My thoughts on private market trends

Despite a decade and more since the financial crisis of 2008, the crisis era policies of those times are still with us—and continuing to expand. In October 2019, the Federal Reserve announced it would begin purchasing $60 billion worth of Treasury bills each month in order to further control its benchmark interest rate. While the Fed noted these actions are “purely technical measures,” the Fed is accumulating assets at a new record rate. There is no denying quantitative easing (QE) played a pivotal role in the current longest bull market in history, but investors everywhere are beginning to wake up to the cold hard truth: growth spurred by growing leverage can never be sustainable.

Nonetheless, the monetary policy that brought us out of a recession continues after a 12-year bull market. Why? According to Ted Rivelle, CIO of Fixed Income at The TCW Group, Credit binges are always popular when the benefits of leverage come today, and the costs of bad debt come tomorrow.”

When Ben Bernanke set QE in motion following the implosion of a financial system characterized by exorbitant credit prices, free-falling asset prices and excess leverage, he never aimed for his policies to lead to the artificial expansion in loanable funds. Despite the Fed’s numerous efforts to curtail this credit expansion, any policy that was once implemented as a response to the crisis can now not be exited without provoking the next crisis. Raising rates and normalizing the Federal Reserve’s balance sheet would be synonymous with pulling the pegs from the bottom of a Jenga tower.

“Monetary ‘stimulus’ offers a siren like promise of effortless prosperity yet ignores the reality that credit binges always sow the seeds of their future destruction.”

– Tad Rivelle, Chief Investment Officer, Fixed Income at TWC

Though QE has been a significant driver of the current bull market, cheap and abundant credit has not ignited an economic boom, but rather artificially elevated asset prices relative to their fundamentals (Exhibit 1). While US corporate profits have been flat over the past three years, repurchase programs fueled by cheap credit have boosted higher earnings-per-share (EPS) and lifted stock prices.

The same phenomenon can be visualized by contributions to S&P 500 price returns during 2019, where 27% of the total return of the market was fueled not by actual EPS growth, but by expansion in the price-to-earnings (PE) ratio that measures a stock’s valuation based on its market price and earnings. (Exhibit 2).

Exhibit 2

While corporate debt levels have boomed during the Post-Crisis Era (Exhibit 3), other areas of the market have experienced similar growth. Private equity assets have ballooned sevenfold since 2002, with annual deal activity averaging over $500 billion per year and the average leveraged buyout (LBO) being nearly 65% composed of debt according to an article in Institutional Investor [1]. Unsurprisingly, covenant lite loans that have enabled private equity firms to purchase businesses at high multiples while maintaining optionality have increased from less than 5% of all newly issued institutional loans in 2008 to now over 80% (Exhibit 4). These loans are issued with fewer restrictions on the borrower and fewer protections for the lender—meaning flexibility regarding collateral, level of income, and payment terms.

Exhibit 3: Non-financial Corporate Business; Debt Securities & Loans

Exhibit 4: Covenant Lite-Loans as a % of All Newly Issued Institutional Loans

However, the rise in private equity’s appetite for corporate debt has been paired with banks sharply limiting their exposure to riskier areas of the corporate credit market, thus creating a void in the market. Enter private credit funds to fill that void. According to Preqin, private credit funds grew from $37 billion in “dry-powder” (capital available for investment) to $261 billion from 2004 to 2019. In an era where investment-grade corporate bonds yield just over 3%, private credit funds bring the promise of high single-digit to low double-digit returns. Despite the allure, historical data does not make a very compelling case for private credit.

Consider the returns for public business development companies (BDCs), publicly traded and regulated companies that allow retail investors access to private market platforms, which have “offered” yields of 8% or higher to investors. In actuality, BDCs returned 6.2% according to the S&P BDC Index—underperforming high-yield corporate debt over the same time period with significantly more severe drawdowns (Exhibit 5).

Exhibit 5: BDC Returns Versus High-Yield Index, 12/31/2004 – 12/31/2019

A central argument for private credit centers around the fact that these loans have experienced significantly lower default rates. However, the risks seem to be obfuscated. In fact, a large percentage of private credit loans are renegotiated before maturity—essentially bringing back to life a loan that would otherwise be headed for the trash (i.e. defaulting). Regardless of this trend, the rate of downgrades in these sorts of loans is appearing to accelerate (Exhibit 6).

Exhibit 5: BDC Returns Versus High-Yield Index, 12/31/2004 – 12/31/2019

Despite fears in the leveraged loan market, Goldman Sachs believes “that worries vis-à-vis the risks posed by the leveraged loan market to financial stability are overstated. But given the current valuations, we think the fundamental weakness and technical fragility of the leveraged loan market are underpriced.” While the melt-up in private equity may be overexaggerated, there are plenty of reasons investors should steer clear—including liquidity (private equity firms generally lock up client capital for 5 to 10 years) and agency costs prevalent between institutions and the private asset-managers in which they supply capital.

If the current environment of sluggish growth and low interest rates persists, a global hunt for higher returns will undoubtedly continue and the boom in private equity assets will follow. A recent study by Steve Kaplan of the University of Chicago and Antoinette Schoar of MIT introduced a metric called public-market equivalent (“PME”) to gauge the merits of private equity. They found that while private equity returns trump those of public equity before 2006, the returns are similar thereafter. This begs the question, why invest in private equity? An asset class characterized by leverage and hidden volatility may prove itself to be a superior asset class, but investors without access to the large institutional investors should stick to simplicity and avoid the allure and fake promises of private equity.

[1] Rasmussen, Daniel & Greg Obenshain. “High-Yield Was Oxy. Private Credit is Fentanyl.” Institutional Investor,https://www.institutionalinvestor.com/article/b1k369v2lg69qt/High-Yield-Was-Oxy-Private-Credit-Is-Fentanyl. Accessed 29 January 2020.

Thanks for reading if you made it this far – Cole

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