With L/S credit managers, here are some questions to ask:
• How does the manager evaluate good credit vs bad credit?
• What is the manager’s experience and track record in this
• How many positions does the manager hold and how are they
sized? -- This is where they will add value and create alpha.
They should be able to identify good credit and isolate rate
sensitivity through short positions.
Crucial in the L/S credit manager’s process is applying leverage.
Understanding how much leverage and where it is applied is essential.
• Does the manager use leverage only on Investment Grade
• How much leverage can they safely use? Leveraging bonds is
not the same as leveraging equities. It does, however, magnify
the credit risk/reward framework.
Most L/S credit funds trade very liquid positions and thus, under
stress the portfolio could normally be liquidated in a matter of a few
days. With these strategies, liquidity should not be the primary
concern, but investors must pay attention to the liquidity provisions of the fund itself.
We have also begun to pay attention and consider the overall liquidity of the underlying holdings. Regulatory changes since 2009
governing the institutions that make markets in fixed income securities has yet to be tested in tough credit markets. Our concern is
that there are less participants making markets to provide liquidity
to funds. While there is usually someone willing to take a profit
and sell on the way up, history has shown us that buyers can dry up
pretty quickly in tough markets.
The up rise of exchange traded funds has created concerns regarding liquidity as large investor pools, who are price-agnostic to the
underlying holdings, buy and sell with impunity – potentially
making those index heavy issues more susceptible to fund outflows.
Other Considerations for funds – operational risk:
• How large is the firm?
• What assets do they manage?
• How long have they been active?
• Who are the decision makers?
• Do they segregate operational, compliance and investment
• How are they regulated?
• Who are their service providers?
• How concentrated is their investor base? (i.e. will they have to
close shop if their biggest investor leaves).
• Can they provide financial statements to verify that they are
• Is there any open litigation involving the firm or principals?
• Hedge funds usually try to isolate one form of risk to profit
from taking another. They rely on the managers’ ability to
generate alpha in that particular area of risk-taking.
• All fund types need to be reviewed for operational risk. The
departure of a key manager or failure of a service provider
could have adverse effects on the fund, with outcomes that
could range from deteriorated returns to outright fraud.
• Private Debt, or Credit as it is sometimes known, has been an
asset class quickly on the rise in the institutional endowment
and pension fund investing space. More recently, many products are becoming available to retail investors.
• Private debt is lending on bespoke terms to businesses and
individuals, funding those loans from investor pools rather than
bank balance sheets. The high yields provided are very attractive, but they warrant careful scrutiny as they take extreme
amounts of liquidity risk and potentially credit risk which can
be very difficult to measure.
• Both spaces can be attractive, but the mainstream narrative for
choosing these strategies can be flawed. Picking the right
managers is paramount.
Private Debt: The argument has been that by giving up some liquidity, investors are able to access high quality private credit and
generate better returns with less credit risk than public market
equivalents. The shift towards private credit alternatives has been
quite popular in the Institutional/Pension/Endowment/Sovereign
fund space, with flows increasing exponentially over the past
decade. Increased regulatory pressures on banks has opened the
door to non-bank lenders finding excess returns in this space, and
pension/endowment style funds are perfectly suited pools of capital
to provide that, given their need for income and long time horizons.
Mortgage Investment Corporations (MICs), other private real estate
lenders, factoring/supply chain financing funds, asset backed lending (ABL)/mezzanine funds or other niche alternative lending
strategies all find themselves classified broadly in the private debt
With private debt, interest rate sensitivity is low given many loans
are of short duration or have floating rate structures. Returns sensitivity is much more related to the type of strategy -- real estate
versus ABL or factoring funds as an example. It is still important
to ask and understand how rising interest rates may affect investor
return, however. As a general rule, the average term of the loans is
important to note as lower terms on average reduce interest rate
risk. Shorter is typically better, although this can be dependent on