As private credit continues its hot streak, the investment industry is looking for ways to package and sell it as widely as possible. To that end, big names in both the private credit and traditional asset management industries have recently partnered to create and submit a so-called “private credit” ETF to the SEC for approval.
By Khang Nguyen, Chief Credit Officer at Heron Finance
Though marketed as providing access to “private credit,” to a wider, more retail audience, the average investor would be well-served to do their homework. What percentage of these ETF portfolios provide exposure to true private credit? Will liquidity be an issue? Whose private credit deals are being accessed? Are there potential conflicts of interest? What about counter-party risk?
To understand more completely, let’s look under the hood. At least one of the potential private credit ETFs would work like this:
If approved this ETF would provide investors with commingled access to private credit, public credit, and investment funds sourced by a well known private credit investment firm.
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The ETF would issue and redeem its shares (albeit only in large blocks) on a continuous basis, at NAV, on a daily basis. ETF shares may be redeemed in cash and/or securities.
The associated private credit investment firm is obligated to provide firm bids on the ETF’s investment assets on a daily basis at certain intervals and is required to repurchase, subject to a daily limit, such assets from the ETF at (or above) such firm bid prices.
Billed as a “private credit ETF,” this structure, in its current form, reveals clear limitations while also raising several questions. First off, even if launched, this ETF would still not offer pure-play private credit investing (any true private credit would be co-mingled with public credit including high yield bonds and various fixed income investment funds). It would also not allow investors the ability to customize their exposure; nor would it provide multi-manager exposure.
But perhaps even more problematic are the following three areas, which we see as significant areas of concern:
Potential liquidity issues
The Exchange Traded Fund structure relies on daily liquidity, but private credit is inherently illiquid.
If redemption requests exceed the private credit firm’s capacity, the asset management firm might be forced to liquidate more-liquid holdings first, leaving a higher concentration of illiquid private assets in the fund. This could trigger a liquidity crunch, especially in volatile markets which can cause investors to (want to) exit en masse.
That being said, unlike traditional mutual funds, this ETF would not permit unrestricted redemptions; instead, investors must accumulate enough ETF shares in the secondary market to constitute a sufficiently large block of shares in order to have such block redeemed. If there is insufficient market liquidity, such a block can’t be assembled, and the redemption request cannot be fulfilled.
Additionally, the fund manager’s pressure to constantly seek to satisfy liquidity requirements, and any responses thereto, may ultimately disadvantage the investors who want to optimize for returns and do not want to exit the ETF.
Potential valuation challenges
With hard-to-value private credit, daily loan and NAV pricing can be inaccurate, leading to shares potentially trading at significant premiums or discounts that hurt investors.
Even with large sized loans that are valued quarterly, there can still be significant differences in their fair market value as different credit managers may have different views about and different approaches to portfolio valuation; such valuation discrepancies can worsen when the loans are distressed and therefore even harder to value (let alone at daily intervals).
Potential conflict of interest and fiduciary concerns
The private credit firm, as the originator, buyer, and seller, introduces several potential conflicts of interests.
This singular dependence on the private credit firm as the ETF’s primary counterparty across such a wide range of activities raises fiduciary issues. The private credit firm has an incentive to undervalue assets during redemptions, ultimately benefiting from repurchasing at a discount. Especially during high-volatility periods, such reliance on one firm as the sole liquidity provider could materially harm retail investors.
The ETF industry has been going through an innovation boom, and while many of these breakthroughs will serve the interests of the end-investor, we at Heron have concerns around whether the ETF structure can effectively handle the idiosyncracies of the private credit marketplace. We recognize what is described above is only one of many structures that could be utilized within the ETF framework, and expect that the firms in question will continuously iterate the product prior to any SEC approval.
Even so, the ETF structure, undoubtedly a flexible and important innovation, has limitations, especially when it comes to liquidity or lack thereof. Ultimately this may be a difficult flaw to overcome when it comes to an ETF providing pure play private credit exposure. Single manager risk will also be an issue until multiple private credit specialists and their deals are made available through one ETF. While feasible, it seems somewhat far off.
