Private Assets on a Tear, But VC is Still Terrible, & Private Credit is Good?

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1. I’m going to write a full newsletter on this but for some reason investors just love private assets. I don’t get it. The returns are the same or worse than owning public equivalents once you use real benchmarks instead of the BS ones private funds use. You are also locked into most private funds for 10 years with limited access to liquidity.

   In my view these assets are more sold than bought. It’s why I think that the richer you are the worse your investment options get. Once you have money, the sales people come out of the woodwork with lots of cool charts and tell you things like, “At your level, we can do some more sophisticated things.”

   My advice is run right to Vanguard (but even they are starting to offer access to private equity now. Sigh.) I think investors are attracted for three main reasons:

   1. Pension funds have employees who need to justify their jobs by finding more complex investments. Just buying ETFs means lots of jobs get cut.

   2. Pension funds want to be lied to. Private funds can value what they own without any outside input. They tend to not recognize changes in valuation as public markets do second by second. They call it volatility smoothing or you can take the billionaire quant investor Cliff Asness’s line and call it volatility laundering. Private assets value changes all the time. It’s just that ‘ not in the interest of the managers to tell you about it.

   3. I think the continuing expansion of these asset classes is mostly a velvet rope line effect. Getting access is exclusive. It means you are important. So KKR and Blackstone are just running Vegas night clubs and the bouncers are evaluating how hot you are or how cool your shoes look to see who gets in. Total BS.

2. But Venture Capital is looking bleak. I think VC is going through a correction that will take a while to play out. It will leave the industry much smaller going forward which I believe is good. There’s only so much innovation to fund and we certainly blew by that limit in 2018-2022. Crypto anyone?

3. And Bloomberg’s Odd Lots podcast has an excellent episode on the growth of private credit. It’s probably the hottest asset class out there but no one really knows the size. Conservatively they estimate it at $1.5 trillion a year. In comparison, venture capital attracts somewhere in the $160-$300 billion range a year. Private equity total deal value is about the same as private credit. Not surprising as the vast majority of private credit funding goes to fund private equity acquisitions.

   The podcast highlights some good things about private credit. Traditionally most lending was originated by banks. There’s an inherent instability in banks though. They borrow short by taking your cash deposits. They are “short” because you can go to the bank and take out your cash at any time.

   But the bank takes that short term money and lends it long (or locks up that money) by giving term loans to businesses or for real estate. That’s an unstable situation. If there’s any perception the long term loans could go bad, people take back their short term deposits. That’s called a bank run.

   Private credit generally raises funds from large investors like pension funds. They are able to lock up those funds for 10 years so there can’t be any runs on the fund. They can then lend long assured that their investors can’t get their money out. That’s more stable.

   The downside is they are opaque. It’s much harder to tell what’s going on in the economy as private credit is lightly regulated. There are also incentives for the private credit funds to keep failing companies alive for much longer. You keep investors’ funds for 10 years but you are always raising new funds so you don’t want to recognize losses in an old fund until you get your new fund closed.

   There’s evidence that private credit funds are incentivized to “extend and pretend” on bad loans. They keep companies that can barely make interest payments or can’t really make the payments out of cash flow from operating the company alive. That’s what we call a “zombie” company. It should just be killed (ie go into bankruptcy) so that better owners can use the assets more productively.

   If that problem gets big enough, it can drag on overall growth in the economy. More to come on this in future posts.

Keep growing,

Alan

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