Making Sense of Private Markets: Liquidity, Risk and Opportunity

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KIM STAFFORD: How do you think about allocating between public and private credit, and how do you think about things like liquidity, transparency, credit risk? How does that tilt the balance of your allocation policy?

DAN IVASCYN: There's so much discussion around private markets today, and it's true that more issuers, more types of investments are being distributed in a private manner relative to what we would consider a public investment. But these are not new markets.

In fact, when I joined PIMCO almost 30 years ago some of the first assignments I had were to underwrite private type investments, 144A's secured debt with various forms of corporate guarantees or other make hold guarantees, other off the run structures, particularly in the asset back and asset based area of the market. In fact, even before PIMCO focused a lot as you know, on asset backed type investments. So there've been a few decades of performance here. And I think a, just a few points that I think are important to note. One, these are highly related markets. I think rather than just talking about public and private, I think it's important to look at investments on two different continuums. One liquidity and one economic sensitivity.

There are areas of the market, the private market where there's very little to no transaction liquidity, no ability to exit that position.

And although there have been discussions about liquidity convergence in markets, a good portion of the private space requires the borrower to give you permission to sell an instrument. There's limits to how much convergence you can have,

Text on screen: Investors should seek a sufficient premium when investing in assets that are harder to trade

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if you actually have to ask for permission to sell at some point in the future. Those investments should warrant a more significant pickup in spread relative to their liquid alternatives.

And then, in other areas of the private opportunity set, there is pretty significant transactional liquidity.

There's no practical reason why you cannot source risk, create risk, work with issuers, looking to access these markets in a manner that doesn't preserve material liquidity.

Text on screen: For more liquid market areas, there’s less need for compensation related to liquidity risks

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And in those areas, again, the requirement for liquidity compensation can be less. So I think investors have to take a look and make apples to apples comparisons.

And I think there's some interesting value that can be uncovered by being very, very careful to make those precise comparisons. And the bottom line is equity valuations are stretched.

There's a lot of money moving into the private assets. A lot of the players in that space seem to, at times, be competing based on market share as opposed to the underlying value proposition. So not surprisingly, the average pickup for going down the liquidity spectrum, fairly narrow, but very, very different depending on what areas of the market or what particular investments you're targeting. And the whole point of what we're trying to do on behalf of investors is look to ensure that we get an appropriate level of compensation for the relative illiquidity. And a lot of that takes very, very careful underwriting of increasingly complex transactions. On the economic sensitivity piece,

Text on screen: Cautious on economically sensitive market areas

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we're most cautious about the more economically sensitive areas of the market, no different than our public portfolios where we have been reducing credit exposure to more economically sensitive areas.

Things like senior secured bank loans, things like the high yield market, although the high yield market's a much higher quality market than it's been in the past. Same view within the private opportunity set. Be very, very careful about the more economically sensitive areas of the market, areas of the market where companies are running much higher leverage. Older economy companies that may have relatively high cash flow today but are susceptible to being the

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victims of disruption, tech disruption, AI disruption, ongoing challenges in terms of private equity sponsors themselves that are being very aggressive towards that segment of the market

At the other end of the extreme, the higher quality areas

Text on screen: Favor high-quality areas across public and private strategies, such as asset-based lending

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of the market, asset backed, asset-based lending, areas where we're quite overweight in both our public strategies, our hybrid strategies, and our private strategies, we think continue to make a lot of sense.

The household balance sheets of the US and Europe and some other parts of the world have strengthened significantly over the course of the last several years. Underwriting quality has been very, very strong absolute and relative to what you're seeing in the corporate credit market because of the post global financial crisis regulations that were so severe. And you've had multiple years of de-leveraging and strengthened housing markets.

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So mortgage related risk, consumer lending, other forms of collateralized lending when underwritten properly make a lot of sense as well today. Now, the only caveat there is that financial engineering, ratings based capital optimization is beginning to increase quite significantly.

Reminds me of the mid-nineties, then the mid two thousands. So everything's not great simply because it has an IG rating. Everything isn't appropriate just because it has the label asset backed or asset based.

Text on screen: Active investing can outperform passive alternatives

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So from the standpoint of generating active returns through investing rather than simply deploying capital, we do think you can continue to provide significant additional incremental returns versus passive alternatives or some of the more narrow strategies that have done well when beta performance was strong, but where I think it's going to get a little bit more challenging going forward given pretty full starting valuations and at times not the type of covenant protections that we would like to see on behalf of investors as prudent credit underwriters.

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Disclosure

Please note that the views expressed are as of the date recorded and may not reflect recent market developments.

All investments contain risk and may lose value. The credit quality of a particular security or group of securities does not ensure the stability or safety of the overall portfolio.

Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. Investments in mortgage and asset-backed securities are highly complex instruments that may be sensitive to changes in interest rates and are subject to early repayment risk. Private credit involves an investment in non-publicly traded securities which may be subject to illiquidity risk.  Portfolios that invest in private credit may be leveraged and may engage in speculative investment practices that increase the risk of investment loss. Investments in illiquid securities may reduce the returns of a portfolio because it may be not be able to sell the securities at an advantageous time or price. Investments in asset-based lending and asset-backed instruments are subject to a variety of risks that may adversely affect the performance and value of the investment. These risks include, but are not limited to, credit risk, liquidity risk, interest rate risk, operational risk, structural risk, sponsor risk, monoline wrapper risk, and other legal risks. Asset-backed securities across various asset classes may not achieve business objectives or generate returns, and their performance can be significantly impacted by fluctuations in interest rates. High-yield, lower-rated securities involve greater risk than higher-rated securities; portfolios that invest in them may be subject to greater levels of credit and liquidity risk than portfolios that do not. Investments in residential and commercial mortgage loans, as well as commercial real estate debt, are subject to risks that include prepayment, delinquency, foreclosure, risks of loss, servicing risks, and adverse regulatory developments.

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