Why a Lack of Fear Around Private Credit Won’t Protect Investors From Risk

On this episode of The Long View, Mark Higgins, author and senior vice president for IFA Institutional, discusses his fears around the exponential rise of the deficit, how active management has performed historically, why the central bank needs to operate independently, and what financial history can tell us about where the US is headed from his book Investing in U.S. Financial History: Understanding the Past to Forecast the Future.

Here are a few highlights from Higgins’ conversation with Morningstar’s Christine Benz and Amy Arnott.

Why the Cycle of Asset Classes With Unrealistic Return Expectations Will End With Retail Investors As the Target

Amy Arnott: We wanted to spend a bit of time talking about the current market environment. And you’ve written about the dangers of unrealistic return expectations. And that’s something that really hurt institutional investors going back to the 2010s because they overloaded on asset classes like hedge funds and private equity. Do you see any similar issues brewing with those asset classes today?

Mark Higgins: I think it’s worse. So this goes all the way back. You have to go all the way back to the early 1980s when alternative investments like venture capital, which was desperately needed back then to fund the computing age, and buyout funds, they had a lot of tailwinds at their back, back then because of declining inflation and interest rates and rising equity valuations. So they got monster returns. That’s when David Swensen came to Yale in 1985. He got in on that early. And he generated amazing returns for the Yale University Endowment. And then he published a book in 2000 called Pioneering Portfolio Management. And he didn’t say this, but a lot of people interpreted the book as if I just allocate to private equity and hedge funds and now private credit and venture capital, I can get Yale-like returns.

But they dismissed the fact that he was, and his organization was, uniquely talented early and he was a great teacher and had great access. And so it really started ramping up in 2000. And now you’re to the point where there are trillions and trillions of dollars allocated to these asset classes, and there are clear signs that it’s overallocated. The distributions have dried up. There’s an article in The Wall Street Journal that I think is about 30,000 companies awaiting exit. And now you have this push. The institutions are getting out. A lot of them are selling assets in the secondary market, including Yale, by the way. I don’t know if they’ve executed the sale, but they were looking into it. And now it’s being marketed to retail investors in 401(k) plans and defined-contribution plans. And what people don’t realize is that this is not the beginning of a cycle. This is the end of the cycle. And what is typical of the end of the cycle is that retail investors are the targets. And that’s what’s going on now. And it’s very concerning.

Why the ‘Lack of Fear’ Around Private Credit Should Be a Warning to Investors

Christine Benz: You’ve been particularly skeptical about the return prospects for private credit. So maybe you can talk about what are some of the warning signs that you see there?

Higgins: It’s just that if there’s one thing I can put my finger on, it’s the lack of fear. And you have seen some fear pick up a little after the bankruptcy of First Brands. But there’s just this general perception that there’s free money to be had here. And what happens in these situations, which has definitely happened here, is you have some kind of false narrative that you hear all the time, well, there’s so much private lending needed because of the aftermath of the 2008-2009 global financial crisis. Well, that happened 16 years ago. That was legitimate in the early years. I don’t buy it now. And it’s just the herd instinct. People make monster returns at a time where it made sense—there was a legitimate gap in the market, which there was after the global financial crisis.

And then the herds descend, yields decline, people start underestimating risk, and it breaks. And look, if I’m wrong, I will be the first to admit it. But I don’t see how we’re not near the end of this cycle, much closer to the end of the cycle, rather than the beginning. And can I put my finger on specific data that indicates this? Well, I can, but it will take a little longer. And a lot of this is with financial institutions. You see big patterns. You don’t necessarily see one data point that is fatal. It’s the pattern. And that’s the pattern I see.

Arnott: And with private credit, I think people look at the yields available on some of those funds. And I don’t know if they realize that the default rate is actually pretty high. I think I was reading something this morning where the default rate on private credit is something like 10%. So, hopefully the First Brand’s bankruptcy will be a bit of a wake-up call. But it seems like people are just focused on the return potential and kind of turning a blind eye to the risk side.

Higgins: Yeah, I think it’ll break. But we’ll see.

How Loopholes Are Quietly Inflating Private Markets

Arnott: So you were talking about patterns. And another thing you discussed in the book is the six different phases of an asset bubble. And I think if you look at the market right now as we’re taping this toward the beginning of October, you could point to a bunch of different areas that might seem a bit bubbly: US stocks, bitcoin, gold, artificial intelligence. Are there any asset classes that you think people should be especially worried about at the moment?

Higgins: The one that worries me the most is private markets. And I’ve written about this recently. I’m converting a newsletter that I did on the evergreen funds that are basically investing in private markets. And I laugh about this, but it’s actually not funny. It’ll be funny in like 30 years or something. But it’s amazing what they’re doing. So what they’re doing, and now there’s a big push to go into defined-contribution plans to hit the retail market, which is that in and of itself is a red flag. And what these funds are doing is they are investing in secondary positions that a lot of the institutions are selling for reasons that we discussed earlier that there’s too much capital there and not enough opportunities. And the evergreen funds are buying secondary positions. And then there’s this obscure accounting rule that was established in 2009 when secondaries were a very, very small market and the market was legitimately distressed because of the global financial crisis.

So there’s this thing called a practical expedient that was really just for reporting purposes. When you buy a secondary position and the general partner is reporting an NAV that differs from what you paid for the secondary position, just at a convenience for it to make reporting easier, you’re allowed to literally in one day mark it up to the NAV. So what a lot of these funds are doing is they’re starting by buying some direct investments but buying a lot of secondaries, immediately marking them up using this practical expedient and reporting these very big returns. And it, I mean, it doesn’t take a genius to figure out the problem with this. There are a lot of problems with it. The biggest problem is the only way to maintain your returns is to keep buying bigger and bigger slugs of secondary so you can get those one-day markups. And a lot of people, it’s surprising, but a lot of people just don’t know that this is happening, that not only are these returns potentially—I would argue that likely—are not real because people are getting rid of them for the reason that a lot of them have multiple bids now. There’s evidence they’re overpaying for them.

And then on top of that, they’re marking them up to levels that may never be realized. And some of the funds are even, or even a lot of them actually, are paying themselves based on the markup. They’re paying themselves incentive fees based on the markup. And there’s a recent article in The Wall Street Journal by Jason Zweig on the practices at Hamilton Lane, the Hamilton Lane Private Assets Fund. And they are distributing massive amounts of money on returns that are shaped by, to various degrees depending on the fund. But a lot of it’s coming from these accounting markups, and it’s really disturbing. I feel like I’ve seen a lot of interesting ways to take advantage of loopholes that probably shouldn’t exist. And I’ve seen worse than this, but this one’s pretty bad.