Private markets continue to grow in scale and influence, offering new sources of investor return and diversification. This part transcript is from the recent Jana Investment Advisers Conference and features Marc deBree, Head of Real Estate and Alternatives at TIAA General Account and Shirley Luo, Portfolio Manager and Director of Opportunistic Credit Research at Shenkman Capital.
Q. The rise of private credit has occurred at pace. Regulators, however, have raised red flags, citing valuation practices, setting valuation lags, timing gaps and core benchmarks. In addition, we’ve seen the rise of evergreen structures targeting the smaller investor groups. Headlines grab our attention. Private markets are eating the world. So, what should we make of all this, and can we answer the question, is a storm brewing?
Mark:
I work for TIAA, Teachers Insurance Annuity Association. We’ve been around for about a hundred years. We were founded to meet retirement needs of educators in the U.S., the university faculty and staff. That continues to be what we do today. Our primary product is an annuity product, so fixed-rate annuity product.
The nature of that product helps understand how we think about investing. So, two key components:
- One is that our annuity contracts have a guaranteed minimum annual payment. The reality of that means we need income to distribute, year after year after year. That forces us to lean pretty heavily on fixed income, often in the public space. At the same time, those contracts are very long-dated, they’re fairly predictable, and they tend to give us pretty good insight into liquidity needs. So, we tend to be able to take a liquidity risk because of the nature of the liabilities. The desire to drive returns for our participants, and the willingness to take liquidity risk, those pieces come together, and that drives a lot of our private sector investing.
The TI general account is roughly US$300 billion of largely fixed income investments, but equity as well. We use both private and public strategies across the fixed income portions of the portfolio. The equity piece is private, we don’t have any public equity investing strategies.
Also read: Private Debt at a Critical Juncture
Year after year, the fund keeps increasing its allocation to private markets. Its mix of fixed income assets is 46.9% to public fixed income, 36.3% to private fixed income and 16.8% to private non-fixed income.
- Volatility is something we’re generally trying to avoid. We want stability and broadly use both public and private markets. They’re both critical tools for us in meeting different needs and matching with our different liabilities. Broadly, our allocation to public markets has declined, while private market allocations have increased.
Q. Shirley, could you please comment on what you’ve seen and your views on the convergence of public and private?
The direct lending portion of the private credit market is already approaching US$2 trillion dollars and that growth has compounded each time that we’ve seen volatility in the public market, whether it was during COVID, whether was during 2022. Where rates were sharply higher, private credit stepped in and has really proven itself as the alternative funding venue for issuers and for sponsors.
We see the two markets complementing each other during times of volatility. During times of stability, they behave more like competitors.
The competitive attractiveness of these two segments will ebb and flow. But the blurring of the lines is getting more profound. For example, some of the private credit deals today have public deal characteristics:
- They’re much larger
- No longer have just three to four investors on day one.
- On the public side, some of the deals are already fully backstopped, fully reversed.
- A lot of times, you even see issuers behind the scenes actually want a dual track between the two markets.
So, I think, we’re reaching equilibrium in which it’s up to the issuer to decide:
- Do they want lower cost of the financing? If so, go to the public market.
- Or if they want a more tailored financing solution, then go to the private market
The two markets are not interchangeable yet, but they are converging. As investors, and as allocator, you almost have to have exposure to both markets now, because you end up having a lot of these same issuers or same type of credit risk.
I’m going to make the argument that the are markets are close to converging. This example happened just a couple of week ago.
In 3Q23, US company, Finastra left public markets and borrowed in the private market. Eighteen months later, the company came back to the public market, saving about 200 basis points (2%) in financing costs. During that time, nothing changed at the company, but the market dynamics evolved, there was more convergence. Both public and private markets are needed. The extra reward for investing in US private credit has declined to around 100 basis points but I think it could tighten even further to around 75 basis points.
Effectively, the punch line is that as investors and as allocator, you almost have to have exposure to both markets now, because you end up having a lot of these same issuers or same type of credit risk. They’re just going back and forth between the two markets which benefits private equity (PE) sponsors on one hand, because it allows PE sponsors to effectively pick and choose which market they want to tap into, based on the business cycles of their underlying portfolio companies.
At Shenkman, for example, we manage both private and public strategies. On the public side, we manage a strategy in which we take advantage of volatility, and it’s particularly designed for us to capture spread and therefore be able to buy credits at discounts to par and, therefore, become comparable in return to private credit. And more importantly, in today’s context, complementary, we think, to private credit.
…I think the motivation and the notion behind it has just been, how do we open the private-credit access to retail and to also investors? I think that notion in itself is already a really well-established one. The one quick thing I’m just going to add to that is that it doesn’t really matter which asset class we look at, just in any history of any asset class. Whenever we are adding retail flows into things, it’s just going to be unavoidable, that we’re going to be also introducing volatility to it.
Q. Private credit investments are unlisted assets in semi-liquid structures, which yes, needs to be well understood by the investor base. I want to ask about some of the concerns specifically. We touched briefly on valuations, lack of transparency and this issue around liquidity.
Mark:
Those are real concerns. And addressing them, being mindful of them, is a critical part of investing in private assets. The governance is different, the liquidity is different, the benchmarking pieces are very different.
In terms of liquidity, we’ve been really successful using the secondary market as a bit of a portfolio shaping process, as well as an exit strategy. We recently took $800 million of private equity investments. We took pieces of different tranches, co-invest and leverage buyout fund strategy and we kept 50% of ownership for ourselves and put 50% out to the market. We’re not fleeing the portfolio, we’re just trying to create liquidity. We were able to achieve par pricing, which is quite rare. We’re currently looking at another smaller portfolio. I don’t think we’ll get that same pricing that will have quite the market appeal. We’ll have to pay discount to par value. But that will be the trade-off that we have to pay to create liquidity and balance portfolio needs.
Q. If there’s a need to liquidate investments quickly. Will investors get back a hundred cents in the dollar? What are your thoughts on that?
Shirley:
Within private credit, the answer is, it depends. And especially depends on what vintage of deals we’re talking about. On average, a private credit deal is about six to seven years old. We’re still sitting on some 2021 vintage deals. If it’s a portfolio with a lot of those COVID vintages, the answer is probably no.
Mark:
On the exit, we talked about secondary exit. We have the illiquidity premium. But sometimes, people can be a little surprised when they’re trying to exit something outside the normal window of exit and they have to give up some return. If you find yourself in an environment where you have to break the expectation of how long that investment is being held, you’re going to give up that premium that you were looking for, because you’re looking for liquidity.
Shirley:
The issue with private credit or direct lending in particular is that as an asset class, it really hasn’t gone through a real downturn yet. But now that it’s close to $2 trillion in size, very mature now. We actually now see 82% of private credit deals now are single-B type of risk or below.
So, a lot of lower-quality credit risk went to the private side. So, I think the next economic downturn, or whenever that’s going to be, I think that’s really going to be at the time in which that 100 basis points premium is going to be retested or reset. It’s really hard to know, sitting here today, what that number will be in the future. But whenever that is, and depending on the shape of the private credit market, you just have to go through it to know.
Shirley:
Within private credit and also public as well, the definition of defaults today is evolving and continues to evolve. On the public side, defaults are now including things like liability management, which is effectively … Oh, it is, is PE sponsors taking advantage of the loopholes in the docs and kicking the can down the road and buying time option. And then on the private side, the equivalent of that is you’re seeing more amendments, more waivers. More companies that used to be cash-paying now they can’t afford it, so they’re going to payment-in-kind. So I think when we’re thinking about benchmarking as well, on the private credit side, you have to factor in this evolving dynamic of the new defaults in your analysis.
