Hedge funds are increasingly looking at the latest hot product — private credit — as a new arena in which they can compete with private equity firms — just like they did over the past decade when they jumped into venture capital. Private equity firms and specialist shops have been expanding into the asset class since the global financial crisis when banks stepped back from lending to lower rated and smaller companies.
The potential new capital may be tempting, but the asset class also is rife with technical and operational issues that many hedge funds aren’t prepared to deal with, said David Nable, managing director of Arcesium, the non-investment technology side of D.E. Shaw that was spun out as a standalone company in 2015.
“Getting this wrong” could put a firm in “hot water” with either investors or regulators or both, Nable said in an interview with Institutional Investor. “I don’t think anyone is taking this lightly, but that’s why it’s such a big deal. It’s like, okay, this makes sense as an investment strategy, but how do we make sure we can actually do it in a proper and controlled way?”
While the trend is still in its infancy, Nable said that every hedge fund manager with at least $5 billion in assets that his firm has spoken to about private credit is either already in the market or actively investigating getting into it. He says this reflects the convergence of public and private investing. “The line is blurred. At the manager level, everyone is doing everything.”
D.E. Shaw, J.P. Morgan and Blackstone are all investors in Arcesium, and Nable said all three have a sizable interest in the private credit market. Blackstone Credit & Insurance has $418 billion in private credit assets. D.E. Shaw has been offering private credit funds since 2008. “All of them are touching this in some way, shape or form,” said Nable. Some private equity firms have funds that invest in both public fixed income and private credit and shift between the two depending on opportunities.
J.P. Morgan and D.E. Shaw declined to comment. Blackstone did not return a request for comment.
Some hedge funds believe they need to raise at least $300 million for a standalone fund to get into the market, given the costs of upgrading technology systems to make the investment worthwhile.
“It is really causing all of these asset management firms to rethink their operating model,” Nable said. “It’s causing the leadership of the firm to really think through how are they going to do this at scale to still be an institutional quality firm.”
He said some hedge funds are simply “chasing the hot trend,” and “don’t really have credibility in the segment” to do well. But strong performing credit hedge funds have natural opportunities to expand from bank loans, for example, into private credit.
There is plenty of demand. Credit — both public and private — was the second-most popular hedge fund strategy among allocators surveyed by BNP Paribas in September. Private credit strategies now total $1.7 trillion, according to Preqin.
Other hedge funds already offering private credit products include such well-known credit investors as Hildene Capital, King Street Capital, and LibreMax Capital. Third Point has told investors that it is raising money for a separate private credit fund. Hildene, King Street, and LibreMax declined to comment.
Nable believes credit portfolio managers and analysts have the skills to make the shift to private credit. But he cautioned that there is a “giant leap” when it comes to the underlying infrastructure. “The very boring stuff of accounting and position keeping and transaction and tax and compliance, all of that fun stuff is meaningfully different because most of the systems and architecture were designed around relatively standardized instruments,” he explained.
Private credit, unlike liquid bonds, don’t have a real-time market feed available on Bloomberg that can give them a price.
“You pull this in as a standardized data feed and the magic happens. You get a p and l, you get investor reporting,” he said. “That does not happen when a fund makes a private loan,” he said. The terms of private market loans are negotiated between two parties and then created, or originated.
Hedge funds need the operational infrastructure to track things like collateral and security clauses. “If you’re making a private loan to a private company, how are you monitoring those covenants? And so all of these things that are attractive from the investment side become quite difficult on the non-investment side,” Nable said.
But hedge funds have a long and profitable history of getting into new and complex financial instruments. Some have become extraordinarily successful because they were early to markets, seeing opportunities that less flexible managers couldn’t participate in.
Nable said for multistrategy hedge fund managers “the bar is lower” because they already have sophisticated infrastructure that would make the adoption of private credit a no-brainer. “For them it’s really a capital allocation issue,” he said.
For some other managers, private credit is just the new label for strategies they’ve always run, which they called specialty finance, mezzanine, or other names. A lot of managers, for example, have long been investing in collateralized loan obligations or issuing CLOs. “Those are now bucketed into private credit to latch onto the trade,” Nable said.