CHG Issue #182: How to Make Liquid Alts

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Last week State Street launched PRIV, the first private credit ETF, which gives us a blueprint for how issuers plan to handle the inherent liquidity issues in these products. We've previously detailed our view that making alternative assets more liquid will reduce their investment appeal by lowering expected returns and increasing volatility here, here, and here. A good analogy for our view is flying private; if you have ever flown private, it is a massively more efficient and comfortable process. You can attend meetings in different states within a day and be back in time for dinner, which has great appeal for dealmaking businesspeople. However, if we wanted to democratize access to flying private, all those benefits would go away as the difference between private and commercial would converge. But this is only one effect of this movement to democratize access to private investments; there will be many other effects, and the development of a liquid secondary market for a broader range of assets could be one of the more impactful ones for the broader economy.

We could be witnessing the beginning of a radical transformation of our capital markets. We are already experiencing a trend of fewer companies going public, partly because the lower cost of capital that comes with the public market has diminished compared with the increasing cost and friction of being a publicly traded company. The development of a liquid secondary market for private assets—not unlike the public equity markets today, but with less regulation and more flexibility—could present a generational opportunity for new businesses that will take part in making secondary markets in private assets.

Before we jump in, we need to quickly address the overarching regulatory issues this movement will stress. Regulators today are overly strict in certain areas and totally blind in others (ex. SIVB). They are like parents who focus on outward appearances and behavior but turn a blind eye to what their kids are doing behind closed doors. One simple tactic that some savvy private credit managers might exploit is the fact that under SEC rules, a loan is not considered a security and therefore does not fall under the SEC's purview. For example, if I want to manage a fund that invests in securities, I fall under the purview of the Investment Advisors Act, but if I only make loans, I don't have to go through all the hassle and cost of registering as an investment advisor. There are all sorts of opportunities for regulatory "arbitrage" that a liquid alts market will open up, not dissimilar to what the company formerly known as MicroStrategy is doing in crypto. We will have to save this discussion for another letter because this moment in history is similar to when equity options first began trading on the CBOE in 1973.

For a liquid secondary market in "alts" to develop, we need more market makers. Apollo is filling that role for State Street within a limit, and State Street can also go to other liquidity providers (aka market makers or other investors) for bids on their private credit assets. By providing liquidity for State Street, Apollo is potentially creating liquidity for its broader PE business. Not only will they be able to scale up low-risk, fee business by originating loans into these ETFs, but they are creating more fertile conditions for exits in their PE funds which will allow them to earn their carry on those funds.

When a market maker like Apollo provides a firm bid quotation to State Street, they have to consider both the intrinsic value of the loan and what other investors would likely pay for it. For market makers, intrinsic value matters less than what other investors would pay because they're in the moving business, not the storage business. Their imperative is to provide a bid that will allow them to sell at a profit in the near term. Apollo has an edge here because if they syndicated the loan, they know who all the other buyers are and can easily approach them to see if they'd like to buy more. It's also safe to assume they have the permanent capital to take down the loan and hold it to maturity if the secondary market price drops far enough below intrinsic value.

AP Grange Holdings LLC appears to be the only private credit asset in this ETF today. If you were asked for a bid on this security, you would want to ultimately know who you could sell it to in short order and mark that price back a bit for your own cost of doing business. For example, knowing that houses in your neighborhood are selling for $500k, you could offer to buy your neighbor's house for $400k if they were looking to sell in a hurry. You could do this to give your neighbor liquidity and then take the time to list the house at $500k. However, in private credit, if you were not part of originating that asset, you probably don't know who the buyers are, and the assets are not as homogenous as they are in a residential neighborhood. In this case, Apollo will probably have a better bid than you because they have more information and may already have a permanent home for the asset.

To compete with Apollo, we can search public records on AP Grange and learn that other funds like Guggenheim's Strategic Opportunities Fund holds some of the debt and that AP Grange was formed to buy a 49% stake in Intel Ireland's high-tech JV Company associated with the state-of-the-art Fab 34 wafer manufacturing facility in Ireland. AP Grange issued 6.5% coupon debt maturing in 2045 to fund part of that $11 billion acquisition and Intel had already put $18.5 billion into this facility, which is ahead of Apollo's investment, so on the surface the credit seems solid. However, building these Fabs is a very complex and costly process, so the investment itself is risky, but you have an investment-grade rated company worth over $100 billion backing this strategic project. When they brought this loan to market, interest rates were about the same as they are today, so this issue came to market with a roughly 225bps spread over the 10-year treasury, and spreads are slightly tighter since then. Given this information, we can assume this loan probably trades around par, and if you have a view on Intel, fabs, rates, credit, or anything else related to this security, or a new buyer for it, you can step up and provide an aggressive bid for the loan. However, if you buy it by besting Apollo's bid, you have to consider why they didn't bid as aggressively since they have better information than you.

There is a natural ebb and flow of information in the secondary market as new buyers develop with new views on different investment opportunities, and the secondary market can diverge widely from intrinsic value. For solid credits, the downside will be somewhat limited because there will be a deep buyer base at any sort of discounted price, but the dynamic is much different on the upside and for weaker credits. As different investments trade at a wider premium to intrinsic value, they can become more liquid and more risky at the same time, and the ability to trade these effectively has more to do with knowing the key players involved than anything related to intrinsic value. For weaker credits, the primary market maker—Apollo in this case—may not provide a very good bid, which can create adverse selection for the investors in the ETF because State Street will naturally sell the strongest private credit loans and keep the weakest ones. This also creates opportunities for other investors with a different view on the credit to step in and accumulate the position, or for market makers to trade in wider bid-ask, more profitable securities. BlackRock's recent purchase of Preqin, one of the largest databases of private company information, was done in expectation of this dynamic unfolding and the value of this information increasing dramatically.

To capitalize on this, market makers will need to minimize their risk as much as possible by developing an emerging buyer base for these "dented credits" and having a good hedging strategy for taking down an inventory of these credits. This can usually be accomplished by shorting liquid market alternatives that are similar and act as a proxy for the underlying credit. This will introduce basis risk—the risk that the proxy and your investment behave differently. Behaving differently can mean how the prices of each move, which is usually the primary concern of market makers, but also how the two perform fundamentally.

With AP Grange, we could easily buy the loan and short treasuries to hedge interest rate risk, and also short the Investment Grade Credit Default Swap (CDS) index to hedge the general movement of IG credit spreads. However, if the AP Grange price does not track the IG index closely, this will not be a good hedge. An alternative would be to dig deeper into the project and short single name CDS on Intel, buy put spreads, or even short a basket of semiconductor names that are the ultimate customers of this Fab plant. This is just a taste of some of the strategies that become available as a liquid secondary market develops and the market prices different discounts and premiums to intrinsic value. Most hedging done by market makers covers systemic risk because once again they are focused on the short-term and also because hedging idiosyncratic risk becomes very difficult and costly. However, if Apollo's bid for these private credit assets is low enough, it will invite other fast money strategies to develop that will seek to capture the risk premium being attached to these assets.

As new liquidity is brought to private credit assets, it will give new life to secondary credit markets like the credit correlation market, which was growing rapidly in the runup to the GFC and to my knowledge never came back to life since then. We could see a resurgence of first-to-default baskets, credit securitizations, synthetic credit securitizations, and so on, as all the different market makers and other participants find opportunities to capture non-correlated risk premium by carving up the newly liquid risk that gets downstream from the big Private Equity companies. Equity vol funds will have a whole new market to trade and arbitrage with the massive equity option market because they are directly linked to credit risk and provide one of the most liquid measures of default risk—albeit only over very short durations.

Longer-term, we believe the net impact of this will be to increase capital formation in the broader economy but also increase leverage and volatility. The public markets are slowly going the way of the dinosaur, and the private markets are transforming to look more like public markets but capturing a larger share of the economy and without all the problems that public markets carry today. The aggregate cost of capital will not be as low as the public market today, but it will be lower than where the private market is today and will be available for a broader swath of companies. The one negative of public markets that the private markets cannot escape is volatility. One of the early motivations for public companies to go private was to lose the short-term focus that the public markets brought to their businesses. As the private markets become more liquid, this benefit will diminish. Perhaps we will settle out with less-liquid capital markets with a higher cost of capital but for a wider universe of companies—and that might be a net positive for the economy. The benefit of increased capital formation must be weighed against the cost of volatility that liquid markets carry. If we end up with more inclusive and less liquid capital markets, that might be a fair trade-off for a reduced impact of capital market volatility on the economy.

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