Private markets fundraising has stalled, exits have largely come to a halt, and few new deals are being struck. But that isn’t stopping managers from racing to compete for fresh cash — this time from individual investors in new and unprecedented ways.
One of the boldest of these moves is a recent proposal for an exchange-traded fund that invests in both public and private credit by State Street Global Advisors and Apollo Global Management. It’s the first — but surely not the last — of its kind if it’s approved by the Securities and Exchange Commission. Indeed, a proposal for a private credit CLO ETF was unveiled by BondBloxx, a credit-oriented ETF issuer, just a few days after the State Street-Apollo one.
To be sure, private equity and other alternative investment firms in recent years have already dipped into the retail market, including with so-called “interval funds” where the money can be invested in private companies and financing deals, but with quarterly redemption terms, typically, and for only a small percentage of the value of the fund. One of the most recent is a KKR and Capital Group strategic partnership announced in May. The two firms plan to offer “hybrid public-private markets investment solutions” starting with a “fixed income offering” next year.
Private assets packaged in an ETF that can be traded on an exchange, as Apollo and State Street proposed in a Sept. 10 SEC filing, is the furthest step along the path to combining public and private investments. “The next wave of private market investors is seeking exposure to these growing asset classes through investment vehicles that are tradable, transparent, and provide liquidity,” State Street said in a statement announcing the proposed ETF.
To its supporters, such an ETF is the ultimate “democratization” of private markets, which historically were available only to institutions like endowments and sovereign wealth funds as well as some of the wealthiest individual investors who could meet high minimums and tolerate the lack of liquidity.
“It's groundbreaking probably on par with the Bitcoin ETFs,” said Brian Moriarty, strategist, Fixed Income Manager Research at Morningstar, in a recent podcast posted on LinkedIn, referring to the State Street-Apollo ETF. But, he noted, “We have a lot of questions and reservations about it.”
The main problem is one that bedevils the private market — which is determining the value of holdings. Accurate valuations are essential to help guarantee that ETFs can be easily bought and sold. The SEC limits the funds’ illiquid holdings to 15 percent of assets and defines illiquid as “an investment that the fund reasonably expects cannot be sold in current market conditions in seven calendar days without significantly changing the market value of the investment,” according to Morningstar.
“The ETF needs to be able to calculate its NAV,” said Moriarty. “Investors and market makers need to know the value of the ETF's portfolio. People need to be able to trade in and out of these assets. And the issue, at least historically with private markets is that they're priced very infrequently, typically quarterly, and they are very illiquid, very hard to trade, maybe even impossible to trade.”
He isn’t the only doubter. “The one thing that we're pretty skeptical on is the value of the marks,” said Nizar Tarhuni, executive vice president of research and market intelligence at PitchBook. “In private credit, there's typically not a desire to trade every day, and so ‘what is the impetus to force you to want a fair market value every day?’”
To help solve this potential problem, Apollo has promised to buy the assets from SSGA on demand. “If State Street says, hey, you have to buy them, Apollo can't say no. Apollo is providing, really attempting to cut through the pricing and liquidity sort of Gordian Knot if you will, with really one swing of the sword,” Moriarty explained.
However “if Apollo is the sole provider of private credit instruments, both delivering them to and buying them from the fund, this raises many questions about fairness and Apollo’s compensation that are not answered in the current prospectus,” said Moriarty and research analyst Ryan Jackson in a Morningstar analysis. The two wrote that the prospectus doesn’t explain how the arrangement will avoid violating self-dealing rules.
Another risk is what happens to swaths of the portfolio if Apollo fails to provide the bids. In its filing, State Street admits that if Apollo can’t buy its private credit instruments, “assets that were deemed liquid by the advisor may become illiquid.”
And if redemptions overwhelm Apollo’s ability to buy the assets, State Street could have to draw on a line of credit for bridge financing, inject its own capital into the fund, “or ultimately shut down the fund,” according to Morningstar.
Apollo declined to comment further, citing regulatory restrictions. State Street did not return a request for comment.
Demand for alternative investments from the wealth management and high-net worth channels is definitely strong, said Aaron Filbeck, head of CAIA’s UniFi, which provides education on alternatives to advisors. But he added that there are a lot of investors who “aren't educated on what private credit is or what private assets are and how they work. And so now you've just got a whole new group of people who are trying to access the asset class in a vehicle that just hasn't been tested quite yet.”
He also argued that the convergence of private and public markets is counterintuitive in many ways. “Private assets are supposed to be longtime horizon patient capital. And I think an outstanding question is by introducing these more liquid vehicles, are we rinsing out the benefits of a long-term investment in favor of satisfying the need for constant liquidity?”
But Filbeck knows that won’t stop the trend. “The general competitive nature of the industry is also a driving rationale,” he said.
Both State Street and Apollo have their reasons. Although the fees weren’t mentioned in the prospectus, Morningstar expects they will be greater than the average taxable bond ETF fee of .31 percent. “If mainstream investors embrace the private credit ETF, State Street could reap a healthy stream of recurring revenue.” it said.
“We are excited to be working with Apollo, a global leader in alternative assets, to continue to increase accessibility to private markets, opening them to an even larger cross section of investors,” said Ron O’Hanley, Chairman and CEO of State Street in a statement accompanying the filing.
The ETF also fits into Apollo’s strategy. In May, Apollo CEO Marc Rowan foreshadowed the latest development, Bloomberg reported.
“We built a third-party insurance business and then we built a third-party institutional business, a fixed-income replacement business, and you will watch us do this in retail,” Rowan said at the Bernstein Strategic Decisions Conference. “You will watch us do this in interval funds. You will watch us do this in ETFs.”
After the deal with State Street was announced, Rowan said in a statement “We believe investors will increasingly supplement their portfolios with private fixed-income and equity strategies. We are confident our relationship with State Street will help accelerate this trend.”
Just days before the ETF proposal was filed, Bloomberg reported that Apollo was planning on building a trading desk that would “buy and sell direct loans in the normally illiquid $1.7 trillion private credit market.” Several financial institutions are also reportedly building out trading desks for private credit.
There is a precedent: Leveraged loans, which already trade in the secondary market.
An ETF that invests in leveraged loans, the Invesco Senior Loan ETF, has $6.8 billion in assets. “Private credit is the natural extension of the term loan ETF,” said one investor in the ETF.
