Unconventional wisdom: This hot investment is a hard no from me
A flood of new money and a narrative that is too good to be true.
Conventional wisdom is a byproduct of groupthink that presents solutions good enough for the average person while simultaneously not being right for any individual. You follow it at your peril. Each Monday I will challenge the investing norms that just may be holding you back from living the life you want.
Unconventional wisdom: This hot investment is a hard no from me
“As long as the music is playing, you’ve got to get up and dance.”
- Chuck Prince
Let me tell you a story. It is a redemption story. Boy goes to exclusive private school. He commits some youthful indiscretions and goes on to find success in business. At a high level this is a bit of a Horatio Alger tale. Boy makes good.
The devil is in the details. The boy’s youthful indiscretion happened far after he was a boy. He was in his late 20s. It involved defrauding the ATO and using his status as a registered immigration agent to steal money from an international student.
His redemption remains incomplete as most of his family and many of his high school circle won’t talk to him. Yet from a business perspective the redemption is impressive,
The Australian Financial Review (“AFR”) details how since starting private credit firm Renown Lending in 2023 Kalpi Prasad has raised enough investor capital to fund a $400 million dollar loan book.
Renown Capital has lent money to about 300 residential and commercial property deals as well as small businesses. This is an impressive pace. It is also illustrative of what is happening in private credit. And why I would avoid it at all costs.
Can you identify a bubble before it pops?
There is a famous fable about Joseph Kennedy. And I’m using the term fable deliberetly as it is almost certainly untrue. Joseph Kennedy was the Nazi appeasing US ambassador to the UK and the father of John Fitzgerlad Kennedy. He was also very, very rich.
One day Joseph Kennedy was getting his shoes shined. Instead of idle chit chat the shoeshine offers Kennedy some stock tips.
Kennedy did not use the tips. Instead he decided that if the guy shinning his shoes was giving stock tips it was time to get out of the market. He reportedly shorted the market right before the crash in 1929.
How Kennedy acquired his fortune is a little murky but there is some evidence he did in fact short the market. Even if it isn’t true this fable about market bubbles is compelling and illustrative. The lesson holds true. When the proverbial ‘shoeshine’ starts piling into an investment it is time to get cautious.
We search for signs of bubbles in the tea leaves because a bubble is a nebulous concept. They are only apparent in retrospect when we craft a narrative showing the obvious folly of people caught up in the hype. Yet this folly is less obvious in the present. Is the story of Renown Capital a sign of a bubble?
Be wary when too much capital goes into a new type of investment
I want to preface this by saying I want things to work out for Kalpi Prasad and Renown Capital. I sincerely hope this is a redemption story for him. Far too few people get second chances in this world.
In saying that I’m still shocked by the seeming ease that Renown Capital raised a substantial amount of money from high-net-worth individuals. This capital was raised by a firm with no track record. It was raised by a firm started by a felon who spent two years in jail for fraud.
To me this is a sign that investors have gone crazy for private credit. I can’t figure out why.
The narrative around private credit is straightforward and has been swallowed by investors hook line and sinker. In the wake of the global financial crisis (“GFC”) regulators required banks to hold more capital which means they reduce lending. Non-bank lenders or private credit stepped in to fill the gap.
Even the most cursory interrogation of this narrative raises questions. We can start with why regulators were concerned about who banks were lending money to. The concerns were raised when banks lent money to a bunch of people that couldn’t pay it back. It almost brought the global economy down.
Into this void stepped the non-bank lenders. What the high-net-worth investors in Renown Capital are getting is a securitised pool of asset backed loans.
Does this sound familiar? It was securitised pools of asset backed loans that brought about the GFC. It wasn’t the investment vehicle that was the problem. It was the quality of the loans in it. More on this later.
In the GFC we had failures on multiple levels. The regulators failed. The credit rating agencies failed. The risk management departments of banks failed. Bank management and boards failed. In no small part all of this happened because everyone was making money. Lots of money.
Fast forward to today. The non-bank lenders aren’t regulated. There are no credit rating agencies evaluating these securitised pools of loans. There is no transparency on who is being lent money. The safeguards that failed during the GFC don’t even exist.
We are told by the private credit lenders that we can instead rely on their internal risk management functions and their underwriting standards. Trust us they say. We won’t tell you who is borrowing money. But trust us. The reason I’m wary is because the motivation to cut corners is substantial.
Throughout history banks have had a principal-agent problem. We’ve all heard the heads you win, tails they lose story. In a bank the goals of the agent (management) and the principal (the shareholders) can come into conflict.
Many of the checks and balances on banks don’t exist in private credit. The only check on poor behaviour is due diligence from investors. But the Renown Capital story shows that investors will fund anyone. Money is simply flooding into the asset class.
Between 2013 and 2023 private credit assets grew from approximately $500 billion US to $1.6 trillion US global. This flood of capital incentives people with little experience or expertise to enter the sector. This competition from inexperienced newcomers presents challenges to credible and prudent lenders. This is an operating environment fraught with potential risk.
For any private credit fund there is a lot of incentive to deploy – or lend – the money as fast as possible. That needs to happen to start earning fees and to make the case to investors that they should provide additional funds which is needed to earn more fees.
Throughout history this combination has led to problems. Lots of capital, a complete lack of transparency, a principal agent problem with incentives for risk taking behaviour and few checks and balances.
The private credit sales pitch
The sales pitch for private credit is straightforward. Private credit is a defensive asset that offers equity like returns. To believe this statement requires a perverse doctrinal view of investing where the label matters more than the attributes of the investment.
Other than being a loan there is little about private credit that resembles traditional defensive assets. Loans may be associated with defensive assets but not all loans are the same.
Casual comments in the AFR article I referenced earlier should at least raise some alarm bells.
”Prasad says non-bank lenders are nimble and can approve loans in a matter of hours, whereas traditional banks can take up to three months.”
One interpretation of this quote is that the big lumbering banks are too bureaucratic to do anything quickly. Another interpretation is the banks are prudent and have underwriting standards that involve assessing the risk of a loan
A portfolio of asset backed loans begins to look a lot like a growth asset if there is enough risk they won’t be paid back. If there is a default and the asset is seized it becomes a growth asset.
For instance, private credit heavyweight Metrics now owns the Rockpool restaurant group after the previous owner defaulted. Running a restaurant is not a defensive asset. Taking over incomplete construction is not a defensive asset.
This is just one cherry picked example but the default risk is always going to be higher for private capital than what we traditionally consider defensive fixed interest investments. The returns are high because the loans are made to risky borrowers.
We know the are risky because of the interest rates. I will once again quote the AFR article:
“Some loan rates in the industry range from between 12 per cent to 20 per cent. Prasad says Renown’s first-backed mortgages in metropolitan areas have rates between 8 and 10 per cent, while construction loan rates start at 10 per cent.”
Nobody is paying those levels of interest rates because they have other options. Just like nobody pays junk bond rates if they can issue investment grade debt. Junk bonds are seen as more of a growth asset than traditional fixed interest. Should private capital be any different?
Equity like returns that are lower than equities
Metrics Direct Income fund has delivered 7.70% a year since inception in 2020. Metrics Master Income Trust has annual returns of 6.31% since inception in 2017. This all occurred in a relatively benign economic environment.
Those are strong returns if you consider private credit a defensive asset. They aren’t so great if you consider private credit a growth asset.
Personally, I can’t imagine a scenario I would invest in private credit. I see too many red flags given the risk caused by the money flooding into the sector.
The risk is too high that poor actors will enter the sector. The temptation to cut corners from more creditable firms facing intense competition is too great. History suggests retail investors late to the game will suffer the most.
I think the assets are more growth like than defensive and historically the returns on other growth assets are better.
There is zero transparency into who is being lent money. The much touted low volatility of private credit is more of a product of the valuation approach than the characteristics of the assets.
All investments involve risk. But sometimes the risk is too high for the reward. I think this is one of those cases.
Questions? Comments? Email me at [email protected]
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What i’ve been eating
Malabar in Darlinghurst is a great place for a lunch. The Indidan food is good and it is BYO. Not a bad combination. Shani and I went there to celebrate completing our book. The book is called Investing Your Way. It is a personal finance book that combines foundational investing theory, real world application, and our own experiences as well. And it is designed to help readers create a financial plan and investing strategy that’s tailored to their unique goals and circumstances. More to come.
