Late last month, we noted with some alarm (but absolutely no surprise), that pension funds are increasingly prone to going “exploring” in private credit.
It’s not difficult to explain the growth of the private debt market. In a world where central banks have driven rates to zero on safe-haven assets, pushing investors out the risk curve and down the quality ladder, a dearth of yield herds folks into corners of the market they might not otherwise be predisposed to dabbling in.
Part and parcel of that dynamic involves leaning into the illiquidity premium or, more simply, accepting the risks associated with illiquid assets if it means yield pick-up.
The size of the private debt market has exploded over the post-crisis period.
According to Preqin, AUM has more than doubled since 2012. Note that the “dry powder” portion of the total $812 billion in AUM sat at $269 billion as of June – that’s just off 2018’s record, and suggests there’s plenty more capital waiting to deployed in this “exciting” world of opaque assets.
Although we don’t have a ton to add on this, we did want to highlight a couple of passages from JPMorgan which underscore the dynamics discussed at greater length in the linked post above.
“The past year has seen a big expansion in the public market universe with publicly-traded equities and bonds reaching a market value of $136tr globally, up 17% from the end of 2018 [bringing] the cumulative expansion over the past five years to 29%”, the bank’s Nikolaos Panigirtzoglou observed, in a note out earlier this month.
That sounds like a large expansion – until you consider that the AUM of the less liquid universe in private markets has doubled in five years.
“According to Preqin the AUM of private equity rocketed from $2.2tr at the end of 2014 to a provisional estimate of $4.5tr at the end of last year (including dry powder)”, Panigirtzoglou goes on to say.
One thing that sticks out there is that even on a cursory visual inspection you can see that hedge funds have seemingly lagged the growth posted by private debt and private equity.
Panigirtzoglou has the numbers. To wit:
Hedge funds bucked the strong expansion trend among private asset classes, posting cumulative AUM growth of only 14% over the past five years, not only lagging other private asset classes but also public markets. As a result, in 2018 the private equity industry surpassed the hedge fund industry in terms of AUM for the first time.
At the risk of oversimplifying things, part of that is almost surely due to performance. Looking narrowly at equity hedge funds (using HFR’s data), last year was one of the worst years in decades for hedge funds versus the S&P.
It comes as no surprise that the only worse year in recent memory was 2013, another year during which the S&P logged gains of ~30%.
Hilariously (or not, depending on who you are), that egregious underperformance came despite the best year for stock-picking in nine years. The Long/Short crowd’s alpha was 13% in 2019, according to Morgan Stanley, but due to fees and a lack of enthusiasm for pursuing the broader market as it trekked inexorably higher, overall performance suffered. According to the bank, funds’ positions in equity products (i.e., index futures and ETFs) betrayed skepticism towards the rally.
Indeed, a persistent theme last year was underexposure. Net leverage averaged 46% in 2019, Morgan’s prime brokerage desk said. That’s tied for the lowest of the bull market. Apparently, there was a mad dash for (chuckles) beta in Q4 among Morgan’s fund clients, but alas, it was too late to avoid underperformance.
Anyway, JPMorgan notes that whatever’s going on with hedge funds, it hasn’t derailed the growth of private assets as group. To wit:
Despite disappointing growth by the hedge fund universe, the total universe of private asset classes including private equity, private debt, institutional real estate and hedge funds, grew by 44% over the past five years, to an estimated $18tr at the end of last year, surpassing the 29% growth of publicly-traded equities and bonds over the same period.
The bank also underscores the extent to which SWFs and endowments have chased into private assets.
Coming full circle, the problem with this is glaringly obvious.
“While warehousing more illiquidity risk is not a problem for long-term investors in normal times, the lesson from 2008 is that it can become a big problem during crises”, Panigirtzoglou cautions. “At the time certain institutional investors facing cash flow problems were forced to offload illiquid investments such as private equity at very high discounts to net asset value, as high as 50%”.
You get paid to take liquidity risk – that’s what it means to lean into the illiquidity premium. But in a pinch, there’s no market.