Why These Alternative-Asset Funds Aren’t for Everyone

Like other alternative investments, private debt funds were mainly the purview of institutional investors until the past few years (see chart). There are now many more ways for retail investors to take part. Fidelity, BlackRock, KKR, as well as numerous smaller players, are offering new funds. Many private credit funds only allow for quarterly redemptions, and even those can be restricted if too many investors head for the exits all at once. Plus, they may have high minimums and fees.

A big reason for their popularity is how well they held up last year when both stocks and bonds fell sharply. Private debt funds returned 4.2% in 2022 compared with declines of 18% for the S&P 500 index and 15.7% for investment-grade corporate bonds, according to PitchBook.

Brad Marshall is global head of private credit strategies at Blackstone, which offers the $48 billion Blackstone Private Credit fund, known as BCred. Coming up on three years since its inception, BCred boasts an annualized total return of 9.8% and a current yield of 10.5%.

Marshall sees two phases in private credit’s growth. In 2020-22, investors were thirsty for yield and wanted to be in a floating-rate fund while the Fed was hiking rates. “Today something else is going on,” he says. Now investors are looking for defensive qualities that private credit offers, he says.

BCred, as well as most direct-lending funds, makes senior secured loans to midsize companies, meaning they’re first in line to get paid back in defaults. Direct-lending funds often make hundreds of loans, so they are diversified. Since they lend directly to borrowers—mostly companies with strong cash flows in growing industries—they can often negotiate strong investor protections, or covenants, says Brad Schneider, head of private credit at Cresset Partners. One of the benefits of private credit is that when a company hits a snag, lenders can figure out a way to solve the problem—perhaps adding more protections or getting a bit higher rate, he says.

“These funds invest high up in the capital structure,” says Torsten Sløk, chief economist at Apollo Global Management, which has its own private debt vehicles. “They stay away from names that will get hit by recession. They have the best protections because they have the right covenants in place.”

Since the securities aren’t publicly traded, private credit funds tend to be less volatile than their publicly traded counterparts, such as business development companies, or BDCs, says Mike Terwilliger, portfolio manager of the
Alternative Credit Income
fund (ticker RCIIX), which can move between private and public credit. Right now, he says he is finding a “deeper arsenal of opportunities” in private credit but may shift to buying more public credits, which in a downturn can typically get very cheap. Private credit isn’t subject to swings in market sentiment. “Those valuations faithfully represent the fundamentals of the business, not the whims of the market,” Terwilliger says.

Kelly is watching to see if too much investor money starts chasing too few private credit deals, which could lead to weaker credit terms. But the opposite seems to be the case now. Companies are turning to direct lending more than ever, and the pipeline is expected to continue to grow.

The biggest risk for private credit investors is tied to risks facing credit investors more broadly: The economy is slowing while higher interest rates are eating into cash flows of many companies, making it harder for them to pay back loans. Richard Daskin of RSD Advisors is wary of credit risk in general—and private credit in particular—because investors in gated funds might not be able to pull their money out in a downturn.

“There are attractive opportunities, but you have to be careful and selective,” says Mariia Eroshin, a managing director at Certuity, which provides financial guidance to wealthy families. “We’re looking for short duration and low leverage. Investors get a premium for the illiquidity risk of private investments, but that risk needs to be taken wisely and thoughtfully,” she says.

Clearly, private credit isn’t for everyone. The funds can feel like a black box. Dan Pietrzak, global head of private credit at KKR, notes there is increasing diversity in the asset class. “Private credit is broader than direct lending,” he says. KKR in fact, is launching a new fund that has a sizable allocation to asset-based lending, according to a filing reviewed by Barron’s.

Many investors are worried about high stock valuations in a slowing economy, and private credit looks like a good alternative. “It seems like it solves a problem,” says Evan Lorenz, deputy editor at Grant’s Interest Rate Observer. “But those higher yields come with some risk.”

A small allocation may make sense for wealthy investors who don’t need to worry about tying up their money for a longer time, Eroshin says. Even then, “there are a lot of things to consider. You need a thoughtful and careful approach.”

Write to Amey Stone at [email protected]