Seeking the holy grail of liquidity within a private credit fund

For many investors one of the attractions of private credit funds is the higher premium/returns available from investing in less liquid loans. It would therefore appear that to want liquidity within a private credit fund is an inherent contradiction. Yet there are ways that investors can enjoy a higher level of liquidity though expectations need to be tempered.

An important starting point is for the investor to be clear regarding what is meant by ‘liquidity’. The concept of liquidity traditionally refers to the ease with which an asset can be converted into cash without affecting its market price or book value. 

Though private credit managers will often refer to their ability to sell loans as providing liquidity, the ability to facilitate sales of private loans will depend heavily on market conditions at the time. 

For this reason it pays investors to be more conservative making such a definition of limited utility when applied to a sector which is best assumed to be largely illiquid in the traditional sense. To make the definition more relevant for private loans liquidity should be reinterpreted to refer ‘to the ability of a loan to return capital to investors without the need to sell the underlying loan’ 

Liquidity is now a measure of the velocity of capital which may in turn be utilised to either be recycled into new loans or returned to investors. The additional benefit of this definition is that it highlights the distinction the investor needs to make between the liquidity associated with the underlying loans (‘natural liquidity’) and that associated with whether the structure of the fund (‘fund liquidity’) allows for early repayment of capital realised.

Making the most of the ‘natural liquidity’ within a private loan strategy

For any investor the starting point is to consider the underlying liquidity of the actual loans they are investing in. There are several ways that private loan strategies can have a higher level of natural liquidity generation. The first is where the loans themselves are structured in such a way that they create a naturally high rate of capital generation. 

 One approach is to utilise a strategy which makes short term loans of say 1-2 years average life. With a diversified ladder of such loans the portfolio can comfortably generate around 50% turnover in capital per annum. Such a high turnover rate should normally be sufficient to satisfy most liquidity requirements. 

A typical example of such a strategy would be higher yielding loan strategies which aim at providing high cost debt as an alternative to equity. In practice borrowers view such loans as temporary in nature given their cost and the resulting turnover tends to be high; i.e. loans are only outstanding for a short period of time as repaid ‘early’ by the borrower.

Linked to this approach is the strategy of investing in ‘vintage’ portfolios. For closed end private loan portfolios there are three distinct phases in their lifecycle (a) capital gathering stage where investor capital is raised, (b) investment/reinvestment phase where capital is invested and capital repayments can be reinvested in new loans and (c) the ‘harvesting’ phase where the making of new loans ceases and all capital is returned to investors as repaid. A vintage fund is one which has entered the ‘harvesting’ phase and so is in the process of returning capital to investors. Funds at the ‘harvesting’ stage will also tend to have a lower average life to their loans as they have moved closer to their maturity dates. Investing into a fund at the ‘harvesting’ stage can provide additional liquidity for an investor by taking advantage of a particular point in the fund’s life cycle.

The second approach is to invest in naturally amortising loans. These are loans which will pay down cash relatively quickly as repayments comprise both principle and interest. With amortising loans principle is amortised or realised over time as opposed to being a bullet payment made at maturity. The regular periodic repayment of principle increases the level of capital generation from the loan portfolio and hence its ability to provide liquidity to redeeming investors. The main loan type which exhibit high amortisation rates are asset backed securities. Typically, such asset back securities are associated with mortgages, car loans and personal loans.

Managing the ‘fund liquidity’

Irrespective of whether the fund is open or closed ended the characteristics of the underlying loans have a material impact on the ‘natural liquidity’ generated by a fund and the rate at which capital can be returned to investors. 

Yet whether a fund can return capital and whether it will return capital are two different issues and depend on the structure of the fund itself or ‘fund liquidity’. As closed end funds have a defined lifecycle set at inception the question of fund liquidity becomes more relevant when dealing with open ended funds.

Open ended funds are simply funds which can issue or redeem units at any time or at the discretion of the manager. When dealing with fund structures open ended funds basically allow two types of access to the natural liquidity generated by the underlying pool of loans. The first shall be referred to as ‘general’ access. 

This is where redemption requests are queued or pooled and then repaid as liquidity is generated by the general pool of assets. In such a structure the investors seeking to redeem have access to the liquidity generated by the total pool of assets in the fund. The benefit for redeeming investors is that they can be paid down at a faster rate. The disadvantage for remaining investors is that it may impede the ability of the fund to reinvest capital and hence adversely impact returns. 

The alternative is where the redeeming investors have what may be referred to as ‘specific’ access. Under this structure, once an investor decides to redeem, a prorated sleeve of the fund is effectively ‘separated’ and set aside to fund the redemption of the investor’s capital. The result is that the investor is only repaid from the liquidity generated by loans within the separated sleeve. The disadvantage for an investor is that it makes the repayment of capital slower. The advantage for non-redeeming investors is that it doesn’t impede the ability of the portfolio to reinvest capital.

A final approach is to facilitate redemptions by holding part of the fund’s capital in more liquid loans. This effectively separates the portfolio into more ‘cash like’ or public loans and less liquid higher returning private loans. Such funds can be viewed as being ‘hybrid’ in nature as they combine both public and private loans within a single strategy. 

The more liquid public loan exposure then acts as a ‘buffer’ absorbing redemption requests exceeding the natural liquidity generated by the private loan portfolio. There are however two primary issues with such an approach. Firstly, it creates an exposure to lower returning public loans even when liquidity is not required by investors. 

Secondly, it puts the onus on the manager to correctly assess the mix between ‘liquid’ and ‘illiquid’ loans required to facilitate redemptions under prevailing market conditions. Failure to correctly assess such requirements increases the risk that the fund may be unable to satisfy redemption requests and may be ‘gated’.

Investors need to keep in mind that irrespective of the liquidity offered by a fund the ‘natural liquidity’ of the fund will be determined by the nature of the underlying loans. This is an important consideration as all open-end funds will allow the manager the right to halt redemptions under specific circumstances referred to as ‘gating’. 

The specifics will vary depending on the fund but broadly they usually allow the manager to stop redemptions where their payment would disadvantage the remaining investors; i.e. manager must at all times act in the best interests of all investors. It is therefore important for investors to be comfortable that the ‘natural liquidity’ of a strategy is broadly consistent with the ‘fund liquidity’ to minimise the risk that an open-end fund may be ‘gated’.

While the concept of liquidity within private loans markets may appear to be a contradiction it is not. The important point with private loans is that the investor should focus on the ‘natural liquidity’ of the strategy and implicitly assume that the underlying loans cannot be sold to return capital. 

Once this is recognised the varying degrees of liquidity available within the private loans market becomes determined by the underlying characteristics of the loans themselves. By appropriately selecting and combining strategies an investor can have access to a higher degree of liquidity though it will never reach the same level as that available from investing in public markets.