The fifteen year bull market that started in 2009 drove investor allocations to US equities to all time highs. We are now at levels exceeding the late 1990s dotcom bubble or the 1960s go-go market.
Investor allocation to stocks as a fraction of all assets since the early 1950’s
Stock market valuations are stretched: current levels were only exceeded in 1929 and the late 1990s. Such high valuations portend future returns below the long-term average.
While stocks will continue their role as a bedrock of long-term investors’ portfolios, it is reasonable to take some money off the table here and diversify into non-correlated assets. Unfortunately, it’s easy to fall into the trap of letting equity exposure sneak back into the portfolio under the guise of alternatives. We’d like to warn investors about this trap.
The three temptations of the alternative investor are private equity, private credit, and private real estate. What they have in common is the naive faith that putting the word “private” in front of an asset class will transform it into something different and uncorrelated.
Private equity
The private equity industry at least tripled in size since the 2009 financial crisis. It has built a mystique of an exclusive asset class, accessible only to sophisticated institutions and well-connected billionaires, and delivering magic returns quite different from those available to poor public equity investors.
The reality does not live up to the hype. Private equity returns are easily replicated by investing in small and medium capitalization public companies and adding leverage. An article by Nicolas Rabener in the Journal of Investing, with the delightful title “Private Equity is Still Equity, Nothing Special Here”, shows exactly how to replicate private equity indexes. The crucial point of the article is that private equity returns, when properly measured, are highly correlated to the stock market and do not provide any meaningful diversification.
Private equity compared to levered small cap stocks
The private equity industry follows the practice of marking its assets only quarterly, to internal valuations. These make-believe prices hide the correlation with stocks and flatten performance in short downturns such as 2020. Even six months into the financial crisis of 2008, private equity funds pretended that their portfolios were unaffected by the mayhem all around them and only started taking markdowns in the second half of 2009. Proper transparency would show that, in reality, they suffered just as much, if not more, than public investments.
Private equity funds got a great tailwind from the drop in interest rates to zero in the decade of 2010-2020. Their highly leveraged portfolio companies benefited from falling interest expenses and easy availability of debt. That has changed since Covid. Interest rates went up to 5%, which is not a particularly high level by historical standards, but it is enough to put pressure on PE portfolios.
Funds are now finding it difficult to exit their investments and are struggling to distribute cash back to investors.
Private credit
The private credit asset class is newer than private equity as it didn’t really exist prior to 2008. After the 2008 financial crisis, banks slowed down lending to middle-market companies, hamstrung by new regulations and stricter capital standards. Private credit funds, often sponsored by private equity managers, stepped into the void and started offering financing to buyouts. The growth of private credit accelerated after 2020, and since 2023 it passed both high-yield bonds and leveraged loans in size of AUM.
Growth of private credit
What are the differences between private credit borrowers and the rest of the corporate credit market? Private credit funds lend to smaller companies that, in the past, borrowed from banks. They have worse interest rate coverage than any other category of borrowers, with debt-to-EBITDA ratios exceeding 4.5x on average. On the other hand, they tend to have better asset coverage. That means that they are more likely to go bankrupt than high yield or leveraged loan borrowers, but their recovery rates in bankruptcy should be higher.
Characteristics of private credit. Source: Moody’s
Companies that borrow from the leveraged loan market have historically been rated at BB or B level in the S&P rating system. BB is the highest “speculative grade” rating, just one level below the BBB- cutoff for investment grade bonds. Private credit borrowers generally do not solicit credit ratings because they’re too small, but if they did, they would rate at B- on average.
The best way to model private credit is to think of it as leveraged loans to smaller, lower quality borrowers. This allows us to use the much more transparent leveraged loan market as a guide to performance of private credit.
Historical default rates on leveraged loans
In every recession, leveraged loan borrowers suffer a wave of defaults, with default rates peaking at around 8% of outstanding loans. This makes sense: these are lower quality companies that live on the edge and have very little margin of safety when things go wrong. Private credit companies, which are even lower quality, should have the same experience in the next recession.
Private credit sponsors who like to tout “low correlations with public markets” should explain how these companies could possibly avoid significant losses in an economic downturn.
Private real estate
The investment consultant Richard Ennis calls real estate “the most over-done area in the realm of private market investing.” Private real estate funds underperformed their public equivalents by 2% per year over a 25 year period, according to a study by the National Association of Real Estate Investment Trusts (Nareit) that looked at data from pension funds.
Real estate is not immune from economic downturns, as the experience from 2008 reminds us. In fact, real estate is not looking so hot right now. There is no evidence that private real estate funds can somehow avoid losses if the overall market suffers.
Commercial real estate prices in the US
The biggest problem with private real estate funds, however, is that investors can’t get out when things get difficult. The two largest private real estate investment trusts, Blackstone REIT with $100 bn in AUM and Starwood REIT with $22 bn in AUM, already limit investor redemptions.
The Blackstone REIT limits withdrawals to 5% of NAV per quarter, and 2% per month. Recently, it has been waiving those limits, but its prospectus helpfully points out that “We are not obligated to repurchase any shares, and our board of directors may determine to repurchase only some, or even none, of the shares that have been requested to be repurchased in any particular month in its discretion.”
The Starwood REIT has an even stricter policy: redemptions are limited to 1.5% of AUM per quarter. At this rate, it would take 11.5 years for half of the assets to be redeemed. It would take 38 years to redeem 90% of the assets.
These redemption policies are wonderful for the managers of the fund but it’s terrible for investors who may, presumably, want to get their money out some day.
It’s a trap!
In the last few years we have seen increasingly aggressive marketing aiming to entice investors into private equity, private credit, and private real estate vehicles. Recent moves by the SEC will further loosen restrictions on marketing to retail investors after heavy lobbying by the private equity industry. We can expect more promises of high returns, low correlations, and low volatility. Those promises are smoke and mirrors.
Private funds are not true alternatives. They package the same exposures available in public markets (small cap stocks, high yield credit, and REITs) in opaque vehicles with poor liquidity and high fees. They do not improve the performance of client portfolios and will not provide shelter from the storm when the economy and the stock market run into a downturn.
What clients really need are alternatives with transparent market pricing, demonstrated zero correlation to equities, and plentiful liquidity even in times of economic stress. We at Incline Investment Management specialize in such products and can educate potential clients on how to protect their portfolios.