When it rains, it pours: Liquidity special report
Private credit is supposed to be an illiquid market, but as more retail investors enter the space, liquidity demands have amplified. Kathryn Gaw looks at the opportunities and risks of a liquid private credit sector…
Liquidity and private credit do not exactly go hand in hand. By nature, the private credit market is designed for investors who are happy to lock their money up for a number of years, in return for a higher interest rate. But recently, some investors have been seeking easier access to their cash, and private credit funds have been working hard to meet this demand.
In November 2023, M&G Investments debuted its first European Long-Term Investment Fund (ELTIF), with £500m committed ahead of the launch. M&G Corporate Credit Opportunities offers quarterly liquidity to investors, making it one of the most liquid private credit products on the market.
One month earlier, both Allianz Global Investors and US investment house Muzinich unveiled semi-liquid private credit funds. Two of the largest funds in the private credit space – Blue Owl Credit Income and Blackstone’s BCRED – offer five per cent liquidity to investors.
It is no coincidence that all five of these funds are targeting the private wealth space, rather than institutional investors. Over the past year, there has been a shift in the private credit sector as the investor base has widened from the traditional mainstays of pension funds, family offices and insurers; to the larger – but more regulated – retail investor space.
The ELTIF regulations in Europe have made it easier for private credit funds to market their products to high-net-worth individuals and sophisticated investors who are keen to get a piece of the booming private debt space. And with returns often reaching 10 per cent per annum, it is easy to see why these inflation-beating yields would be attractive to investors following years of stock market instability.
“Interest from retail and wholesale clients for investments into private markets have been on the rise for a while,” says Jo Waldron, head of client and solutions, private credit at M&G.
“The asset class has previously been accessible mainly to institutional investors seeking the benefits of diversification and potentially higher returns.
“The new ELTIF regulation will meet this demand, offering a regulated and easily accessible vehicle across Europe capable of providing access to these assets with improved liquidity and lower minimum investments, enabling its inclusion in model portfolios.”
As more retail investors flood into the private credit market, fund managers are beginning to realise that their needs are different. While institutions are happy to sacrifice liquidity for a fixed return, retail investors want to have it all.
At a recent Citywire event, Richard Hope, co-head of investments and head of EMEA at Hamilton Lane, said that liquidity was the top concern for his private wealth clients.
“The most consistently asked question in our funds when we’re talking to investors is: ‘If it all goes wrong, how do I get out?’,” he said.
This is understandable. Retail investors have been through the wringer in the past few years, with Covid-related market crashes, stubbornly high inflation eroding away the value of their cash savings, and high interest rates heaping pressure on even the wealthiest households.
Read more: Asset managers respond to more demand for private debt liquidity
“Everybody is looking at liquidity to some degree,” says one private credit executive.
“And this is why you have to be extremely thoughtful about understanding the needs of a client. In 2022, people were faced with a unique situation where everything – both equity and debt – went down at the same time.
“And because there was such a significant valuation change in the public markets, many folks who would not have ordinarily been concerned about liquidity all of a sudden became concerned. So this is all about people understanding their liquidity profile.”
Yet there are risks involved in seeking liquidity from private credit products. The underlying assets in a private credit fund are typically long-term corporate, environmental, or real estate loans with a term time of four to eight years. In order to give investors the option of an early exit, fund managers have to get creative.
Some do this by staggering their loan terms, so that – in theory – different tranches of loans will mature at different times, allowing for partial redemptions. Others offer ‘semi-liquidity’, where limited withdrawals are offered at the fund manager’s discretion.
“Alternative asset managers are creating opportunities for quarterly liquidity, particularly for funds with retail/high-net-worth investors,” says Ana Arsov, managing director of the Moody’s financial institutions group.
“However they allow for only five per cent quarterly liquidity outflow which is prudently managed by appropriate cash, revolver access and also more liquid assets to allow for that event.
“Nevertheless, accessing retail investors is indeed a growing trend in capital formation and it does come with both heightened liquidity risk and reputational and regulatory risks.”
Arsov is not the only one predicting enhanced regulation as liquidity requests rise.
“I’m expecting regulation at some point to come in because of the size of deals that are being done,” says Patrick Marshall, head of fixed income, private markets at Federated Hermes.
“The fact that some direct lenders now underwriting transactions and seeking to sell those transactions on to other institutional investors is in many ways something that the investment banks did before 2007.
Read more: Goldman Sachs bullish on private debt in 2024
“In terms of liquidity, I think if we want to become an established asset class, we have to be transparent in what we promise our investors and what we can deliver. And to me there is a liquidity gap premium in the fact that we’ve got illiquid assets underlying in a fund and then some people are claiming that they can provide liquidity. It doesn’t make sense to me. So I think the regulators probably in time will need to look at making sure that what is being promised is deliverable.”
The ETLIF regulations could be seen as a first step towards regulating liquidity in the private credit space. The rules place the onus on the fund manager to choose the most appropriate liquidity management tools for their investors, as long as redemptions do not happen more frequently than quarterly.
Meanwhile, at the smaller end of the credit market, regulated peer-to-peer lending platforms have been innovating in liquidity management for years. Most major P2P platforms in the UK and Europe operate their own secondary markets, where investors can trade loans or loan parts. In many cases these sales are finalised within 24 hours of being listed, but the speed of the sale very much depends on the quality and duration of the loan, and whether it is being sold at a discount.
But with more and more funds offering liquidity to attract new investors, how viable is this as a new model for the private credit space?
“I don’t think it’s viable at all,” says Marshall. “People invest in private equity and private debt for a number of reasons. One is the liquidity premium, which is part of the yield. The other is to get income for liability-matching purposes, or if you’ve got a growth strategy it’s a counterbalance against what I would call high-risk strategies.
“My view is that this move towards providing liquidity when you’re seeking to earn an illiquidity premium makes no sense. A lot of these products that offer liquidity, it’s not real liquidity. It’s usually through a constraint where the manager can buy some of the loans with a funding line attached to the fund or something like that. But it is usually structured in such a way that the manager can decide if that liquidity is available or not.”
Marshall notes that there have been a number of instances where real estate funds have closed their liquidity because too many people were trying to withdraw from it. Blackstone hit the headlines last year when its real estate income trust was forced to limit redemptions after withdrawal requests surged to 15 per cent. In December 2022, Blackstone’s BCRED private credit fund reached its five per cent redemption limit for the first time.
“I would argue that this liquidity trend is not real, and I think the regulators will probably put an end to it in time because it doesn’t work,” says Marshall.
“I think the reason people are pushing for it is that people are trying to find ways to get retail or wholesale funding into the sector, so they need to offer liquidity.”
As the private credit market grows and attracts more retail investors, the risks associated with enhanced liquidity will come under increased scrutiny.
Meghan Neenan, head of North American non-bank financial institutions at Fitch Ratings, warns that investors may struggle to find all the information they need to make informed decisions about investing in semi-liquid credit products. This lack of transparency, combined with the possibility of mass redemption events, could mean that investors are choosing products which are not necessarily suitable for them.
“Relative to vehicles without redemption rights, there is certainly more risk in credit vehicles that allow for redemption activity as the assets may be illiquid,” says Neenan. “Relative to public business development companies (BDCs), perpetual BDCs with redemption rights often operate with a liquid sleeve of level one and two broadly syndicated loans which can be sold to fund redemptions or undrawn revolver capacity.
“Fitch rates one perpetual BDC publicly and it has a lower targeted leverage ratio than its affiliated public BDC, which we think is appropriate given the redemption terms.”
As liquidity becomes more of a priority for private credit investors, regulators are sure to be keeping a keen eye on the sector. Next year, even more retail investors are expected to enter the private credit market. More retail-focused fund launches are in the works, and in April, the Innovative Finance ISA will be extended to allow investors to make tax-free investments in Long-Term Asset Funds for the first time.
Ahead of this influx of non-institutional investors, fund managers will face a new challenge – how to find the balance between offering liquidity and managing risk, while continuing to offer the yields that make this sector so attractive.