Active-Passive Conflict – Wealth of Common Sense

My first job in the industry was as an analyst for a corporate investment advisory firm specializing in managing money and investment plans for hospitals.

Hospitals may be nonprofits, but they sure make a lot of money.

My boss taught me a lot about setting investment rules, the importance of asset allocation, risk profile and time horizon. When I first started at the firm, he used a new client to teach me the importance of matching assets with liabilities when building a portfolio.

These hospitals all had numerous investment funds to manage: endowments, foundations, retirement plans, operating funds, etc.

There were also malpractice insurance funds set aside for lawsuits against doctors and other medical practitioners when an error occurred. The new hospital came to us with the entire malpractice fund in cash. The money had to be paid so they didn’t want to take any risks.

But my boss knew that these claims often took longer than expected. A simple case can take 6-18 months to be paid from the time a claim is made. More complex cases that go to trial can take up to 3-5 years until payment is made.

We had them review the history of malpractice claims and discovered that the average case takes about three years from the time the claim is filed to the time payment is expected.

The emphasis on cash led to a mismatch in the fund’s asset-liability mix. They had the ability to take more time and therefore increase the return on that portfolio. So we did this for them. It wasn’t a huge difference, but it was enough to make the hospital management happy.

The idea of ​​matching your investments to your goals, risk profile and time horizon has been engrained in my mind since the early days of my career.

I’ve been thinking about this asset-liability matching idea with all the headlines about private loans in recent months:

Private credit is essentially a funding market for borrowers who have outgrown their local banks but are not yet ready to finance their operations through Wall Street. These are private, direct loans with higher rates because you don’t have to deal with bondholders or overly regulated financial institutions.

When regulations after the 2008 financial crisis made it more difficult for banks to provide these loans, private market managers such as Blackstone, Apollo, KKR, Ares and Blue Owl stepped in.

Like other corporate bonds, you have credit risk if the borrower defaults on the loan. But the biggest difference between public loan and private loan is the liquidity or lack thereof in these loans.

Private loan funds fared much better than most fixed income during this period because the loans were variable-rate, meaning they adjusted to market yield movements. 2022 bond bear market. This, combined with much higher returns, has meant billions of dollars have flowed into the space in recent years, much of it through the asset management channel.

The problem is that much of the hot money either (a) did not set the right expectations with their investors upfront or (b) did not have the right time horizon in mind when allocating to the space.

These private loans are not tradable. You clip your coupon and hold the loans until maturity. This means you should have a time horizon of at least 5 years, but 7-10 years is probably more reasonable.

Interval funds allow 5% redemption every three months, but these special loans are not intended to be taken out.

This isn’t a short-term asset class where you should try to bide your time by getting in when rates look attractive and getting out when you’re worried about credit problems flaring up.

I don’t know enough about the credit quality of the private credit space as a whole to make a judgment on this asset class. Many investors and reporters think exposure to software and weak credit standards will lead to some booms. Private credit experts say everything is still fine beneath the surface.

No matter how this all turned out, there was a clear mismatch between this fund structure and the expectations advisors set for their clients.

You need to think long and hard about your time horizon for any investment, especially illiquid assets.

Frankly, there are too many investors who don’t think about this before allocating to private credit.

Further Reading:
Why Is Private Equity Crashing?