this space.So, the returns that were being offered, you know, investors had a lot of faith that those were being paid back. And the other thing that needed attractive was the interest rates were floating. So this market really, really expanded. You know, coming out of Covid when interest rates were very low. And when your interest rate floats, that means it adjusts with the market.

So if if interest rates broadly are going up in the market, then your loan, you are now, making a higher interest rate on that same loan. And so again, in a period of very low interest rates, that was extremely attractive. So the growth in the private credit market has been exponential, very much faster than many other traditional fixed income areas.

So here we are today. Yeah. I mean, I can even personally attest to some of my viewpoints on the growth of this specific industry. I mean, there was a period of time, let’s call it, in 2023 when I was getting, let’s call it, on average, five emails a day from boutique private credit managers who I’ve never heard of, who have apparently been doing this for 30 years, telling me how I need exposure here.

It was very evident in terms of just the sheer uptick in number of points of contact. I was, I was receiving. But also, you know, that aligns with this democratization of private credit and other illiquid securities, these types of investments were previously not generally available for the average Joe, for the average retail investor that has changed meaningfully over the last five plus or so years.

And so I think that is pertinent to this conversation as well, because my next question is really, Erin, like what is making headlines right now? Why are you seeing private credit become one of the busier topics this year? Yes. So as Daniel mentioned, there’s been, a lot of product innovation, a lot of investment vehicles that have launched over the past couple of years that didn’t exist before.

And, really because of the popularity of private credit, you’ve seen asset managers try to make it more accessible to, investors that have been you know, typically trafficked in this space. So there’s a lot of these funds, and we’ll get into the fund structures a little bit more later. But let’s back up to like, let’s clarify. They are selling these private investments to retail investors.

There’s these are high fee products. These are not the nearly free low expense ratio ETFs. Yeah. Well it’s also you know from their perspective I don’t know if you can technically classify as doubling their total addressable market, but it’s meaningfully expanding their total addressable market. So this is don’t don’t mistake this for just a sheer favor from these investment managers.

Like, the more they can correct any of this. Yeah. Snowball effect. Yeah. So the headlines really are around some of these private credit funds that have launched in the past couple of years from big names like Aries, Apollo, Blue Owl. They are seeing an increase in redemption requests from their investors. So investors are asking to get their money out.

And again, as Daniel mentioned, and I’m sure you’ve heard on on the podcast all year, there is some concern about, defaults picking up, in particular in the software space, AI is disrupting our world, as we’ve talked about a lot. And so therefore there’s some concern with private credit funds in particular, given that, some estimates would say that in aggregate, private credit is exposed, you know, about 20% to the software sector.

So to Matt’s point, earlier, you know, software companies, they don’t have a lot of assets backing their businesses. So if a company gets into trouble and they need to pay their lender, what are they going to sell? Right? These are very asset like businesses. So and that’s like I think the evolution of this space. Right. Because I from my recollection back when I was, you know, strictly more on the asset management side, prior roles, this was more of a collateralize manufacturing brick and mortar type lending structure.

This was never I don’t ever remember that being software companies. Exactly. Yes. So I will say default rates on private credit. You know, over the past year or so they are still remaining very low. You’ve seen a little bit of a tick up, but it’s not, you know, earth shattering concern. I think the concern is more what is it going to look like in the future?

And therefore that is changing investor sentiment around many types of investments. But these in particular now the structure of these funds is really important. Many were designed with this idea. They either have to or they intend to offer some limited liquidity to their investors. It’s usually up to about 5% of the funds value per quarter. Now, what is happening now is that more than 5% of the fund’s value wants to get out.

And therefore, you’ve seen some of these investment managers not be able to pay back, their investors, you know, right away. And so what is happening is some of these funds are getting into redemption queues, where it might take a couple of quarters to pay this out. We don’t know. This is how these funds are designed. If you knew that this may not be a surprise, but you don’t want to think, you know, a stress scenario will happen.

So the funds are doing what they’re supposed to be doing, but you very much are seeing, you know, some stress on the, assets in the fund. And are they liquid enough to meet all these redemptions? And again, are investors going to come back to these funds if they’ve had a bad experience or the experience that they didn’t expect?

Right. And into my eyes, some of this you can you can attribute to just a classic snowball effect. So what happens when you introduce a higher population of retail investors to an illiquid set of vehicles. You run greater risk of people making knee jerk reaction investment decisions and that’s why I say it’s the snowball where, more people hear about what’s going on, more people that are prone to get nervous, try to sell some of those other investors, see the redemption gates being involved, and then they try to sell.

It’s this it’s this challenge that these investment managers are going to be facing in perpetuity. Now with offering these vehicles to retail investors. Yeah, let’s let’s, you know, have a, you know, investors. Imagine this. So you’re retired. You’re you’re maybe selling some some stocks or you want to buy a house or do vacation home, whatever you want to do and you want to sell this fund.

And just because right now the conditions, the market really isn’t great for this fund. You wanted to, you know, raise some cash for some other purpose. You’re struggling to do that, and then you’re forced to sell other parts of your portfolio that you might not want or you never intended to sell. So, you know, it can have some effect on just how people operate their day to day financial lives to when these periods of stress occur.

Right? Liquid markets. I think another interesting structural point about these funds is that redemptions usually are met on a pro-rata basis. Meaning the more that redemption Q builds, you know, the less investors, you know, get out just because you put in your redemption request first doesn’t mean you get honored first. Right? So that is this prisoner’s dilemma that’s going on.

You know, what are advisers and clients thinking about that are investing in these funds? If I don’t get out now, what’s going to happen? Will you know that my guess is these Q’s are probably going to get bigger before. Yeah. I mean, we should have said this to begin with. You know, disclaimer, this is another area of the market that we just focused on.

This isn’t something we’ve utilized in client portfolios. So so yeah. Disclaimer you know, we we generally do favor the more liquid spaces of markets. Yeah. So so here’s the thing. You know I we’ve talked about how the retail boom in in alternative assets has occurred over the last 3 to 5 years. The democratization is certainly a good thing.

More access for more people. I think it’s great. Now, you can literally go online and Google my name and search city Wire. And what you would find is an interview I did three and a half years ago that talks about pushing back on this democratization, pushing back on the need for every retail investor to have exposure to these assets.

It really relates back to two things. And I’ll explain why this is still relevant today. Number one, with so many new investment managers emerging to try to take advantage of the boom in this space, I would certainly hate to see one of these smaller managers reach for a deal to fill their allocation. And that goes bust. And, you know, it just gives a black eye on the industry as a whole.

And I would also very much hate to see a lack of education, you know, from advisor to end client, which it’s hard to say, but I think realistically is is happening has happened and will continue to happen unless it’s confronted head on. The education side of things is arguably the most important, and you probably wouldn’t be seeing as big of redemption pressure as we are.

If the advisor community at large educated all clients that are exposed to these properly beforehand. Not right now, but three years ago when they got slotted into this thing. So Erin, like, I mean, how do you if you’re going to approach an education conversation on private credit or other illiquid assets for a, general retail investor, where would you start?

I mean, a lot of the stuff you’ve talked about already, right. But what else? Yeah, I think it’s just not, underestimating the the tail risk, the, you know, these funds try to offer, you know, 5% or whatever their, their amount is of liquidity per quarter. But what if they can’t, right. And preparing investors for the possibility that.

Well, under, not normal circumstances. Right. You may have to sit in this fund for a while. So yes. I don’t, you know, want to see that happen for you. But if that is the case, could you sit in this fund for three years? Right. And I’m not saying that’s going to happen, but, that would probably weed out some investors just if you ask them that hypothetical question in the first place.

Right. Or again, maybe you buy less of it than a lot of clients probably have now. Right? So I think Daniel, to your point, just because the investment minimum or the investment vehicle is accessible to you, many of these funds have very low minimums. Right. The other way you can invest in these funds is, again, those traditional kind of private funds that lock your money up for 5 to 10 years and you have to invest $1 million, right?

That’s not practical for most people. So many of these semi liquid funds that are in the headlines today very accessible. You know, the whole sales process is there, right. Easy tax reporting, possible quarterly liquidity $10,000 minimum. It still doesn’t mean even though you can access it that you should or you are a good fit. Right. So I really do think it is, the advisor community, to again, thoroughly explain and touch on the worst case scenarios.

And again, you know, make sure you know your clients. Right. You don’t have to bring all of these things to every client. You got to know if your client is skittish, or would they be upset if they had to sit in this fund for two years? I think that’s a big thing. You know, it’s up to advisors to kind of know their clients.

It’s easy for somebody who is looking to some else for guidance. But yeah, I know that sounds fine. Yeah. Like 11% sounds great. Yeah, I can handle it. But when the advisor knows well, every time the markets do dip right, you’re you’re calling you’re nervous. I think that’s right. Advisors jobs. Yeah I, I do want to defend the structure of these funds a little bit because when you have a run for the door, you don’t want these investment managers to have to liquidate everything, right?

That’s only going to force them to sell assets at bargain prices. Right. So the fact that they can only or they’re only expected to redeem a little bit of the fund, despite the fact that more of their clients want to get out, is actually a good thing in the long run, right? They have this balance of kind of duty between the clients that are trying to get out and the ones that aren’t.

They still have a fund to run, right. So again, I think the structures are designed okay. It’s just the are the clients that are in, actually the best fit. Right. So we’ll happen to see, you know, we’ll see as this plays out. And we’ve seen this before, I mean, a couple years ago, Blackstone has a semi liquid real estate fund called very same thing.

They had a run on redemptions. There was some concern. They actually had a large institutional investor infuse some cash in the fund to help meet redemptions. Managers have tools to try to manage themselves out of this. So again, I you know, I wouldn’t be surprised if we saw more of those creative solutions this will be an opportunity for somebody to come in and, you know, maybe rescue this space, I guess.

But so again, I think it’s the funds could work probably in too many portfolios. But again, I just think some investors who are having this experience right now probably won’t come back. Yeah. Yeah. And that’s again that like black eye on the industry that perpetually will be a concern of mine any time we get these call it shiny new objects that emerge today.

It’s private credit. I’m not going to be able to say what it will be tomorrow or next year, but this is a business and businesses will take advantage of that. Right? So, I think this is all really helpful education because obviously private credit has been very much in the headlines. I think it’s very much worth understanding the space, at least at a surface level, regardless of what size of investor you are.

Again, these are tools that are now available to the bulk of individuals and institutions. So it’s worth understanding. We’re always happy to have conversations from an educational perspective. It’s one of our unique attributes at blue Chip. I think that should be well understood. So, Erin, before we close out this conversation, anything else to add? Any final points?

You know, I think private credit as an asset class will survive. I think the need is still very much there. For this particular strategy. Like any type of credit cycle, we will some see some defaults, like we always do. Right? And if you’re in one of these funds, you hope that your investment manager did a good job underwriting these loans, and they stressed them and understood, you know, what they were buying.

I think it’s just know what you own. Know what you own. Just because you can get into something doesn’t mean you should. And, you know, liquidity is not certain it’s there until it’s not. And, you know, yeah, just take your time upfront understanding, especially when you start investing outside of your liquid markets. That’s well said. Well thanks so much for joining us, Erin.

I think this conversation, like I said, is very relevant to just about everybody. So worth a listen. Share with your friends. Until next time. This is blue Chip now signing off.