Private credit: The case for freeing investors from the grip of passive management

First, growing awareness of fees (sparked by John C. Bogle, the prophet of passivity, and amplified by Warren Buffett, amid the height of the cultural zeitgeist) enabled passive funds to take stakes from active managers throughout the 2000s. Last year, total assets under passive management exceeded active, accounting for 53% of market share.

The shift towards passive investing has had profound effects on the market

As more and more “buy” and “sell” decisions were dictated solely by money flows, profits and other market signals became muted, stifling the market’s response mechanism.

The deterioration of fundamental investing has paralyzed many hedge funds that once made bold directional bets (long and short) – replaced by factor-based capsule trades (often with nanosecond holding periods) – amplifying the collapse of market efficiency.

The negative situation has enabled the birth of big tech companies, market-dominant, mega-capitalized companies that reap huge fortunes from lofty, self-reinforcing valuations.

If a negative market-weighted vehicle receives inflows, those dollars buy a proportional share of the index components, without any regard to the company’s valuation. The company will receive investor dollars regardless of whether its stock trades for 1x or 1000x sales.

This is just one example of a larger problem, which is that public markets are no longer strictly seeking the highest and best use of capital. Instead, they reward constituents of large indices with a lower cost of capital, which ultimately stifles competition and hurts small companies. By weighting the same securities through negative instruments, investors’ holdings appear to be a sea of ​​sameness, which increases systematic risk and limits diversification.

Retail investors are being disproportionately hit; Their options for distributing their hard-earned savings were restricted by public markets. Moreover, a universe of stocks that is shrinking (with roughly 4,000 public companies today, up from 8,000 in the late 1990s) and increasingly concentrated (the top 10 components of the S&P 500 account for roughly 40% of the index compared with about 20% in 2000), represents a narrow field for most investors.

Private markets, and private credit in particular, offer an effective solution to the negative problem

First, in terms of form, there is no negative approach to finding, repairing and selling a jet engine, for example. Likewise, structured equity requires a company-specific capital solution; There is no specific approach. Asset-based lending involves double underwriting – an assessment of the actual assets as well as the financial health of the borrower. A passive approach to such an IPO would spell disaster for investors.

If we envision a passive approach to private credit, inflows would require managers to allocate capital randomly among existing borrowers. More capital may benefit some borrowers, but more often it would suffocate companies with larger debt loads. Relatedly, how will passive vehicles be able to unlock liquidity in an illiquid asset class, other than catastrophic forced sales?

Market performance (relative to similar strategies) has nothing to do with negative compounds; There is no outperformance or underperformance, there is only index performance. Hence, raising capital is largely an algorithm of lower fees and marketing dollars.

In private markets, it is not enough to simply beat the index

In contrast, private sector managers must pass the Darwinian test to raise capital. Brand value and marketing can overshadow their effects, but performance, (unique) pipeline and process are ultimately paramount to investors.

To achieve success in their jobs, managers must manually survey the world of private companies to identify those capable of generating a return on investment; Good companies get more capital, and bad companies meet their demise with bankruptcy. Likewise, successful managers expand, while unsuccessful ones fade away.

As the share of migrating capital increases to passive status, private credit provides compelling active managerial compensation – and also contributes to the long-term health of our economy.

Individual investors and retirees should not be denied access to private market opportunities

Private markets were once a gated asset class. Attempts to incorporate private assets into 401(k)s should be applauded, both to expand the availability of capital and expand access to it. However, management must go one step further, recognizing the anticompetitive consequences of negativity and wary of any 401(k) structure that disproportionately rewards size – whether to managers or potential borrowers.

If access to private markets were expanded to include all companies (not just large corporations) and all investors (not just institutions), this would benefit investors, companies, and the American economy as a whole.

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