Commentary: Private equity is really just a (highly leveraged) bet on credit

No investor is immune from the economic cycle, and many frequently refer to today's environment as "late in the cycle." Unfortunately, given the wanton indifference to the appropriate pricing of risk on the part of developed market monetary authorities, that's a bit like saying someone "may have had a sip" when they are so inebriated they can barely speak or stand. At the same time, seeking to fund their organizations' spending obligations at pension plans, endowments and insurance companies, institutional allocators have become increasingly aggressive in their search for strategies and investments that will meet those obligations, while also offering more protection in the next downturn.

Having a vantage point both as an investor and as a board member and investment committee member of several non-profit institutions for many years, I see quite an array of investment choices, as there has been an explosion in the number of products that have emerged to meet this demand for strategies that will meet their target returns while also offering more downside protection, particularly in the alternatives universe. From my perspective, these dynamics have created a dangerous illusion, where investors are getting less diversification benefit than they think because of label obfuscation, but also due to the masking of structural leverage that is embedded in many of the products that would be more diversifying if not adulterated.

Allocators (and the consultants from whom they receive advice) have sought to create staid order from the cacophonous melee caused by this explosion of options by crafting neatly ordered "boxes" in which to fit all the new offerings. First there was fixed income, then it was private credit, then private credit became direct lending or distressed lending or specialty lending, and then specialty lending became things such as trade finance funds, non-performing loan funds, cannabis lending funds, and many other highly specialized areas. The more choices, the tidier and more creative "benchmarks" that are used to evaluate them.

In building their portfolios, investors are also diversifying based on the filtering mechanism of those underlying categories. While there may be some inherent diversification among these buckets, following this approach is counterintuitively increasing investors' exposure to the cycle — the very thing they sought to minimize in the first place. When it comes to reducing macroeconomic correlation and equity risk, these categories frequently create distinctions without difference.

For example, there is a notion that corporate or real estate private equity investments are somehow fundamentally different from similar public equity exposure. Are they uncorrelated with one another? Why are they really placed in different categories? The same goes for junior, mezzanine and equity tranches of collateralized loan obligations — which pool leveraged loans from banks and then package them into tranches with different credit ratings — vs. other forms of credit. Is that really credit? Is it fixed income? How junior of a security in the capital stack of a CLO must one go before suddenly taking equity risk?

In all of these, you have a collection of return streams that are at the bottom of the capital stack, underneath lots of more senior (and frequently secured) obligations. Further, corporate and real estate private equity typically give you this exposure with a lot less diversity (i.e., a small number of companies or properties, also increasing idiosyncratic risk) and near total illiquidity, while CLOs offer historically weak underlying credits coupled with historically weak underwriting standards.

And in both of these cases, the underlying structural leverage further increases correlation, and structural leverage also carries into investments that should otherwise be diversifying. Take the example of highly levered real estate investment trusts. Real estate should be a diversifying exposure to equity, and, depending on the exposure, it can itself be cycle-agnostic or even countercyclical. But if you take real estate and apply significant leverage, what is likely to happen in an environment where investors are averse to holding companies carrying heavy debt on their balance sheets with short-term maturities? That leverage turns what should be a diversifier (vs. equity exposure) into equity risk by increasing the sensitivity of the asset to the overall cycle. And further, there is frequently insufficiently clear accounting and reporting for this structural leverage (i.e., leveraged real estate funds are put in the real estate bucket without regard for differing levels of leverage of the various other components of that bucket), further contributing to the mirage.

When "credit" at the top of the capital stack gets hit, investors at the bottom of the cash-flow stack will experience increased severity of loss for being more junior, more leveraged and less protected (if they are not completely wiped out). If a manager said to you, "You're worried about being late in the cycle? Well let me sell you a relatively undiversified pool of 10 to 15 investments. These will get hit first in a downturn, and they are currently paying you razor-thin and historically unprecedented low absolute levels of yield for taking that risk. And, to further sweeten the deal, we leverage the investments six to eight times in order to further exacerbate their sensitivity to the market." I imagine you would throw them out of your office. But, voila! Let me call it private equity, and now it's somehow different. Of course, logically that is not the case, and investors need only look to past downturns to see that it is not empirically the case either. REITs, which were historically uncorrelated to markets, lost nearly as much as the S&P 500 in 2008. And the same thing goes for CLO equity; where dubious debts are turned into securities, most of which have high investment-grade ratings, and a false sense of safety for investors is created.

Now more than ever, investors are confronted with the difficult problem of needing to meet their return targets at a time when we are at lows in the risk-free rate as well as spreads in virtually all assets. This, combined with the structural leverage of the products being offered, is creating a coiled spring of tight spreads, which are being justified by reference to other tight spreads. We have historically low risk-free yields combined with historically low credit spreads that are pooled and then further leveraged through structural leverage. When these so-called different categories of investments in allocators' portfolios actually add to the macro cycle correlation of the overall pool of investments (and further, do so in a way that provides the third "coil" in the three-layered coiled spring of leverage), investors will find themselves on the wrong end of a great unwinding when risk-free rates revert to norms and credit investors demand appropriate compensation for the risk they are assuming. And so it is ever more important that investors focus on the actual risks of their investments, including clear measures of exposure to macro/equity risk, the correlation among their various investments and their structural leverage to understand whether the underlying nature of their assets is actually serving to create an optimally protected portfolio.

Daniel Zwirn is CEO and chief investment officer of Arena Investors LP, New York This content represents the views of the author. It was submitted and edited under Pensions & Investments guidelines, but is not a product of P&I's editorial team.