Private Credit Funds: Why We Exercise Caution

Eugeniu Chirau

Oct 3, 2024

Private lending has become one of the fastest-growing segments of the investment market since the global financial crisis of 2008. Investments in private debt funds have become mainstream. Investors are increasingly including them in portfolios, expecting higher returns and lower volatility compared to bonds. Large management companies even plan to launch liquid exchange-traded ETFs that invest in non-traded debt and are aimed at retail clients. However, the private lending sector, unlike public debt, is significantly more complex and less transparent.

Private debt funds often turn out to be poor products due to the lack of transparency regarding the actual quality of loans in the portfolio, their valuation, and the fund's control over collateral, as well as managers' tendency to hide problems until the last moment.

Private debt funds, especially short-term ones, are usually created in niches where banks do not operate or have withdrawn from. This is most often argued by the strict Basel requirements for reserves. However, it is not so much about Basel as it is about fundamental problems in the sectors (fraud, ineffective legislation, high share of operational costs). The exit of banks from lending sectors like diamonds or art confirms that even for banks, the industry is too complex.

The yield of private lending most often does not cover the risks, especially when an abundance of money leads to the expansion of the niche market to sizes unnatural for it. Only a small part of it reaches investors. High operating expenses and management fees make such loans too low-yielding for end investors, who, however, bear all the risk.

Investments in such funds are riskier than investments in market instruments due to the lack of effective channels of information transfer between investors and managers, as well as among investors. This problem cannot be resolved without gaining full access to documentation on loans and collateral and information on cash flows within the fund and other companies in the fund management group. Such monitoring is similar to the functionality of teams in banks responsible for the credit portfolio and monitoring the entire situation with borrowers.

Such funds are very weakly regulated, and the valuation of collateral and loans can be done as the management team sees fit. We very rarely encountered funds that make any timely reserves for impairment/revaluation of loans. And even for these funds, the valuation of their assets cannot be confidently accepted as adequate (fair).

Managers usually have the ability to close the exit from the fund even without writing off assets, essentially making investors hostages (they will also pay commissions and expenses). There are no effective mechanisms for investor cooperation and taking control of the fund, especially if the investor base is not represented by large names that could promote this cooperation. This applies to some extent to all funds, but most often to private debt funds.

Older funds can be considered riskier than newly launched ones, as they accumulate problematic assets. Investors, knowing this, will exit them as quickly as possible—at the first signs of problems. Managers, aware of the problems, will close the exit as soon as withdrawals exceed some usually small threshold (as a percentage of assets). As a result, it is not advisable to own any significant share in such funds. Even having a small investment in the fund (relative to its size), it is most reasonable to exit immediately at the first signs of deterioration in the markets where the fund operates, or in the fund itself, or when systematic asset withdrawals from the fund begin.