It’s been a rough stretch for private credit.
The sector has been rocked by surging redemptions amid concerns about AI disruption and falling returns. That has prompted the capping of withdrawals and raised questions about the future of these alternative investments.
Much of this upheaval is happening in semi-liquid funds that have attracted retail investors who typically don’t have the time horizons of ultra-high-net-worth investors—the so-called “democratization” of the asset class. But the situation could have repercussions for more patient investors at family offices, including those with concerns about their own positions or about possible problems—and opportunities—down the road.
“There is a lot of nervousness at the moment in the private-credit space,” says Greg Nott, chief investment officer at Northwood Family Office in Toronto. He says the genesis of the problem was largely AI-disruption trades in the equity markets, with stocks of software businesses that could get upended by AI “getting hammered really hard. And then people started realizing that a lot of these private-credit funds have significant exposure through loans to software companies.”
I don’t think that we’re going to see a massive amount of forced selling.
Greg Nott, Northwood Family Office
That phenomenon was coupled with the fact that newer entrants to the space, typically in semi-liquid structures, “got a bit nervous and started increasing their redemption requests,” Nott says. “Once that ball got rolling, it really picked up steam and you saw pretty much most of the larger semi-liquid managers have to gate their funds this past quarter.”
Many family-office investors are remaining patient, “but there’s a sense of prisoner’s dilemma in this,” Nott says. This means that even an investor who’s in a fund for the long term thinks the manager is doing a good job and doesn’t really want to sell or redeem, but is now “seeing in the headlines that everyone else is redeeming. Then you start to question what’s going on.”
A manager who needs to sell loans to meet redemption requests is also likely to sell the better one first, Nott says. “If you stay in the fund, you’re at risk of getting stuck with lower-quality exposures, so you may decide, ‘Well, then I should probably get out as well.’”
Another issue that explains recent investor behaviour is a quirk of the private-credit space, which has a series of publicly traded business development company (BDC) funds, Nott says. These were trading at a discount to their net asset value (NAV), he explains, “and if you were in a non-traded BDC that had similar exposures and you could sell at NAV—versus having to redeem at a discount to NAV in the traded BDCs—there is some logic there.”
Alex Da Costa, chief investment strategist at Prime Quadrant, a multi-family office in Toronto, says his company has participated in the space “but in a very measured way,” with a small number of partners who have deep experience and built funds that should be able to withstand large redemptions.
Herd behavior is one feature of markets that we’ll never escape from as long as human beings are investing.
Alex Da Costa, Prime Quadrant
“Herd behavior is one feature of markets that we’ll never escape from as long as human beings are investing, and when you see these headlines, it spooks people, and so there’s a cycle there,” he says.
Da Costa sees this as a turning point where “investors who probably should never have been in these vehicles will be trying to get out,” because the investments aren’t appropriate for their goals. He also notes that some advisors have been incentivized to sell these vehicles to their clients, and with some of those incentives gone they have “moved on to the next thing,” taking out weaker funds.
“I think that’s not necessarily a bad thing,” Da Costa says. “It’s an evolution of the space and we need these things to happen every now and then.”
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Prime Quadrant is carefully monitoring the performance of the assets of the funds that it holds, and “we objectively have not seen any real pickup in stress, defaults or any of the real warning signs that have people worried.”
Doug Beck, principal, portfolio manager and chief investment officer at Access Family Office in Mississauga and Ancaster, Ont., says Access started a private-credit rebalancing when it “noticed some cracks structurally” related to retail investors seeking high returns who were less committed to remaining in funds.
“When issuers start experiencing net redemptions and they start throttling or they go full gate, folks all of a sudden want their money out,” he says, noting that “right sizing” allocations and choosing good fund managers is critical.
Ultra-high-net-worth investors in family offices today are typically “sitting on the sidelines and saying, ‘Let’s see how this thing plays out,’” says Beck, who believes that private credit will “potentially get worse before it gets better.”
Anyone considering getting into an opportunity should be “super selective and have a very strong understanding of who the actual borrower is,” he says. “There’s a reason why some of these borrowers can’t go to the bank and get prime; there’s obviously elevated risk.”
Da Costa notes that it does make sense to rebalance a portfolio that is over-allocated to private credit.
“Or if you think you might need liquidity, and this was a source of liquidity that you were looking to tap, then maybe you should be trying to take some chips off the table,” he advises. “But if this is a core part of your portfolio, and it’s sized appropriately and you’re not desperate for liquidity, then stay the course.”
He feels that taking a long-term view and being comfortable with the fund general partner is key. “Patient investors in good places should be okay, assuming there isn’t a material deterioration on the actual asset-quality side.” At some point a credit cycle is “inevitable,” Da Costa adds, with defaults picking up. “For us, we’re not panicking yet.”
Nott says he wouldn’t be surprised to see sustained high redemption requests for the next couple of quarters, and for gating to continue at 5 per cent.
“However, I’m not sure this snowballs into some sort of systemic, market-wide episode,” says Nott, who doesn’t agree with comparisons to the 2008 mortgage crisis. “I don’t think this has the same potential for that sort of mass contagion across the markets.”
He points out that a lot of exposure to private credit remains in “vintage” illiquid draw-down funds, while more recent semi-liquid entries into the space are in the headlines. “They’re the ones getting gated, because that’s the retail money,” which represents a minority of the assets in private credit. “I don’t think that we’re going to see a massive amount of forced selling.”
Nott says that Northwood has “been very patient in entering into this space,” as fixed income is generally not very tax efficient for UHNW investors, and a “hot asset class” often brings new entrants who can have a negative impact. “If we start to see some dislocations in this marketplace, we might actually look to add more from where we are.”
If is is a core part of your portfolio, and it’s sized appropriately and you’re not desperate for liquidity, then stay the course.
Alex Da Costa, Prime Quadrant
The key is to look for private-credit opportunities with experienced managers that don’t have a lot of fund leverage, are diversified, have limited software exposure and low loan-to-value levels, Nott says.
“Some of the funds out there have gotten pretty concentrated,” he adds. “You’d want to see a diversified portfolio of loans.”
Mary Gooderham is a writer, editor and communication advisor based in Ottawa. She leads Cohen Gooderham Communications and has worked as a journalist for more than 40 years at The Globe and Mail, as a recording officer at the International Monetary Fund and as a custom content creator for online and print media. She’s been a contributing writer at Canadian Family Offices for four years, focusing on investment strategy, trusts, philanthropy, women in finance and estate planning.
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