Two European ETF chiefs question suitability of illiquid private assets for ETFs. By Chris Flood, chief correspondent, ETF Stream.
Credit is due to Stefan Hoops for his frank assessment that including private credit strategies inside an ETF is an innovation that investors should be dubious about.
Speaking during the first quarter results for DWS, the boss of the German asset manager said that he personally was ‘a bit more sceptical’ about whether an ETF offering daily liquidity was the appropriate fund structure to deliver illiquid private credit strategies to investors.
Hoops noted that mixing exposures to illiquid private loans and publicly traded bonds could present problems if investors were pulling their money out of an ETF holding private credit in a stressed market situation.
This would force the ETF manager to sell the liquid public bonds and potentially leave the remaining investors with a larger exposure to private credit.
How private credit loans that do not trade regularly can be valued accurately in a volatile market environment is another unresolved question for ETFs that are designed for continuous intra-day trading.
The candour expressed by Hoops is particularly noteworthy because DWS and its majority owner Deutsche Bank announced as recently as March that they would work together to bring more opportunities to invest in private credit to clients of the asset manager.
The agreement will allow the alternatives division within DWS to have preferred access to certain asset-based finance, direct lending and other private credit asset opportunities originated by Deutsche Bank.
How an external investor can accurately assess that transactions involving these assets between DWS and Deutsche Bank would be done at a fair price remains unclear.
The scepticism expressed by Hoops is shared by MJ Lytle, the head of Janus Henderson Tabula, who also questions the suitability of illiquid private assets for ETFs.
“My biggest concern is that we [ETF managers] get into some sort of exposure [private asset investments] that we are not supposed to be in. We are not supposed to take illiquid private assets into a daily liquid vehicle and then to say ‘we will figure out a way to make this liquid’. They [private assets] should be in a closed-ended fund,” said Lytle, speaking at the ETFGI Global Insights conference in London this week.
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In the US, the partnership between State Street Global Advisors and Apollo behind the creation of the SPDR SSGA IG Public & Private Credit ETF (PRIV) has attracted scrutiny from regulators.
Apollo appears to have been employed as the pricing agent, buyer and seller of Apollo sourced private credit investments for the ETF, a clear conflict of interests.
Conor MacWilliams, the founder of Cape Cod-based Outer Beach Consultants, has recently filed a complaint with the Securities and Exchange Commission over the accuracy of the valuations of private assets held by PRIV.
“There is no way for a retail investor (ME!) to look at their market valuation assumptions and verify them,” said MacWilliams. He has written a series of lacerating Substack posts, complete with occasional profanities, about PRIV but repetition of those criticisms has been vetoed in similarly robust terms by ETF Stream’s editor.
But the potential rewards – profits – for asset managers that can “democratise” private assets for mainstream investors are just too big to ignore, according to Boston Consulting Group. It foresees a period of “significant experimentation” in the years ahead with investment managers pushing private assets into active ETFs, model portfolios, interval funds and evergreen vehicles.
Larry Fink, the head of BlackRock, has suggested tokenisation will offers a solution in the future to the liquidity challenge as dividing the ownership of an illiquid private asset into multiple smaller shares could allow these units to be more easily held inside an ETF.
However, multiple practical difficulties confront managers that are currently trying to marry private debt and public bonds in a ETF wrapper. Hedging such products will be difficult for market makers. This will mean that trading spreads – the gap between buying and selling costs for ETF units – are likely to be extremely wide.
Vanilla ETFs that hold publicly traded equity and bond markets rely on healthy two-way flows – interest from both buyers and sellers – to help them track their underlying indices accurately. But uncertainties over the pricing any private debt held by an ETF in combination with high trading costs will increase the risk of trading losses for investors.
In addition, no asset manager has explained clearly how a winding up process might work if an ETF holding private assets were forced to close. Presumably investors would be locked in until those private assets matured or could be sold on.
More broadly, the push to include private assets inside ETFs is occurring at an increasingly challenging time for illiquid investment strategies.
The IMF last month pointed out that nearly half of the companies borrowing from direct lenders, including private credit funds, were running with negative free operating cash flows during the final quarter of last year.
These companies are increasingly relying on payment-in-kind provisions where interest payments are deferred and added to the final debt bill or amend-and-extend restructurings. Such developments – better known as ‘amend-and-pretend’ arrangements which increase debt burdens – have prompted more questions about the valuation practices of direct lenders, according to the IMF.
It also cautioned that private equity managers are loading additional debt onto their portfolio companies via direct lending facilities in order to raise cash that can be returned to their clients.
It is clear then that the risks of defaults for all investors in private credit are rising at the same time as the drive by asset managers to include these illiquid assets in ETFs is growing.
