Thoughts from Coromandel Capital on Volatility of Private Credit Funds

Almost every investor experienced the agony of unrealized losses as the S&P 500 has declined by roughly 20% in 2022. Regrettably, bonds have not been as effective in stabilizing portfolios as they usually were, with core bond portfolios (e.g. BFMCS) also falling by roughly 14% due to a sharp rise in interest rates in 2022. There has been nowhere to hide. Well, except maybe private markets. This has reignited the debate on the volatility of Private Equity (PE) vs. public equity.

AQR’s Cliff Asness called out the seemingly low volatility of PE funds and their returns being smoothed due to PE’s lack of mark-to-market valuations. This phenomenon has been dubbed as “volatility laundering.” To clarify on terminology, a PE fund’s return, when measured before an exit, needs to apply level 2 or 3 fair value technique to determine the terminal value of asset, which is different than the case of a public equity fund’s return where prices are directly observable in the market. On the other hand, Christopher Schelling (512 Alternatives) defended PE funds’ lower volatility by focusing on public market’s overreaction and its poor track record in forward looking by comparing change in P/E multiple and next year’s earnings growth. In other words, higher volatility of the public market is a bug, not a feature, due to overreaction and poor forecast of future earnings.

How about Private Credit (PC)’s volatility? We asked this question as the above debate has been about the equity markets. A natural comparison can be between PC and Collateralized Loan Obligations (CLOs) as structurally both have credit enhancement features with PC being the private market and CLOs being the “public” counterpart in the sense of being traded in a secondary market (not in the sense of being accessible by the general public). See this excellent primer on CLOs by Guggenheim. CLO tranches are traded infrequently however, making the private vs. public empirical comparison difficult to conduct. But we can rely on well-known financial theories to comment on the volatility of PC funds.

·??????When structured with floating rate, e.g. benchmarked to Secured Overnight Financing Rate (SOFR), PC receives and pays investors a variable yield. Akin to a floating-rate bond whose price is typically near par on coupon reset day, the value of PC should not (all else equal) fluctuate much (if any at all) with respect to the market benchmark rate.

·??????Spread risk still impacts the value of PC, leading to volatility. Spread can be credit spread and/or liquidity spread.

·??????Even with a fixed-rate structure, PC pays out a high yield, often double digits, leading to a lower duration and hence lower volatility. This also implies that the volatility from the spread risk should be benign.

·??????Due to different credit enhancements (i.e., support from post-financing cost yield generated by the assets financed, lender requiring 20% +/- contribution towards the cost-basis of the asset, reserve accounts, collateral and financial covenants, etc.), the value of PC is not sensitive to small changes in losses of the collateral asset pool. However, large losses surely impact the value of PC, leading to volatility.

In addition to structure, the quality and cyclicality of the underlying asset matters greatly to the volatility of PC funds. Consider a pool of unsecured consumer loans and a pool of music royalty assets. The latter has proven to be more resilient to economic downturns given the lack of correlation to broader markets since media consumption in less reliant on economic cycles, whereas the former is susceptible to the financial health of a consumer which, at present, is dealing with purchasing power erosion due to inflation and household indebtedness that is past the pre-COVID trendline resulting in increasing Debt-To-Income (DTI) and consumer’s assessing their payment obligation hierarchy (i.e., pay auto before mortgage so can still drive to work while undergo judicial foreclosure process, etc.). Coromandel Capital benefits from its proprietary deal sourcing channels that allow it to focus on portfolio construction, as opposed to chasing growth and short-term fees, by deploying capital into acyclical and counter-cyclical assets to achieve low volatility returns that are resilient to economic downturns and even benefit from idiosyncratic tailwinds.