Not Another Investment Podcast
Understand investing beyond the headlines with Edward Finley, sometime Professor of Finance at the University of Virginia and veteran Wall Street investor.
Not Another Investment Podcast
Demystifying Hedge Funds and Private Credit with Craig Bergstrom (S2 E4)
This episode delves into the complexities of hedge funds and private credit, exploring their distinct roles within investment portfolios. We address the performance challenges of hedge funds over the past two decades and the rising prominence of private credit, considering how both options can coexist as alternative assets in investor strategies.
- Discussion on misconceptions about hedge funds
- Overview of various hedge fund strategies and their risks
- Analysis of hedge fund performance in relation to equities and bonds
- Examination of fees associated with hedge fund investments
- Insight on private credit as a growing investment avenue
- Comparison between the roles of hedge funds and private credit
- Understanding the implications of competition on future returns
- Emphasis on the evolving landscape of alternative investments
Show notes:
Malkiel, A Random Walk Down Wall Street
Lowenstein, When Genius Failed: the Rise and Fall of LTCM
Thanks for listening! Please be sure to review the podcast or send your comments to me by email at info@not-another-investment-podcast.com. And tell your friends!
Hi, I'm Edward Finley, a sometime professor at the University of Virginia and a veteran Wall Street investor, and you're listening to Not Another Investment Podcast. Here we explore topics in markets and investing that every educated person should understand to be a good citizen. Welcome to the podcast, I'm Edward Finlay. We're really grateful and very lucky to have as our guest today Craig Bergstrom. Craig is the Chief Investment Officer and Managing Partner at Corbin Capital in New York City. Corbin is an independent asset management firm that specializes in multi-strategy head funds and opportunistic and private credit. Craig, welcome to the podcast. Thanks for having me. It's a great pleasure.
Speaker 1:We're going to talk with Craig today about a topic that I think is very much in the press these days, and that is the role of alternative assets like hedge funds and private credit in long-term portfolios. And for listeners who have heard episodes in the core season one, you might, if you want to refresh your recollection, go back to episodes 14 through 17 on hedge funds to get a flavor of that. If you've never heard them before, you might want to go back and listen first. But if you don't have time to do that, we'll explain what we're talking about anyway, and so, without any further ado, we'll kick it off. Hedge funds themselves. It's really a misnomer Like when we pick up a paper and we hear about hedge funds it sometimes sounds like it's one thing, but it seems to me hedge funds are probably lots and lots of things. Give us a flavor for what. Give us a kind of a contour map of hedge funds, if you can.
Speaker 2:Sure Ed. And to your point. You know there are jokes that hedge funds are, you know, are not an asset class. I think that's correct. There was one commentator long ago who joked that they're a compensation scheme like a you know version of economics. We think about them generally as portfolios managers, funds that trade generally in liquid market or traded assets, typically with an orientation towards generating absolute returns and or a lot of security selection alpha, if that makes sense. So high level-.
Speaker 1:And just to sort of unpack that for a minute. I think by security selection alpha you mean they're good stock pickers. They do better than the market would do.
Speaker 2:Well, maybe, but not quite.
Speaker 1:Okay, what's that mean?
Speaker 2:So one of the big sort of I think easier to understand hedge fund strategies is long-short equity. That typically involves people picking stocks on the long side and trying to outperform the market with some of their portfolio, typically also picking stocks to be short stocks that they think will underperform the market or their longs usually has some component of equity market return or beta and a large component of equity alpha or active stock selection risk, and a fair number of market commentators talk about alpha like it's always good. It's not there's negative alpha right, it's just active stock selection risk.
Speaker 1:And so that's why not just you're good at being a stock picker to beat the market that's true for the long side of a strategy like equity long short but it's also having some insight into which stocks are going to do worse than the market on the short side, and I suppose you've got to get them both right.
Speaker 2:Well, if you get it enough right on one side or the other, you could still generate an attractive return. But, yes, the best, most durable sort of stock picking track records long short equity track records are generally coming from organizations that we think can do well picking stocks on both sides. There are, though, a lot of other categories of hedge funds. There are, though, a lot of other categories of hedge funds, you know.
Speaker 2:Another big category are credit hedge funds, often focused on, you know, stressed or distressed corporate securities, bonds or loans. There's a smaller category of hedge funds focused on asset-backed credit. There are also hedge funds that pursue what we would call global macro, which is generally more directional trading, often in bonds and FX, but sometimes other things like commodities or equities, and that's a strategy generally where managers are trying to create a more sort of uncorrelated, often convex profile, and in recent years recent meaning, let's call it the last 10 years, in particular since the GFC we've seen tremendous growth in a small number of very large firms that do all of those things and more things right, the so-called multi-strategy hedge funds Gotcha.
Speaker 1:Now you used a couple of phrases there that I think are useful to sort of highlight for listeners, and so one of the things that you mentioned is something that suggests you used the word convexity, and so I think it'd be useful to just put in lay terms vexity, and so I think it'd be useful to just put in lay terms what are the kinds of non-normal and non-linear risks that you typically expect to see in hedge fund strategies at a very high level?
Speaker 2:Sure, and as a former derivatives trader, concepts near and dear to my heart. But maybe we won't go too deep just because then everyone will turn off their podcast and turn to other things you know. So in both investing or in derivatives trading, right? You know volatility is sort of the most commonly accepted and easiest to understand metric of risk, right?
Speaker 2:How much does an investment move from day to day? Or metric of risk, right. How much does an investment move from day to day? Or month to month, right. And you know, just for context, there, historically hedge funds have been a mid single digit volatility, right. Six or seven vol. That's less than half of equity market volatility, so you know. So I do think it's unfair when commentators say, oh, hedge funds haven't kept up with equities. They're generally, you know, in the kind of modern era, the last 20 years or so not meaning to do that right.
Speaker 2:There are much less risky in terms of volatility talking about other risks but there are much less risky in terms of volatility talking about other risks but they're a much less volatile asset. I think that even if they were earning exceptional risk-adjusted returns, it's going to be hard for them to keep pace with equities.
Speaker 1:This is a great point, right and important for listeners to really kind of process. That that when we pick up the newspapers and people are talking about hedge fund strategies, things like how did it do versus the S&P 500? How did it do versus, you know, the Russell index, are really kind of inapt comparisons.
Speaker 2:I think you're saying yes, I think that's not the right way to think about it. I don't think that they're for everyone, right? I think that you know. I think that they make sense for, you know, for large, sophisticated investors. You know, in some cases, very large investors, you know, who are looking to narrow the band of outcomes of return at the plan level, right, and you know, to you and to think about some of the press criticisms, it's like well, this hasn't kept up with equity. Well, if historic returns are all you need to know, then as a big institutional investor, you would be absolutely silly to own any bonds. Bonds have been pretty underwhelming for very long periods of time.
Speaker 1:Well, for 30 plus years, right.
Speaker 2:Okay, well then, that's easy. All we need to do is own equities and no bonds. Okay, I think most prudent fiduciaries would say, well, that's not quite right. Right, you know, in my investing career which is which is long, but not hundreds of years long there have been periods where the S&P was down for 10 years and I think that many people, especially younger people who are investing now, would find that hard to believe.
Speaker 1:Yeah, and in an earlier episode, listeners were treated to sort of a description of the lost decade in which, as you say, equity returns for essentially 2000 to 2010 were zero on an annual basis.
Speaker 2:And at times times, significantly negative Correct. So hedge funds are not, I think, typically going to outperform equity. They have historically outperformed bonds by a pretty significant margin. I think that the role-.
Speaker 1:Then again, I suppose that's an unfair comparison.
Speaker 2:In the same way, right unfair comparison in the same way. Right, I agree. I think that the point is that you would own it to increase the odds that you make your objective at the portfolio level, in particular, if you run a large pool of capital where coming up short is way worse than making a little bit more money and you're trying to meet a funding requirement for a pension or an endowment or foundation, for example, right.
Speaker 1:What are some of these non-normal and non-linear risks in terms of why would an investor care about owning them? What's the point?
Speaker 2:Sure, well, so this is actually not peculiar to hedge funds. It's really true of all financial assets, right? So your easiest first stop to think about risk is volatility. And then there are some assets that we'll talk about in a few minutes where that's probably not a measure of risk that's very accurate or meaningful. But then, when we talk about higher moments of distribution, right, it would be the odds that you have a way worse outcome or an outcome that statistically, should air quotes never happen, right, but you know. But there's a rule of thumb that financial markets generally have a lot of tail risk, right, a lot of outcomes you wouldn't expect from their volatility In both directions.
Speaker 1:Really good results as well as really bad results.
Speaker 2:Yes, but we see more in the downside note. So the rule of thumb and I haven't looked if this is recently true, but sort of when I was a you know, a much younger trader that we were taught was that most financial markets have a four standard deviation event each year and some financial market will typically have a 10 standard deviation event, which is sort of a statistical should never happen.
Speaker 1:Really anomalous Millions of years. Yeah, anomalous, Got it Okay and so okay. So all financial markets have got some of these right non-normal risks, so you own it if you're an investor. Is that something, then, that hedge funds especially try to create? Is it part of the secret sauce of a hedge fund strategy? Is it a byproduct?
Speaker 2:I think it's hard to tell right. I think that in your best cases, with your most talented managers, you see, you know, you see sort of upside skew without downside skew. If you do this a long time and you see enough, even very talented managers, you see, that often there is, you know, there are downside outcomes where you thought it was just skill. So you know. So I think that, unfortunately, the answer is it depends. But there are some hedge funds, you know hedge funds and hedge fund strategies where, because of leverage or because of relative value trading or other things about what they do, that they trade natural gas or electricity, that you end up with nonlinear for good or for ill patterns of results.
Speaker 1:Yeah, and that's useful, I suppose, in a portfolio. Is that a?
Speaker 2:fair thing to say. I guess I would present it in a more value, neutral way. It's some of what you might be trying to get as a sophisticated investor, right? So if you say, hey, my portfolio is all US equities, you have some reasonable diversification, but not as much as if you own equities in the US and elsewhere. You get more diversification if you own high quality fixed income assets, but still a little bit more if you own high yield bonds and as you add other, both assets and trading styles, I think it's intuitive that if you do it, you know in a thoughtful way, you should be able to produce you know potentially a little bit of a. You know to produce potentially a little bit of a higher quality or certainty of risk-adjusted returns. I can't remember who said it, but it was a true financial markets luminary Diversification is the only free lunch.
Speaker 1:Right, yeah, I mean, I think that's right and so OK, I get it. I think that's right and so okay, I get it. An investor would own these kinds of risks in a portfolio precisely because they're not going to be perfectly correlated with the main risks in their portfolio. And so one can then be creative, be innovative and fashion a portfolio in which you might get better returns with the same volatility. You might get lower volatility for the same returns. It's not as simple as just saying I want to own hedge funds or other alternative strategies in my portfolio because they're going to do better. It's as much as to say instead, this is about the alchemy of building a good portfolio.
Speaker 2:I think that's spot on Okay, and I think a lot of disappointment comes from people who view it, you know, in a more optimistic way than that.
Speaker 1:Yeah right, which is all too human Right.
Speaker 2:A little bit too much, bobby Axelrod, if you'll forgive me.
Speaker 1:Okay, okay, so great. But for the last 10 to 20 years the headlines that we read in the papers these days report that hedge funds. And again the headlines are going to be hard for us to understand because journalists are just saying hedge funds but we don't know which of these various strategies they're thinking about or talking about. But in general it's a fair statement to say most hedge fund strategies, at least in nominal terms for the last 10 to 20 years, have not earned returns consistent with most long-term investors' goals. It's been tough.
Speaker 2:I think there's absolutely room for investor disappointment and frustration. When I came into this business 23 years ago, after some time in related businesses, I think that probably 10-year trailing returns for hedge funds admittedly in a higher interest rate environment, were in the low double digits and, to your point, over the last 20 years or so, hedge funds have been annualizing. If I look at various hedge fund benchmarks, which are not perfect but I think are a reasonable proxy have been annualizing at more like six Right.
Speaker 1:Which, for most long-term investors, is really going to be tricky to achieve most goals if you're earning nominal returns of only about 6% on average.
Speaker 2:Sure, Although I would also hasten to add that over that period equities generally are only a couple hundred basis points higher. Equities are around eight, which is sort of in line with their very long-term annualized returns. Bonds are, I think, only two or three right, so also probably not inconsistent with their long-term returns.
Speaker 1:So this is a bigger issue. When we read headlines that say to us oh my gosh, hedge fund returns have been so disappointing for the last 10 to 20 years, is it that the shine is off the knob, or something like this? Really, if I'm understanding you, it's like well, let's put this into context. First, they don't sound like they're consistent with long-term investment goals. Sure, but neither do equity returns sound necessarily so consistent, or bond returns. That is a cross investment space. There's been in the last 10 to 20 years a bit of a tricky challenge in running long-term portfolios to reach your long-term goals.
Speaker 2:Sure, I mean equities. Us equities over the last 10 years have been stupendous. Well, yeah right, you know, but over much longer timeframes. The prior 10 years US equities were, you know, were essentially a loser Right, Right, you know. That said, you know, while I think that context is important, I do think there are some specific challenges in the hedge fund market. So I think that fees are too high and I think that increasing competition across a fair number of strategies has also taken some toll.
Speaker 1:So let's talk about fees. What makes you feel I mean the fees, the fee structures? Let's tell listeners roughly what that looks like.
Speaker 2:So you know, historically for a long time in the early days the standard was one in 20, meaning 1% base fee and 20% of profits. Sometime in the late 90s, early 2000s, that crept up to one and a half and then two and 20. And for a while two and 20 was a fairly standard fee structure.
Speaker 1:Well, their business school classmates in private equity were earning two and 20. So maybe they should earn two and 20.
Speaker 2:I think the hedge fund maybe went to it first, they went first, okay. But I think those are generally generally way too high and I think in particular it became way too high at a time when competition was increasing and, importantly as well, I believe, market volatility and some flavor of available return shrank. So at one time 1 in 20 was a much smaller percentage of the gross return and 2 in 20 became a very large percentage of a lower gross return.
Speaker 1:Overall return. You know, one of the things that I've read recently is some Some academic has studied hedge fund returns and hedge fund pricing and they claim that the performance part of the fee, the 20 part of the performance fee, when you consider when it's charged and then what ultimately happens after the fact probably looks more like 50%. Do you think there's any credibility to that?
Speaker 2:in general, across all hedge funds so there's another problem and this is a. You know, this is sort of a master class level of detail. But you know, while a typical hedge fund has what we would call a high watermark or a loss carry forward meaning they don't charge the incentive fee if you're not profitable that doesn't mean that a lot of them don't shut down after being unprofitable, right. So that produces what we would call a stranded high watermark, which does effectively mean that the effective incentive fee is a larger percentage of profits than the stated or nominal one.
Speaker 1:Right, right and so okay. And then the fee level. Just to give listeners sort of a bit of a contrast. If one were investing only in equity risk, what would you expect to pay a skilled active manager who invests only in long equity risk?
Speaker 2:Well, I mean, you know, the most obvious one, and especially for sort of individuals, is, I would say, you know, take the pay nothing and get the index return right.
Speaker 1:And what does that cost? Roughly Nothing, nothing, right, I mean that's you know, sign up at Vanguard. Let's put a real point on that, right? So two compared to zero.
Speaker 2:Right. So that's a big nut Right. You know active management fees vary a lot. But you know, with a shout out to my long ago boss, jeremy Grantham, who was a super thoughtful market observer Alpha is definitionally zero sum right. So for any one manager to have positive alpha, someone else is experiencing negative alpha Over time. Retail investors are a reasonable part of that. Some structured investment programs are a reasonable part of it. But the track record for traditional long-only stock picking is pretty dismal. You know that is generally a value-destructive activity.
Speaker 1:And you can pay for it. But I think you're right that the evidence is undeniably clear that, net of their fees, it's negative, it's value destroying.
Speaker 2:So I think that actually, you know, I think, that hedge funds generally are doing a little better than that, but perhaps you know, not at the industry level. You know well enough to cover a fee load that has come down from the two and 20 I mentioned, but it is still, I think, higher than it should be. I'll add one more point about that, though you know, I think a fair amount of real life experience would tell you that is a big mistake to be too fee focused, too fee-focused, and in fact, if you look at many of the most successful hedge funds by returns, but by dollars as well, they are by far some of the most expensive funds in the market.
Speaker 1:Yeah, I'll echo that sentiment for listeners too. In the portfolios that I run, I literally don't examine the fee structure in the first instance. I examine their returns net of all fees, for the risks that they take. It just seems to me I'm not terribly concerned about how much they pay themselves, as much as I am that they're earning return more than the risk that they take Right, yeah, and I think that's a perfectly fair comment.
Speaker 1:That's a perfectly fair comment. Okay. So higher fees than just owning run-of-the-mill, systematic risks in market is one element you mentioned in your description about competition. Something about retail investors we're recording today, on November 20th in 2024. And in today's Financial Times there was a piece about how Ray Dalio's firm, bridgewater, has announced a partnership with State Street to have an ETF that mimics or in some respect earns the returns of his all-weather portfolio. The all-weather portfolio for listeners who aren't familiar with Ray Dalio is the strategy that he devised, really thinking about his family and his own assets and people who weren't terribly sophisticated, and how to sort of earn very reliable returns over time. Is that a feature of what's going on in the hedge fund space? Is there retail money coming into some of these strategies that then trades away some of the magic, or is that a false?
Speaker 2:flag. I mean, I think that you know, the hedge fund business has just gotten a lot larger than it was 30 years ago. It's gotten a little bit more institutional. You know, maybe the pendulum is sort of swinging back the other way, but I don't think that retail participation is sort of a big driver of that. And in some ways and not to make this Wall Street bets us versus them like in the entertaining movies I think that there are times when retail investors collectively are on the better side of things. There are times when sort of active stock picking is getting the better of it. I think it's reasonable to think about it as zero sum, but not really as sort of an active conflict or conquest, if that makes sense.
Speaker 1:Got it. But size, you think, has had an effect that the kinds of returns that hedge fund managers might have earned prior to let's just draw a line 2014, let's say, were better. It's factually true, were better than they have been since 2014. But the size of the hedge fund industry, you seem to think, might have something to do with that.
Speaker 2:How does that work? I think that's right, but I would draw the line much earlier.
Speaker 1:Okay, where would you put the line?
Speaker 2:I would put the line sort of let's call it back in like 2000. Gotcha Right. So hedge funds Pre-global financial crisis yes, yeah, yeah, okay.
Speaker 1:And why there? Why? Why there? Why not? What's your thinking? Because that's when I started in this business, Gotcha. So it anchors you in terms of what you've seen and before that. You think that the performance of hedge fund strategies in general were better than after that moment.
Speaker 2:because you know, as I said, I think that you know certainly base rates is part of it, and I think higher base rates, you know generally, make me more you know certainly base rates is part of it and I think higher base rates, you know generally make me more you know constructive about hedge fund returns from here than over, you know, over, let's say, most of the prior kind of 15 or 20 years.
Speaker 1:Right, and so how does that work? Like so, over the last 15 years, base rates meaning for listeners just kind of the risk-free rate, either short or intermediate or long have been very, very low since the global financial crisis. Really, I suppose, how is it that those low rates have a negative impact on hedge fund strategies broadly?
Speaker 2:Sure, and not to split hairs, but I would say typically long rates not mattering a lot.
Speaker 1:Got it Really.
Speaker 2:Short rates out to a couple years, I think are what I would be more focused on as drivers of hedge fund returns. Ok, Most hedge fund strategies have a fairly direct pass-through from short-term risk-free rates, from short-term risk-free rates. So if we talked about long-short equity, those funds earn short rebate on positions that they're short based on short-term interest rates, right. So very roughly 5% rates and a typical long-short fund being 60% short. That would translate into 300 basis points of perspective return.
Speaker 1:Interesting, but when the short rates are one or zero or zero.
Speaker 2:Zero Gone right, and that's not perfectly the math, but that's the illustration. Many credit strategies also, effectively, are investing in assets, either asset-backed or corporate credit, that have a rate. Substantially all of them have a rate component to it right, Either floating rate or things like high-yield bonds. And even in global macro there's a second derivative concept, which is higher rates might mean a more volatile environment and more trading opportunities.
Speaker 1:Yeah.
Speaker 2:But the linear fact is that most global macro funds carry a lot of unencumbered cash. I see and they.
Speaker 1:If that's earning zero, they earn cash on cash rates, right, right, right. That's interesting. Yeah, I mean it wasn't. It's not the most intuitive thing for me to think about, but the way you describe it makes a lot of sense that a lot of the kinds of trading strategies in hedge funds have more likelihood of success, either because of the sort of returns you might earn on your short positions, or because of the fact that you've got bond exposure, or because of the implicit nature that higher base rates means there's more volatility in markets, like we could go on and on. Right. It makes it possible to do better.
Speaker 1:So the last 10 to 20 years is an anomaly. We'll see, we'll see right Excellent. We'll see, we'll see right, excellent. This brings us, though, to a nice kind of juncture in the road. So, 10 to 20 years, hedge fund strategies, which should have been earning returns consistent with the long-term goals of a portfolio, but not be perfectly correlated. They've been doing the second job reasonably well, but the first job has been challenging, and lately, private credit has more recently become a darling of long-term investors in terms of their alternative asset allocation. How is that in a portfolio different from owning diversified hedge fund strategies?
Speaker 2:So in some ways it's totally different in terms of the assets and the strategies. But, to your point, I think a reasonable number of investors rightly view them as not perfectly substitutable but as playing some potentially overlapping know, potentially overlapping roles in a portfolio. And if I sort of I'm going to imperfectly carve out and say, you know, I have my public market assets that are typically daily liquid but fairly competitive, and you know, and so I'm earning beta returns in equities and credit and I, you know, in many cases have a, you know, private equity portfolio where I think I can earn excess return, but on a very long time horizon, you know, with with a reasonable degree of risk and loss potential. So these are things I might do in between those things. They might be less liquid than my public market securities but hopefully, with a return pickup and a diversification benefit, they will be not daily liquid but more liquid, or shorter duration at least, than my private equity portfolio for a somewhat lower return and maybe, in the tails, a more defensive characteristic to ultimately corporate securities valuations.
Speaker 1:And with the added benefit that nominal returns for private credit, at least over the last 10 years, have seemed a lot more conventionally aligned with long-term portfolio goals. Let's turn the sock inside out. So we talked about what's made hedge fund performance less than attractive over the last 20 years. When thinking about now the future for private credit, isn't there a risk that we're looking backwards at private credit and saying, oh, but these nominal returns have been really quite good, et cetera? But going forward, we really might find that in 10 years we're going to be talking about the subpar performance of private credit.
Speaker 2:Sure, there is no investment idea so good it can't be spoiled by the wrong entry point or too much competition, right, you know? I think it's maybe worth defining a little bit sort of what we mean by private credit and a little bit of, you know, sort of the nature of that market. So generally it's lending, right, you know, as opposed to equity or first loss dollars across corporate and various asset-backed strategies. As it happens, we're more active in sort of niche and asset-backed strategies. But I think for this conversation it's more useful to talk about what the market is broadly, and 70% or 80%, depending on how you count, of the private credit market is what we would call sponsor-backed lending. So what that means is typically bilaterally negotiated loans to companies owned by private equity firms. And you know, I think private equity is fairly widely understood, you know. But typically private equity firms are using leverage and you know sometimes that leverage comes from traded credit markets, high yield bonds or leverage loans.
Speaker 2:Private equity companies are essentially never investment grade. But a large part of the market, in particular for smaller private equity deals, comes from private credit firms that are active in sponsor-backed lending and that is very generally trying to write loans to reasonably, reasonably high quality businesses with smart, sophisticated private equity sponsors. The hope is that in the downside node, the private equity sponsor will support the business right, meaning put in more equity, and that they'll be well managed. That is often, but not always, the case, you know, and those are that is generally trying to lend at a risk free right or SOFR plus, you know, kind of 6%, let's call it. You know, at times the spreads have been higher than that.
Speaker 2:Right now, for big you know big sort of competitive situations, the spreads are lower than that. But that's, you know, sort of where it is and generally that's been a very scalable strategy. Right, because private equity has grown a ton and you know, continues, while the last few years have been a little slow, continues to be very active and it's a strategy that's produced solid absolute returns and generally very good risk-adjusted returns. To our earlier conversation, some of those excellent risk-adjusted returns come from the strategy, like private equity not really being mark to market right. There's, you know, there's a quarterly NAV that you typically get a quarterly net asset value, but it's not truly in most cases, mark to market, so there's a fair amount of smoothing.
Speaker 1:Yeah, I mean listeners will recall in the earlier core episodes on private equity understanding that not only are the valuations quarterly, but they're based on business data one quarter before that. So there's sort of some staleness and there's some smoothing going on. So this also happens in private credit. The same issue inheres in private credit.
Speaker 2:Yes, and you know, and I think in most cases that's. I think sophisticated investors certainly understand that, but I think it is also broadly a feature, not a bug, right? Like I don't think that sophisticated investors are saying hey, you know, with high yield down five last quarter and leverage loans down four, do you really think you are flat? I think they're saying oh, thank you, I will go to my board and present this as being flat.
Speaker 1:And listeners will remember my using the phrase volatility laundering, which is coined by, I think, cliff Asness, but I can't remember if that's really who said it. All right, so private credit is in the business. Well, let's stay with the sponsored back lending, and that's the big gorilla in the room. They're going to be lending to private equity sponsors. They're going to be underwriting this in much the same way that equity investors are underwriting it, except they just have a different risk exposure. And so, from your point of view, that means what? In terms of how like that sounds very different than the kinds of risks you own when you own a diversified hedge fund strategy.
Speaker 2:Indeed, you know, in some ways good and in some ways maybe you know less good, right, so I think you know it's a, it's an interesting standalone risk return, right, I think that you know, as I often say, if I ran a big pension I would certainly own some of that exposure, you know. At the same time, I think it is, you know it's different from hedge fund exposure, right, hedge fund is, you know, exposure is typically, you know, as I said, sort of an alpha or active management component combined with some, you know, some elements of kind of risk or market beta risk or market beta. When we think about sort of sponsor lending, the collective sponsor lending experience looks a lot like the senior debt part of the collective private equity experience right.
Speaker 2:If you owned every private equity fund and every sponsor lending private credit fund, private equity fund and every you know sponsor lending private credit fund, you would own up and down the capital stack of all of the private equity owned company, yeah, both sides. So you know, I think, to your point, it is a, you know, somewhat shorter duration, somewhat, you know, less risky. You know exposure, you also, I think, would do well to think about it, as you know, as not entirely different from your high yield and leverage loan exposure.
Speaker 1:Right, right.
Speaker 2:Those are also largely financing high yield, less so leverage loans, largely financing private equity owned businesses. I think that we generally think there is probably somewhat higher quality underwriting in the private credit business than in the broadly syndicated loan business which in turn flows through to the CLO business, the collateralized loan obligation business. We're active in both of those, but you know. But as to your you know your opening question, as competition increases in sponsor-backed lending, you know, we think that does produce some long-term challenges to good underwriting.
Speaker 1:Yeah, I mean.
Speaker 1:So that's perfect, because I was going to say let's apply some of the lessons that we think we've learned about the last 20 years of diversified hedge fund performance to the next 20 years.
Speaker 1:And one obvious thing, it seems to me, is the competition idea is that if this thing is as darling as it is and if investors are flooding in and that means there are more and more of these private lenders out there then credit choices become so much more important, and when credit choices become a lot more important, it's going to necessarily squeeze how much of a premium you might be able to extract for making that loan loan. What about the other thing that we talked about with hedge funds, which is to say so we have this moment where, for the last, say, since the global financial crisis, we've had very, very low base rates and we've also had, for regulatory reasons, banks becoming much, much less able to make these kinds of loans and even more recently, the syndicated loan market had become much more distressed and there wasn't the availability. But, looking forward in time, can you talk a little bit about whether or not the future might be telling us something that's going to look different?
Speaker 2:Wow, bunch of good questions there, ed. Let me try to speak to a few different themes. The first thing that I would say because it's brief but I think interesting is actually good news, and that is that, unlike hedge funds, we do see significant compression in the fees charged for sponsor back lending.
Speaker 1:Oh, interesting, so it has come down your fees point I see it has.
Speaker 2:You know, in part because it's been such a scalable business and such a good business, people have gotten a lot bigger and been willing to take lower fees to do it Okay. So be mindful One fewer headwind, be mindful of your access point, but you know and what the fees for the structures that any individual or investor is paying. But there certainly are ways to access it at much lower fees. Next piece of good news is that we at least broadly, believe in somewhat, you know somewhat higher for longer Rates. Yes, sorry, base rates higher for longer. You know I'm reluctant to make you know too many. You know, besides the obvious kind of post-election predictions about the future, but I think it's fairly widely agreed that a lot of you know a lot of Trump administration plans are likely to be inflationary, you know. I think that implies higher base rates in the long term. So again, that would be, you know, on a standalone, good for private credit, also good for hedge funds, but good for private credit.
Speaker 1:Got it.
Speaker 2:But then, you know, sort of the final element is, you know, and this is you know a little bit me, you know me talking my own book, but you know, at least, when we think about private credit, you know we try to focus on niches and parts of the market where there is less competition, right, where you know and I would love to say that it's where there's no one else who does it. That's not, you know, not reality, but you know we're trying to look at, you know, less scalable strategies where maybe there are five market participants but not 25 market participants.
Speaker 1:It's interesting. I've heard that argument before and I think it makes tons of sense. But I wonder in your experience, whether, when you do try to find managers that operate in more niche-y markets where the opportunity sets are smaller, more difficult to identify the good ones, don't you also increase the likelihood of tail events, the likelihood of getting it wrong, compared to a bigger, broader, more competitive market?
Speaker 2:It's an interesting question. I mean, certainly, novelty embeds its own risks. There are still, though, things that we think there are very long observation windows for hey, this has been out there for 15 years or 20 years that's about as long as anything in private credit. So we think we have a good set, but maybe it's less competitive for some other reason. So, for example, maybe it is and you know, and certainly sometimes things are less competitive because of structural complexity or you know, which is could be good or bad, or because of tail risk, which is generally going to be bad, but, for example, we see less competition in things that are the same, or higher IRR but a lower MOIC multiple of multiple of invested capital.
Speaker 2:So you know. So there are a fair number of private assets where, if the average life is only two years, a lot of people don't really want to bother, right, you know. We also see a lot less competition for transactions, generically below $100 million compared to above $100 million A lot of people do the work for $100 million and far fewer, for $40 million.
Speaker 1:I see, and so that's not niche-y, which was sort of the topic that I was addressing, as much as it is just a smaller space with fewer players and maybe you wouldn't expect to see those tail events under those circumstances. I think that's fair. Events under those circumstances, I think that's fair. So let's see if I can recap this a little. Okay, so hedge fund strategies, they're really trading strategies. You have some exposure to traditional risks, but the nature of the trading strategies mean you also own other types of risks. The trading strategies mean you also own other types of risks and historically a diversified hedge fund portfolio was additive to a long-term portfolio because it didn't co-move with the rest of the traditional assets and because managers were able to earn returns in excess of their risks. Last 20 years that's proved problematic. Fees might be a problem that helped Well. Years that's proved problematic. Fees might be a problem that helped Well, not a problem. Fees might be one reason that that's been the case. Competition has been a reason and rates have been a reason, but that going forward it might be.
Speaker 1:So when we read headlines about hedge funds oh my God, is it just? You know that was a flash in the pan. We should take care. We should be careful about drawing those conclusions. Private credit, which is the thing that has sort of, is the new shiny object. We should also take care, because, while it too plays a role in a portfolio and has these sort of very favorable elements that we think are useful, they've also, for the last 10 years, had some really favorable headwinds, and the future might be good for them. Higher base rates might be good for them. More competition might actually be neutral, or maybe not so good for them, but there are going to be a varied number of reasons, and so beware of the shiny object. What have I missed?
Speaker 2:I mean, you know, I think that that's a pretty good summary. You know, I think that's sort of definitionally true of investments, right?
Speaker 1:We've just defined investing.
Speaker 2:If past performance were indicative of future results, it would be easy.
Speaker 1:Right right.
Speaker 2:And you know there's another commentator, you know who says something that I think is interesting. Right, you know it's not turn-based. By doing nothing, you are doing something right, that's right.
Speaker 1:I like that.
Speaker 2:Systems are dynamic. Makes sense for a large, sophisticated investor with a perpetual timeframe is very different from what makes sense for an individual, even a wealthy, sophisticated individual who is, for example, taxable.
Speaker 1:Yeah, and I mean I don't think we can emphasize that point enough that, whether we're talking about hedge fund strategies or whether we're talking about private credit, in both cases the tendency has been a slow and steady push towards involving more and more access for retail investors into those classes, and I think that retail investors should take care. And I think that retail investors should take care, and as we talk about policy, we should take care that retail investors understand these pretty complex ideas and that it's more than just the risk of buying stocks and bonds. Craig, this has been terrific. I can't thank you enough. I want to close with one thing that I ask each of the guests to do, which is I like to call it your pearl of wisdom. It can be about anything. It could be personal or professional, or market-oriented, anything. And Craig for listeners. Craig is looking at me like we didn't discuss this and that's the idea. It should be off the cuff, but can you offer listeners just Craig Bergstrom's pearl of wisdom?
Speaker 2:the cuff, but can you offer listeners just Craig Bergstrom's Pearl of Wisdom. And you know, and I maybe I should start with that you know, with some of the you know the sources that I like, right, like I, you know I think that Random Walk on Wall Street is deservedly a classic, so I would recommend that If you want to learn more about, you know, hedge funds and what can go wrong, I think, when Genius Failed is a, you know, super fascinating like and a great read. So I might start with those two.
Speaker 1:Great Craig, thanks a million.
Speaker 2:Thanks for having me.
Speaker 1:You've been listening to Not Another Investment Podcast hosted by me, edward Finlay. You can find research links and charts at notanotherinvestmentpodcastcom. And don't forget to follow us on your favorite platform and leave comments. Thanks for listening.
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