The term hedge fund has evolved over the last 70 years. It began as a reference to a strategy of hedged investment risk. Today, hedge fund is a generic name given to unregulated or lightly regulated pools of capital. These strategies range from conservative to aggressive. They can also invest across a wide spectrum of assets including, but not limited to, stocks, fixed income, commodities, derivatives, and currencies. Profits can be generated by asset prices going up or down. Liquidity is typically offered no more frequently than quarterly or four times a year. Hedge funds can be broad or niche in terms of investment scope.
Private equity generally refers to an ownership stake in a private company. There are typically significant changes implemented to the company’s financial profile, operations, corporate strategy, and/or management while under the ownership of the private equity manager.
The private equity manager then seeks to sell the company at a much higher valuation through an I.P.O., sale to a strategic buyer, or sale to another private equity buyer. There are multiple flavors of private equity that include leveraged buyout, venture capital, and growth equity.
These are non-bank pools of money that are invested in loans or bonds to private companies. These are loans that are extended to small, medium, and large companies.
This form of investing has gained in popularity since the Great Financial Crises caused many traditional banks to pull back from many lines of lending due to increased regulation. Private credit can take the form of senior debt, junior debt, distressed debt, syndicated bank loans, asset-backed loans, and other specialty types of loans.
This style of investing can be achieved with debt or equity. However, this style of alternative investing does not typically do so with publicly traded debt or equity. This involves the direct financing or ownership of real estate assets. These investments are illiquid and can involve multiple types of real estate (multi-family, office, retail, warehouse, industrial, etc.).
The main difference between Private Credit and Public Credit is their liquidity. Public credit is debt issued or traded on the public markets. Private credit is privately originated or negotiated investments, comprising potentially higher-yielding, illiquid opportunities across a range of risk/return profiles.
The liquidity risk premium refers to the excess return that investors receive for investing in higher-risk securities that are not readily traded in the public markets.
Private Credit investing is similar to public credit investing. The main difference between the two is the ease with which public credit investors can buy and sell debt securities. Private Creditors do not have this luxury and thus take on more risk. For this reason, Private Credit Investors demand a liquidity premium.
Investors in alternatives have a larger opportunity set in Private Credit because banks have been constrained by regulations since the Global Financial Crisis after they measured their credit risk poorly.
Private Credit investors often invest in more opportunistic, distressed, and middle-market situations than do public credit investors.
This is evidenced by the higher default rates seen by Private Credit investors relative to investment- grade public credit. Still, many Private Middle-Market investors have seen lower default rates than their counterparts in the public high-yield space.
As discussed in prior notes, the 60/40 portfolio is challenged by the low yields on offer in the risk-free market.
Yet publicly traded, high-yield bonds don’t even add enough returns to cover the cost of inflationary pressures and this is BEFORE accounting for loss rates. Beyond the extremely low risk-free rates, credit spreads are supposed to compensate investors for this risk of defaults. Currently, Private Credit is seeing lower default rates relative to publicly traded high yield securities.
While this may seem justified because the Fed purchased some high yield securities earlier this year, they are now in the process of unwinding these purchases.
Meanwhile, as we discussed in our Fed policy primer, the question of whether the Fed will utilize its tools to stop inflationary pressures is in doubt.
By taking a more active approach and harnessing alternatives, investors can still earn satisfactory returns in excess of inflation and publicly traded debt.
Investors in risk-free treasuries and publicly traded high-yield bonds need to BELIEVE that the Fed will do what it takes to stop inflation.
Whether you are a new or existing advisory client, we will explore all investment opportunities that are available for you.