By Richard Quin, CIO and Principal, Bentham Asset Management
October 2022
Fund structure plays an important part in the performance of credit funds. A well-structured fund supports pricing transparency, liquidity and fairness for unitholders. This series by Richard Quin from Bentham Asset Management discuss fund attributes. Part 1 showed what a well-constructed, open-ended credit fund should look like. Part 2 continued on with lessons to be learned from past failures and this article concludes the lessons and lists key investment considerations.
9. Measuring volatility
The volatile markets of March 2022 have generated debate about the “volatility” added to portfolios by actively traded and revalued assets, such a liquid credit markets, vs the “smoothing” impact of holding private assets, such as private debt, which are not regularly revalued.
In times of ample liquidity, illiquidity premiums tend to be small. When liquidity tightens, illiquidity premiums increase. The risk is that the true valuation of private assets will suffer from that additional discount.
In our view, choosing not to revalue an asset does not reduce the asset’s volatility, it simply hides it. The asset’s volatility is replaced with a different risk: that an extreme price movement eventually occurs when a revaluation is forced by an adverse credit event.
10. Accrual valued funds can turn into mark-to-market funds at the most unfortunate times
Funds using Accrual Based (AB) accounting can become a mark-to-market fund at the most unfortunate of times. Investors can receive a nasty surprise with a significant negative gap in their unit price. The fall should be roughly equal to the change in market price plus a present value of fees which the fund is obligated to pay (for a closed end fund). Initially in a market sell off, funds using AB accounting are outwardly unaffected. However, it is not uncommon after a period of market underperformance that some investors redeem their holdings, leading the manager initially to sell liquid holdings to meet the initial unit redemptions. The remaining investors are then left with the more illiquid, concentrated positions.
Key Takeaways:
- Valuation catch ups are uncertain and can be large and negative.
- Beware large gaps in Net Asset Valuation to trading prices
11. Transparency of economics and alignment of interests
All economics from the fund’s investments should be for the benefit of the fund. We believe this should include the obvious principal and income payments on bonds and loans, but also any fees or discounts associated with originating or purchasing assets.
We have been surprised to hear that some credit funds have been taking loan upfront or arranging fees for the benefit of the manager, rather than the fund. These fees can be substantial, and not passing these on in full to the fund could give rise to a conflicted situation whereby the loan margin is reduced to increase the loan upfront fee (benefiting the manager, harming the fund investors). Usually the discounts/upfront fees are higher the riskier the deal (reflecting the difficulty in underwriting). This could result in a perverse incentive where a manager pockets the higher up-front fees, while the investor is left with a riskier loan and possibly lower coupon.
Key Takeaways:
- The full economics of an investment should flow to the fund.
- Transparency of economics is important to ensure alignment of interests
12. A fair buy-sell spread protects all investors (fair allocation of transaction costs)
A buy-sell spread is a cost paid by investors upon investment into or redemption from a fund. It represents the underlying transaction costs of buying/selling assets (bonds or loans) to fulfil a new investment or fund a redemption.
Buy-sell spreads are not management fees, and do not get paid to the fund manager. Buy-sell spreads are paid to the fund – for the benefit of existing unitholders.
As the underlying costs of transacting assets can change over time, we believe the buy-sell spread on a fund should vary accordingly according to market conditions. All things being equal, trading costs increase during times of stress and lower liquidity (wider buy-sell spreads) and decrease during the good times and higher liquidity (tighter buy-sell spreads).
The purpose of buy sell spreads is to protect long term unitholders from bearing the cost of trading from other unitholders entering or exiting the fund. As such, we believe that an active buy-sell spread should be seen as a beneficial structural feature for long-term investors in a fund.
The value of an active buy-sell spread is most obvious in times of market distress, where limited liquidity may make transaction costs sizable: an exiting investor who withdraws capital from a fund would otherwise be able to burden the remaining investors in fund with the costs of their exit.
Bentham monitors buy-sell costs on underlying assets on a daily basis, and adjusts the buy-sell spread on our funds monthly (or as required).
We are disappointed to still see open credit funds in Australia with a +0bps / -0bps buy-sell spread – failing to fairly allocate the costs of transacting to the investing / redeeming party. We note that funds which do not have an active buy-sell spread may instead apply ‘swing pricing’ when market liquidity becomes an issue. Swing pricing swings against an investor removing assets when liquidity is tight (e.g. application 0% / redemption 2%).
Key Takeaways:
- Buy-sell spreads are not a management fee.
- Buy-sell spreads aim to allocate the trading costs of investment / redemption to the investor making the investment or withdrawal, protecting long-term investors from bearing these costs which can fluctuate over time.
- Bentham believes the best practice is to match the buy-sell spread to current market conditions and has adopted this as a formal policy.
- A buy-sell spread helps prevent preferential treatment for investors able to game or arbitrage mis-priced funds.
13. A note on the Australian hybrid market
The Australian hybrid market has some unique features which warrant consideration before including such securities in an open credit vehicle.
While Australian hybrid securities are predominately listed on the ASX, this does not guarantee meaningful liquidity. Many of these securities have low turnover relative to other listed and unlisted credit and fixed income markets.
As franking credits can only be utilised by domestic investors, the buyer-base for hybrid securities is typically limited to Australian investors. The investor base may be further reduced if legislative changes are made limiting cash refunds of excess franking credits for individuals. A narrow investor base limits liquidity – particularly in difficult market conditions.
Key Takeaways:
- ASX listing does not guarantee liquidity.
- Larger funds relying on ASX liquidity may be disappointed.
14. MTM valuations impact broader exposures
Lack of mark to market valuations can mask real exposures. Beyond unit pricing concerns, there are knock-on effects for investors who are measuring and hedging aggregate exposures such as currency and duration.
How to Invest in Private or Illiquid Assets
As discussed throughout this paper, private or illiquid assets are not suited to open credit funds. This doesn’t mean that private credit assets can’t have a place in an investor’s portfolio, but the investment format needs to align with the nature of the private assets.
Key considerations should include:
- Investment timeframe: does the investor/ vehicle’s time horizon match the tenor of the private assets? Can the investment be held until realisation if required?
- Fair terms for pooled vehicles: are the gates, application and redemption terms firm and fair? Are the rules the same for all investors? Can anyone transact on stale prices?
- Illiquidity premium: is sufficient premium being paid for the portfolio’s illiquidity? Note, the illiquidity premium is not constant, and requires monitoring. There is no free lunch: the price for the additional yield on private debt is illiquidity and the inability to maneuver.
- Commitments are equivalent to negative liquidity convexity, i.e. calls for liquidity usually occur when liquidity is at a premium.
