Episode 305 - Is Private Credit Special?

This episode delves into the growing asset class of private credit, exploring its nuances and implications for investors.

1. Private credit is a rapidly growing asset class, often marketed for its high yields.
2. It carries hidden risks due to the high interest rates on loans and the substantial fees charged by private credit funds.
3. The perceived stability of private credit investments might mislead investors about the actual volatility and risks.
4. Academic research suggests that the returns from private credit, when adjusted for risk and fees, may not exceed those of public market assets.
5. The discussion highlights the importance of proper benchmarking and understanding the true nature of the risks involved in private credit investments.

1: Introduction

Hosts introduce the topic and discuss the popularity and fundamental characteristics of private credit.
Benjamin Felix: "Private credit is by far the asset class I've been pitched the most in recent years."

2: The Appeal of Private Credit

Discussion on why private credit is appealing to investors and the dangers of its high yields.
Cameron Passmore: "It's getting lots of attention, especially because of the floating rate aspect which seems to offer protection against rising interest rates."

3: The Reality of Private Credit

Exploration of the risks and real returns of private credit compared to other investments.
Benjamin Felix: "The problem with private credit is that it might look stable on paper, but the actual risk is comparable to equity."

4: Expert Opinions

Input from financial experts and academics on the growing interest in private credit and its sustainability.
Mark McGrath: "The market's rapid growth and how it's presented to investors is a key part of our discussion today."

1. Understand the Fees: Investigate the fee structures of private credit funds before investing.
2. Risk Assessment: Consider the higher risk associated with private credit due to the nature of its borrowers and terms.
3. Seek Transparency: Demand clear information about how returns are calculated and reported.
4. Comparison with Public Assets: Compare private credit investments against traditional public assets to assess true performance.
5. Consult Experts: Speak with financial advisors to understand the nuances of private credit in the context of your overall portfolio.

Private credit is one of the fastest-growing asset classes, and today we take a closer look at why that is, and if it’s really worth the hype. When you invest in private credit, you are essentially lending money to borrowers who might have difficulty accessing loans elsewhere. While these assets may be profitable, they can also incur a lot of risk and typically come with illiquidity. It is traditionally traded among institutional and accredited investors, rather than retail investors, namely, non-professional investors. Since private credit has gained so much popularity in recent years, we use today’s conversation to unpack how private credit works, the role of private credit funds, the associated performance fees and risks, and what retail investors should know about this asset class before deciding to invest. Our conversation investigates one of the top reasons for private credit’s rise in popularity, namely risk-adjusted returns, before evaluating whether this is a worthwhile reason to invest, depending on who you are. Stay tuned for our after-show section where we discuss the proposed changes to the capital gains tax, why the death of value could be exaggerated, and more!

People

Benjamin Felix, Cameron Passmore, Mark McGrath

Companies

Leave blank if none.

Books

Leave blank if none.

Guest Name(s):

Leave blank if the episode had no guest.

Content Warnings:

None

Benjamin Felix
This is the rational Reminder podcast, a weekly reality check on sensible investing and financial decision making from two Canadians. We're hosted by me, Benjamin Felix and Cameron Passmore, portfolio managers at PWL Capital.

Cameron Passmore
Welcome to episode 305. This week we have a nice, tight but important episode. Ben, why don't you queue up the main topic? Today we're going to talk about private credit for our main topic, which should be lots of fun. I think it's an interesting topic.

Benjamin Felix
I will be repeating myself, but this is the asset class by far that I've been pitched the most in the last few years, which is interesting. Yeah, it's becoming very popular these days. I'm getting lots of questions about it as well, and definitely from the wholesalers and those types as well, but as well as from clients and the public. So it should be a good 1. May 22 we have a webinar coming up that's getting lots of interest.

Cameron Passmore
Mark, you're involved in this event. Why don't you queue that up? I'm involved now. Thanks, Cameron. I wasn't involved as of yesterday morning, and then I got a message from Cameron saying, hey, you want to help out with the webinars?

Mark McGrath
Yeah, sure. I'd be happy to. It's on optimal compensation strategies for business owners, and that would extend to professionals or anybody with a corporation who has a choice to pay themselves by different means, salary versus dividend. But it's going to get a lot deeper than that for anybody out there that also listens to you. Money scope.

I know Ben and doctor Mark Soth have done some really deep dives on this topic. I think, Ben, you said it's episodes 12, 20 13, if I'm not mistaken. So we are going to present myself, my colleague, Brady Plunkett and Spencer from Henry Warren, our friends at an accounting firm that we work very closely with. And are we at 500 registered guests yet? We were at 450 yesterday.

Cameron Passmore
I think we're flirting with 500 now. It's amazing. Flirting with 500. Yeah. And they'll probably be a late push before the webinar, so should be a good one.

Mark McGrath
It's gonna be very detailed, and if you're a business owner or incorporated professional, it's gonna be for you. So we'll put a link in the show notes, but there's also a link on our homepage, pwlcapital.com dot. It's on the first page. It's gonna be good content. Spencer is one of the two tax accountants who reviewed the notes for the money scope episodes.

Benjamin Felix
He's brilliant on this stuff. Beautiful. Okay, guys, ready to go to the episode? Let's do it. Let's go.

Cameron Passmore
Okay, 305. Let's get going, Ben. All right, so private credit. So in my role as a portfolio manager, but also because I have this title, head of research, that one of the implications of that is that I get pitched a lot because people look through a website or whatever and decide that I'm the guy to pitch their product to if they want to get it on our. Explains why you get so few pitches.

Now they're going right to you, which is awesome. Yeah. Makes me want to change my title. But like I said in the introduction, private credit is by far a long way. The Atlantic class.

Benjamin Felix
I've been pitched on the most in the last couple of years. So what is private credit? It's loans, unlike bonds. Like a bond is a loan, but in the case of private credit, they're not publicly traded, not created by banks. They're created by non bank entities, like a private credit fund or a business development company to fund private businesses.

So the name implies like bonds, but in private markets, and also sort of not like bonds, which we'll talk about now, this asset class gets promoted to retail investors and other investors for its high yields. We'll see a 9% yield and stable returns. And that's the part that I have more of a problem with. But as you can probably guess, I'm skeptical of the asset class, and it's. Pretty new, is it not, that it's being opened up to retail?

Mark McGrath
I think for a long. It's new to the retail class. It's not a new asset class necessarily, but the proliferation of publicly available funds and institutions that are offering it now is growing very rapidly. And I think that's obviously why we're here talking about it today is because it's growing fast. Some validation listened to a Prof.

Cameron Passmore
G interview as well as Demoderan, the valuation expert for NYU Stern, and he was talking about it on this week's podcast that he's actually looking at credit, and he's a long devoted, equity only investor. So you start hearing more and more in other types of channels, and it's. Not a bad asset class. Like, I don't want to be the guy out here disagreeing with Demotoron, and you got to look at what are you actually getting. And if you're Demotor end, maybe you can find good opportunities in the asset class.

Benjamin Felix
But in aggregate, is what I want to talk about, whether there's anything special there. Now, this is one of the fastest growing asset classes. I think in terms of growth in total aum, private equity is the fastest growing. Private credit is in second place. Incredible papers that I've read on why that's happening.

It's intuitive when you hear it, but that growth has largely been driven by investor demand for high floating rate yields. Because we've been through this long period of low interest rates, although theyve come up now, but we went through a period of low interest rates and then people were worried about rising rates. Private credit tends to be floating rate, which protects you a little bit from rising rates. And its got higher yields than publicly traded fixed income. So thats one side of it.

And then the other side of it is tightened capital requirements for banks, which pushed small and mid sized companies to find alternative non bank sources of credit. So those two things happened in the last kind of, I don't know, 20 or so years became increasingly prominent factors. And that is what I have seen argued in any way as the reasons explaining a lot of this growth. We've got investors seeking yield and then companies needing non bank lending, and then boom, we get this big, fast growing new asset class. Now, within private credit, the fastest growing part of that market is private credit funds.

So these are funds that raise money from investors and then make direct loans to private firms, typically firms. And this is important, that can't get bank loans due to their credit worthiness. Now, another interesting point that I've seen this as an argument for why this is an interesting asset class, and we'll get to that to whether or not it does make it interesting. But one of the arguments is that loan terms are negotiated individually with each borrower and the terms often contain features that traditional fixed income would not like, a structured equity component like warrants or something like that, as part of the overall deal warrants. Are they not like a long term call option in a way that gives.

You a version of equity exposure in the borrower? An important thing, and this shows up in the high yields. The interest rates on these loans are high. The borrowers are too risky for banks, which means that the loans already command a higher interest rate. But then the other thing is that private credit funds have to build their own fees into the rate that they're charging these borrowers, and their fees are high.

So a typical fee structure is 1.5. I've seen 1.25 as low as 1.25. I have not seen lower, although I haven't surveyed the whole market. That's just my casual observation. So call it 1.25 to 1.5% plus a performance fee of 15% to 20% over a hurdle.

So all in, it ends up being three or 4% in total fees that you would expect to pay, and that ends up getting reflected in the pricing of the loans. That performance fee is widespread in private. Credit, from what I've seen. Yeah. Interesting.

So you take those two pieces, we're lending to higher risk borrowers in the first place, and there's equity like features in the loans. I think private credit, and I don't just think this is what the data suggests, private credit can start to look a lot more equity like, or at least have a meaningful equity component than bond like. But the tricky thing is that due to its nature as a private asset class, that equity like risk is not going to show up as volatility. So on paper or in a pitch deck, the result is what looks like high returns, low risk and low correlations to public assets like public stocks and bonds, for example. Now of course, all of those things, if you can get them, if you can get an asset with high returns, low risk and low correlations, that is the holy grail of portfolio management.

Everybody wants that. But of course, private loans are not valued daily. They dont have a secondary market to establish a price. So their reported returns are not always going to reflect the true volatility in the value of the underlying assets. The price is what, the value is a different thing.

Mark McGrath
Who values them? In a credit fund it would be. Similar to private equity. I dont know the exact details, but Im sure they would have some third party valuation, which is fine, but well talk about some of the research on the relationship between net asset value of private loans and market value of private loans. Theres some really interesting research on that.

I saw an article somewhat recently, like in the past few months, it was arguing about valuations on private credit. And I guess they had different evaluators looking at the same, not a bond, but the same loan, and there was no agreement on what the actual value was because I guess measuring the risk and the creditworthiness of the issuer is a challenge. So you had different shops valuating it at $0.75 on the dollar, $0.50 on the dollar, $0.82 on the dollar. So without market pricing, you're just accepting the valuations that are being given to you by whoever's evaluating it for the fund. I think I saw that article too.

Benjamin Felix
Yeah. So we don't have market pricing. If you took all of the private valuations like you were just talking about market, if you took all of them together, you might get something like a market price, but I don't think that the private credit funds are usually doing that. When private credit assets are marked down, and this part's important, and there's some of the research we're going to talk about is on this, the marks down will tend to be a lot more muted. They won't be as deep, they won't be marked down as much compared to an otherwise comparable publicly traded asset.

So that, again, becomes really important when you're looking at these things and asking questions like what is the volatility? What is the downside risk, what is the risk? More generally speaking, that's super important, the smoothing effect. It's similar to what we talked about with private equity, but you take return smoothing and generous valuations, especially during bad times, on private loans, and it can make the asset class look a lot more attractive than it is. Maybe if risk is evaluated properly, if we can call it that.

So all this kind of starts to touch on the question that I think every investor should be asking before allocating to an asset class, which is what underlying risks, what economic risks am I taking and how do I expect to be compensated for those risks? We know about systematic and non systematic risk. An individual stock, you're taking stock specific risk. So you've got to know what risks am I taking? In the case of private credit, a fundamental truth is that financial assets represent discounted future cash flows.

The value of a financial asset is going to change when one of those two things changes. Discount rates can change. Cash flow expectations can change. That's why we see price variation day to day in financial markets. When assets are valued by the market, that's always true, the value will change.

But in the case of something like private markets, we don't have live valuations and we don't have market valuations. Even if you had a private valuation, like you talked about earlier, Mark, even if you did get a private valuation every day, that's not going to represent the value that you could sell it for if you went to the market. So one really interesting perspective on this that I found in a paper in the financial analyst journal titled direct lending returns is 2023 paper. They look at publicly listed business development companies, BDCs. These are closed end funds that engage in direct lending and they themselves trade in the public market.

It ends up being a really cool laboratory, and I'll explain why. So they're relevant to private credit because they're required to invest at least 70% of their assets in non public equity and debt of us corporations. And they've been showing in other research to be good benchmarks for the returns of private credit funds, a decent proxy for private credit. So in the paper, what they do to evaluate BDC performance is they build a benchmark consisting of small cap value stocks and leverage loans. Because those public assets end up explaining most of the variation in BDC returns.

They take some public assets and they just did this empirically like they looked at what package of public assets are representative of the returns of bdCs. And so they found this mix of small cap value stocks and leveraged loans, which are both publicly traded and mirror the returns of the publicly traded BDCs. That equity bond mix as a benchmark is quite important. And there's another paper on this we're going to talk about in a little bit. So this is the important part of this paper.

They find that when BDC performance is evaluated based on net asset values, and this mark to your earlier point is when they're valuing the assets themselves, it's an on paper valuation when they do their regulatory filings, not a market valuation. So measured from that, measured from net asset values, BDCs outperform the liquid benchmarks by 2.74 percentage points per year. And they have very high sharpe ratios. So that looks really good. It looks like what we talked about earlier as the sort of pitch of private credit.

It looks like you can take risks similar to publicly listed assets, similar to risky stocks and bonds, while earning a. Big alpha is that before any fees. Are considered, this is the net return of this security. So it'd be after the fees of that security. But then, of course, the issue is that BDCs don't trade@their.net asset values, particularly during times of market stress, they'll tend to trade at a discount.

And we know the market is this pretty efficient pricing machine that's taking in lots of information and outputting a price. And so you can think that when the market assigns a price below the reported net asset value, we could take that as meaning that the net asset value was not accurate. You could also take it as meaning the market price is not accurate. You could say the market overreacts. That's the argument, right?

Mark McGrath
Is the market is irrational, the market under prices and overprices stuff all the time. And our valuation is more accurate. You get that in all private asset spaces, right? Like private real estate, private equity and obviously private credit as well. So either the market's wrong or the firm whos evaluating the price is wrong.

Benjamin Felix
There could be some validity to that. I would tend to trust market prices more. I think from a investors psychology perspective, one of the most interesting aspects of private equity and private credit is that it allows investors to take more risk and have higher expected returns, even net of fees, while feeling like theyre taking less risk. Theres a paper from Auntie Ilmanin talking about how the premium for illiquid assets may be negative. You'd expect to earn a premium for holding illiquid assets because they're riskier.

But he's argued that it may actually be a negative premium because people have a high demand for the smoothing effects of illiquid assets. So it's not obvious that there's a benefit to holding illiquid assets from a financial perspective. But from a behavior perspective, there could be, which would actually drive down the expected returns of the assets anyway. Oh, it's interesting. I was talking to a friend of mine who works for a firm that does a lot of private assets like private equity, private real estate, and private credit.

Mark McGrath
We were just chatting yesterday about it, and he was talking specifically about those behavioral benefits for retirees and the psychological comfort they get from withdrawing from a portfolio that looks very stable on the surface. You pointed out the high sharpe ratios and the lack of volatility, and thats really, cliffasness would say volatility laundering. Theyre just not pricing it frequently and its not being priced by the market in aggregate. But there may be a behavioral benefit to that. And I could see that for somebody retiring and drawing from a portfolio.

Benjamin Felix
Preston, its not a crazy argument. No, I dont disagree. You look at private equity and you look at private credit net of fees. We can make the argument that the returns are not better than public assets, but theyre also not terribly worse. I think the bigger issue you have to deal with in private markets is dispersion, where the difference between picking a bad manager and picking a good manager is huge.

And its not so easy to just buy an index fund like we talk about with public markets. So that dispersion piece can really hurt you or help you depending on whether you pick a good fund or not. But if we just look in aggregate, I dont know, man net of fees, the performance is sure say its the same as public assets. So theres no benefit financially to owning these things. But if you get a big behavioral alpha from smoothing, who are we to say its a bad idea and some.

Cameron Passmore
Cool stories to tell. This is all before tax too, right? So presumably private credit is taxes, interest income primarily? Id assume so, but thats not something that ive looked into in any detail. But that would make sense.

Mark McGrath
Yeah. So on an after tax basis, depending on the situation, of course, and whether youre holding it in a non registered or a corporate account, or you might get equity like returns, gross of tax, but net of tax would probably be significantly worse. Okay, so back to BDCs. We talked about how, on a net asset value basis, they outperformed the liquid benchmark on a market value basis. Because, remember, were talking about securities that are publicly traded.

Benjamin Felix
Weve talked about their net asset values, which are the reported asset values, which is like what you would get with an unlisted private credit. But in this case, we get this additional layer of insight. Because these securities actually do trade in the public markets using their market value, the BDCs do not outperform the liquid benchmark. So that suggests that when they're properly benchmarked and properly priced, the apparent excess risk adjusted returns goes away, at least in the case of BDCs, although we're going to talk about private credit funds in a second, private credit funds specifically. So there's a 2024.

It's a pretty new paper titled it's a working paper. The other one was published in the Financial Analyst journal. This one is a working paper. This one's called risk adjusting the returns of private credit funds. And so what they do is they apply a cash flow based method to form a replicating portfolio that mimics the risk profiles of a large sample of private credit funds, roughly similar to what we just talked about.

They're looking at the private credit funds and figuring out which public assets they can use to benchmark. And they find using an equity and debt benchmark to measure risk, that a typical private debt fund produces an insignificant, abnormal return to its investors. So again, back to the idea. If we properly measure risk, there's nothing really special going on here. So that means that investors are not getting any alpha, they're just getting compensation for the risk that they're taking in the funds.

Their risk adjusted excess return is indistinguishable from zero. Now, they do note in this paper that if you remove equity from the benchmarks, private credit looks really good. So if you benchmark private credit against public fixed income, it looks very attractive. So I think that highlights the importance of proper benchmarking. It also suggests that anyone adding private credit to their portfolio as part of their fixed income allocation may really just be increasing their overall equity exposure while feeling good about it, which, like we talked about earlier, maybe that's fine.

I don't know. And this is similar to other corporate bonds, is it not, where there is some equity risk in the issuer? I think it's a little bit more explicit in this case because of the structured equity component to the loan contracts. But, yeah, if you go into high yield, itll start to look like theres equity exposure in there as well. Its completely unreasonable to not have some equity exposure in the benchmark then, is it not?

I would argue so, yeah. People are probably using this as a. Bond alternative that im not sure about. Id have to survey people that do this, but if they are, theyre taking more risk than they realize. You wouldnt substitute this for bonds unless your intention was to increase the amount of risk that youre taking.

Mark McGrath
But given how many retail investors are getting interested and how easy it is for them to access it now, and theyre seeing it as stable fixed income allocation in their portfolio, to your point, many of them are likely taking a lot more risk than they thought they were. And just replacing this with their bond allocation with something like this is significantly different than what they thought they were doing, potentially. That would be my hunch. Its only a hunch, but that would be my hunch. And thats one of the reasons that I think this is an important topic, because there are firms in Canada that very explicitly target low investible asset retail investors who are marketing this fairly aggressively.

Benjamin Felix
I would say, in terms of just showing off the high yield and the stability, its not like its not affecting anybody. And its not like its only being pitched to ultra high net worth investors who can afford to take a little bit more risk than they maybe realize that theyre taking. So theres no free lunch? There's no free lunch is what the research that we're talking about suggests. Now, we also know that, in theory, skilled fund managers will attract assets to their fund up to the point where they're no longer able to generate excess risk adjusted returns.

So none of this stuff should be too surprising. And that's Burke and van Binsbergen, who we had on, I don't remember which episode, 200 and something. Jonathan Burke had the original theory on this in the Birken Green 2004 paper, and then Burke and Binsbergen have continued to develop it. But basically, assets will flow into managers up to the point where all of the benefits of the skill of their skills are absorbed by the manager in the fees that they collect. And the investors and their funds earn returns that are in line with the risk that they're taking.

Cameron Passmore
Episode 222 20 that was a great episode. The argument there is basically that there's an efficient market for manager skill. Some research on private equity. This is a paper from Ludovic Fallopou, who we also had on to talk about private equity. His paper has a cheeky title where he refers to private equity as the billionaire factory, because private equity managers generate large fees for themselves while delivering net returns that are similar to public equities to their end investors, which is exactly what you'd expect in an efficient market for skill.

Benjamin Felix
And it's important here because this means that there's nothing wrong with the opposite. Private equity and private credit managers are extremely skilled because they're able to earn net returns that are in line with the amount of risk they're taking while charging 4%, or in the case of private equity, 6% total fees. So thats a lot of alpha to generate. But the problem is it gets absorbed by the size of the fund and accrues to the manager, not to the investors. The investors just get the expected return in line with the risk that theyre taking.

Cameron Passmore
Ludovic Fallopu is episode 210. Thats another good one. So I think in the case of private credit funds, it looks like the managers are able to apply their skill in identifying, negotiating, monitoring private loans. This is no joke. This is serious due diligence.

Benjamin Felix
They're working with companies that couldn't otherwise raise financing. It's all impressive, and I'm sure that people running these funds are absolutely brilliant. But the thing is, they charge a fee rate. They charge a lending rate to the borrowers that approximately equals the risk adjusted borrowing rate for them plus the fees that the private credit fund is charging. And in the end, for the end investors, and in line with what theory would predict the fund managers absorb the benefits of their skill as fees.

And the end investors, as I've said a couple of times now, end up taking a whole bunch of risk, in this case, probably more than they realize, paying high fees, which maybe that's not so bad if you're getting a net return that matches public markets with lower fees, I guess. But the big piece is they're getting returns that they could get much cheaper and something we haven't mentioned yet, with better liquidity if they just use publicly listed assets. So I think it's perfectly fine. We've said this a couple of times now. If investors are fully aware of a lot of the stuff that we've talked about, and they go into private credit anyway, they say, yep, I got all this.

I get that. I could replicate it with public assets, but I want private credit because it feels good, or it lets me take more risk without seeing volatility, or I can tell my friends about it or whatever. I think that's fine. I think the problem is when we have high fee investment products being marketed as safe and stable, having high expected returns. I dont love that.

I think that theres probably cases, and this again is just my guess, I dont have data for it. But there are probably cases where retail investors probably dont have the tools or the knowledge to evaluate the risks that theyre taking in products like this, not even just retail. Ive talked to investment professionals who pitch private credit using stuff like the sharpe ratio or using mean variance optimization routines. I had one person, I don't even feel bad saying this because it was so ridiculous. I had one person, a professional, scold me.

He was like trying to mentor me on this, that why should be using private credit? Because look at when you run an optimization, look how high the optimizer says the allocation of private credit should be. And optimization routines are based on expected returns, correlations, standard deviations, all of which are probably not representative. When were dealing with private assets like this, they also told me what the sharpe ratio, look at the sharpe ratio in this fund and I would argue thats irrelevant or at least needs to be taken with a big grain of salt. Or you need to use an adjusted sharpe ratio that accounts for desmoothing of returns and other unique characteristics.

Mark McGrath
I just tweeted this morning that the sharpe ratio on my house is like 37, which is just insane. Of course theres zero volatility. Theres no market for it. The only way I know what its worth is, if I look at the BC assessment they send me, and thats just a tax notice more than anything, right. So there's zero volatility and it just keeps going up in value.

So to your point, I don't think that Sharpe ratio is exactly useful in an asset that by design has no volatility. Right. So how does the conversation go, Ben, with the promoter? In that case, it was a third party consultant, not a promoter. Didn't go very well.

Benjamin Felix
They thought I was a fool because I didn't understand the benefits of private credit and we weren't going to come to an agreement on that. But as soon as you're putting illiquid assets into a portfolio optimizer and looking at the whatever, 30% allocation that it spits out as optimal and then saying yep, im going to do that, im going to give your head a shake. I think to marks point about the house just using volatility as a measure for risk. When an asset class is valued irregularly or not valued at all, and not market tested on the valuations, of course thats going to lead to incorrect conclusions about risk and expected returns and how the asset fits into a portfolio illiquidity. We mentioned that briefly.

Illiquidity is not great under any circumstances. There is a theoretical case, we talked about this briefly earlier, that illiquidity commands a higher premium, and thats one of the arguments that ive seen for private credit having higher expected returns. But theres also the theoretical case that the premium is actually negative because people are willing to overpay for the smoothing effect of illiquid assets. I dont know. I dont know how obvious it is that illiquidity is a benefit, although ive seen it pitched that way in the case of private credit.

So I think for most retail investors, allocating to private credit is going to get you for sure, high fees, its going to make it hard to evaluate how much risk youre taking and what kind of risk youre taking, and its going to come with illiquidity. And in return for those generally unfavorable characteristics. I have not seen evidence of a compensating excess risk adjusted return when properly benchmarked and measured, which is not necessarily easy to do. And then the reason in the research that ive read is that any excess return gets absorbed by manager fees, which is not surprising because thats what youd expect in an efficient market for manager skill. Fascinating.

Mark McGrath
Presumably if the fees were low enough, then this would be interesting. But theres just, thats an interesting point. Ive thought about this. If we say now, dispersion is still a problem. Theres so much dispersion in private manager returns that youre still taking quite a bit of, I think, uncompensated risk there.

Benjamin Felix
But dispersion aside, say you can access the private credit asset class as a whole and not worry about dispersion. If most people are paying 4% fees in total, and excess risk adjusted returns are zero. If you can get into the asset class as a whole for 2% fees, I think that's actually good. Like you do expect a little bit of excess return in that case, but it's not so easy to solve for dispersion. And you start thinking about that.

Okay, so how would you actually do that? How would you get low fees? You'd have to get going with scale or know someone maybe, but you'd have to go in probably with scale. Now, if you go on a scale, it might be harder to have full access to the asset class because to go on a scale you have to go in with all the managers to avoid the issues with dispersion. So you have to have a lot of capital.

I dont know. Its not obvious to me how youd make that work. We dont touch it so the people who keep pitching me you can stop. Same please and thank you. Probably wont use it, but is there a place for it?

Like we said earlier, its hard to say any asset class is objectively dumb when a lot of people invest in it. That doesnt mean that investors are always smart. People demand exposure to asset classes for some reason. Theres some amount of revealed preference in demand for asset classes and that can be a lot of stuff that we would say is dumb, like demand for thematic ETF's. Is there an argument that's intelligent in any way?

Probably not, but are people getting something out of it? Clearly they are, otherwise they wouldn't keep buying them again and again. Are you doing a YouTube video on this as well? Yep, I will. Great.

Cameron Passmore
Look forward to that. Anything else you want to go to the after show? I don't have anything else to add Mark. No, that was good. It's very fascinating.

Mark McGrath
It's not something I've spent a lot of time with. Very enlightening. For me it's great. But be curious on people's thoughts. If people hear what I said and think I'm missing something, happy to hear it, because I've talked to a lot of very smart people and people that I respect who have said, you got to look at private credit, it's a real thing with real opportunities.

Benjamin Felix
And I'm sure that's true at some level, but I find it hard to get away from the economic logic that you're still taking risk even if you don't see it. And when that risk is properly benchmarked, it doesn't seem like there's a whole lot of a free lunch, which again is what you'd expect, especially with an asset class that's growing and has reached a level of scale that this one has. You got to find the next big thing, you know what I mean? Before it's big. If you want to get excess returns.

Mark McGrath
Even at its most basic level, because people on Twitter, whatever, will ask me about this stuff all the time and they'll show me a credit fund and like you said, there's almost zero volatility, consistent payouts, right? And it looks like a money market fund on the surface. But if the rates are that high, if the expected return is that high, you must be taking risk there. If you look at whatever the risk free rate is and this is paying 5% higher than the risk free rate, especially when it comes to fixed income, it becomes very obvious whos going to borrow as a firm at 1012 14%. To your point earlier, if they could just go to the bank and alone at four or five, six, 7%.

So by definition theres got to be risk there. And I dont think that people even at a basic level understand. They just, they get attached to the yield, right? Anything, its a shiny object. Its like a high dividend fund with a 7% yield.

They love the yield and it looks good, but the risk happens slowly and then all of a sudden. So id be curious to see when or if this unwinds at some point. Preston, another comment I saw just in reading about this stuff is that at the current scale that its at, private credit hasnt gone through a full economic cycle. The floating rate debt is good from the perspective of the lender because youre going to have less duration. So youre not going to be as interest rate sensitive.

Benjamin Felix
But from the perspective of the borrowers who are already high risk borrowers, if rates keep going up or just high rates in general, the fact that the debt is floating rate is not so good. It makes the debt more expensive. And if theyre already in a relatively precarious position, which is why they had to borrow this way, that just makes them riskier. What is the duration on these things? Obviously theres going to be some variance.

But im not sure because these are. Shorter term loans, then presumably theyre less risky than longer term. The duration is going to be much shorter than an aggregate bond fund for sure, just by the nature of it being floating rate, but I think it is also shorter term but definitely shorter duration than aggregate bonds. Preston, separate topic, hows the buzz around the recent budget proposed change of the capital gains? Because the energy around the tool that our dear friend and colleague Braden built, with your help, Ben, is just getting lots of page views.

Cameron Passmore
The tool's on our homepage, much like the invitation we mentioned earlier, but he was telling me it's up to 111,000 page views and over 842,000 calculations. Wow. Are you hearing that same kind of energy mark in your Twitter conversations? Not specifically around the tool, although I have posted it a few times. Not the tool but all the capital gains.

Mark McGrath
Yeah, I mean, especially with clients. We've got some big clients that have big decisions to make. There's so many tricky parts to this. Right. Like one, it's just a proposal at this.

.2. They tabled the capital gains. They stripped it out of the bill altogether. So we don't know where it is, I guess, right now in the process, or I don't at least talking to multiple accountants. So with accounting or tax funding, I find it's a risk spectrum.

And you'll find some accountants or tax professionals are quite conservative and they say, we're absolutely not doing this thing because we think there's tax risk. And you'll find other accountants or tax professionals that are more aggressive, and we'll acknowledge that there might be some risk to it, but we'll do it anyway. So just as an example, I have a client where they've got significant capital gains in a corporation, but it's with a number of commercial real estate properties. And so their question is, can I trigger the tax somehow on these assets but without actually selling them? Like we want to keep the properties, we just want to pay the tax bill before June 25.

I've talked to two different accountants that have given me completely different opinions. One says, absolutely not. There's tax risk, and unless you actually sell and dispose of the asset, you can't do it. But I talked to an accountant on Twitter yesterday and he said, oh, I'm doing it myself right now. I have to do the same thing in my own corporation.

So there's just a lack of clarity. Theres a lot of confusion. Its a complex topic and the clock is ticking. A buddy of mine is selling his commercial building and he moved up to closing date just inside the window. Yeah, theres a lot of listings you can actually search.

Somebody else I know on Twitter sent me this, but he did a search for listings that have been put up for sale since the budget announcement with a closing date before June 25 as a way to see if there was a spike in people trying to fire sell their property to get out of the new capital gains changes. And I dont have the data in front of me, but it was quite obvious that people are doing that. Theyre panic selling like cabins and cottages and investment properties and that type of thing. I talked this morning to a very successful entrepreneur who himself is not happy. He could not do this because hes got illiquid assets.

Benjamin Felix
When you leave Canada, theres a deemed disposition of your assets. People call it an exit tax. If you have an illiquid asset, doing that would be a mess because if you have a super valuable private company and leave the country, and you've realized the gain on that. You then have to raise the liquidity to actually pay the taxes, which is for, I think, obvious reasons, pretty messy, or can be pretty messy. But he was saying that a lot of people he knows who are successful entrepreneurs who have liquid assets are leaving or doing everything they can to cut ties with Canada.

And I know you've talked to physician doing that, too. So it's interesting times can be to see what happens. I talked to a physician yesterday, or the spouse of a physician, I should say. And they were saying in the physician Facebook group, which has tens of thousands of members, he said there are some very serious conversations among, and this is totally anecdotal, right, but very serious conversations. And a number of them are leaving, confirmed are leaving.

Mark McGrath
And it's not like they decided this over the past week. There were a number of things that led them to consider this. And this is perhaps the straw that broke the camel's back. And we'll see what happens. Of course, a lot of people maybe overreact and say they're going to leave.

Benjamin Felix
And don't, but, or maybe the legislation doesn't go through. We still don't know. There's going to be a lot of pressure on the government. I saw some stories on LinkedIn this morning. Different groups are reaching out to the government to apply pressure.

Cameron Passmore
So earlier this week, Ben, I don't know if you can talk about this or not, but you had a conversation with arguably one of the highest profile people in the money game in Canada. Yeah. So Dave Chilton reached out to me through my YouTube channel. He left a comment and I get notifications when I get comments. And I saw this comment and I was like, no way.

Benjamin Felix
Couldn't believe it. I was trying to find it. Hey, Ben, it's Dave Chilton. I know who you are, Dave the wealthy barber. I enjoy your videos and podcasts, especially this one.

It was on the most important lessons in investing video. Youre well informed and very genuine. Its clear you really want to help people. Well done. I was like, man, thats cool.

Super cool. And then someone from his team messaged me not long after that on LinkedIn and said they wanted to chat. So we had a call, which is also super cool, super nice people. Anyway, theyre just looking to do some video content. And so theyve kind of been serving the canadian market of content creators and they just wanted to chat.

It was pretty cool. And the video that he describes, this endeavor, he's not talking about any sort of economic part to this. He just it seems to be just giving back and creating some sort of intellectual foundation legacy of sorts. He's a super genuine guy and he wants to make content that's going to help Canadians make better decisions. He's not taking sponsorships, he's not monetizing it.

I think he might be selling hats, he joked.

But yeah, I'm sure it's gonna be great content. And I may collaborate on him with some stuff if they wanna do that. And he said he might come on the pod since we reinvited him, turned us down the first time. Yeah, he said that back when we asked him the first time. He didn't know how to evaluate whether a podcast was good.

He was just declining everything. I first met him, I think I told you guys this story. He did a seminar for us when I was back at money concepts in 1992. I think the book had just come out. That's just as the mutual fund story was getting going in Canada.

Cameron Passmore
He did a presentation at the Talisman hotel here in Ottawa, which has since been demolished. And that's a old time hotel, one of those classic old ballrooms. He did a great presentation, I think, at the time. I remember he had the highest at the time, highest mark for the CSC course ever, I believe. I don't know if he's been beaten since then.

I don't know. But he told the story of sitting down at that card table, which he still uses to rewrite the most recent version edition of the book. He sits down, he does it all by hand on loose leaf paper. He put some pictures up about that with the card table and him sitting at it. And it was really neat.

I think he's in the same house too, I believe. And he goes the same. If you've seen him on, he was on. Might've been Rick Mercer or something, where they show him going to the diner. Or maybe it was a story on Dragon's dining because he was one of the dragons, but he goes to the same diner for most meals.

I don't think he cooks. This is the thing. I talked to a friend of mine who works for a hedge fund in Toronto. He was in town visiting. We were chatting and I mentioned this and he told me a story about how he was visiting a client where Dave Chilton lives.

Benjamin Felix
And they're at a diner and the client tells them, watch. At exactly this time, Dave Chilton's going to walk in and order exactly this meal. And my friend's like, yeah, no way it's going to happen right on cue. Right on time. Walks in, orders the exact meal.

The guy said he was pretty funny. Seems like a great guy. Yep. Anyway, can we talk about the value premium for a second? I'd love to.

Cameron Passmore
Always. We haven't talked about value premium in a long time. I was just looking at the data on the value premium, as I do from time to time. And do you remember in 2020 and 2021, value was like dead, horrible performance. It had been crushed by growth, did not do well through the pandemic.

Benjamin Felix
And a lot of big managers were capitulating, giving up some asset managers. Value focused managers were shutting down. Some robo advisors gave up their allocation to value. A few other stories like that. I heard some more anecdotal stories that I have not verified directly, but from other advisors who knew other advisors who were big users of providers like dimensional who have the value tilt.

So I heard some stories about big advisors giving up on their exposure to value through dimensional during that period of time. It was a bad time for value. There's a paper that came out from Rob Arnott, January 2021, titled the Death of Value has been greatly exaggerated. I think I was just curious. I don't know.

I just decided to take a look. How is value done since then? I took when that paper was published, January 2021 as the declaration of the death of value. And since then, so through until April 20, 2024, in the US, value. And this is very specific to this period, to be fair, in the US especially, value still done terrible, generally speaking.

But for that specific period, 2021 to April 2024, us market wide value beats growth by 1.56% annualized over the full period. Whatever, no big deal. And again, in the US, value has been crushed. Generally speaking, if we extend that time period back a little bit further. Canada though, man.

The canadian value premium of that period, 10% annualized MSCI Canada IMI value index returns 15.17% annualized over that period. MSCI Canada IMI Growth Index 5.15% over the same period. Emerging markets 8% sorry. Emerging markets 7% EFI 8% annualized. Crazy.

Cameron Passmore
That's the spread. The value premium. That's value minus growth indexes long only indexes. Yep. Well, you got to stay in your seat.

Mark McGrath
This confirms my biases, so I'm very happy to hear this data. Thank you. Me too. Me too. And you know what?

Benjamin Felix
Kicked it off, actually, and I messaged you about this, mark, and then you tweeted it before I had the chance to. I was looking at the DFA core and vector funds, and I was like, whoa, they have smoked XIc like a canadian market index fund. And so that just got me looking at how is value done elsewhere? And its done quite well in recent history. No kidding.

Mark McGrath
Even in the US. I didnt know that over that period. But again, if you go back any further in time, its ugly in the US for value. I dont think I still have those data up. It's really surprising for the US actually.

When you say it looks really ugly. If you go far back, are you talking since the great financial crisis or further back from that? No, not even that far back. If you go back like five years, ten years, rough go for us value. But even over those periods, value in other places has done relatively well.

Benjamin Felix
The value drawdown was never quite as bad elsewhere as it was in the US and now that it's recovered, the value actually looks pretty good again other than in the US market. So the death of value was in fact exaggerated then? It seems to be that way. And like one of you guys said earlier, you got to stay in your seat. Someone said this.

I'm not the first person to say this, but when the death of an asset class is declared, that is the time to invest in that asset class. The famous death of equities magazine cover from the not going to pick a year, I won't remember the year, but way back when. Ben, I must point out here that the death of bitcoin has occurred many times. And I don't know that you've invested it any of those times as a result of it being declared dead. So I'll keep that in mind.

I only buy bitcoin at the peaks. That's right. Don't we all? So, Scott Galloway discussion. Oh yeah, we have that in the notes to talk about, don't we?

Man, the response to the Galloway episode in the rational Minder community and the YouTube comments on Twitter was generally not positive from our audience for various reasons, but just, I think a general difference in approach from a typical rational reminder guests who tend to be very methodical and evidence based. And Scott, I'm not making any claims about whether what he says is evidence based or not, but he says a lot of stuff that's relatively inflammatory. I think what the audience had hoped for is that we would scrutinize every single thing that he said, which could have been interesting maybe, but that's also not generally our style. The other interesting thing is that I did hear feedback from quite a few people that loved the episode. It was funny, right?

And it's now, in terms of statistics, it's now edging up on being the best episode in terms of downloads from the last ten episodes. That's a YouTube statistic. Who is just behind, I think, the most important lessons in investing video. So people are watching it. Some people didn't like it in our audience, but a lot of people apparently did.

Cameron Passmore
It's also popular for the audio downloads, too. Top couple over the past dozen or so episodes. But he has a polarizing figure. So I think a lot of people have a. Probably have a bias coming into it as well.

Benjamin Felix
He says some different stuff about masculinity and gender, and it's inflammatory, seemingly on purpose at some level. Interesting, though. Interesting episode. So since we've had two us episodes in a row, there's no new reviews to read out this week and no one's reset on LinkedIn, so it's pretty quiet on that front. We haven't done an episode like this back to back in a long, I don't think ever, perhaps, or going back a few hundred episodes.

Cameron Passmore
Any other topics you guys want to cover off or mention? Not for me. I'm good. I'm doing a huge landscaping project right now. Full property.

Mark McGrath
I say I'm doing it. I'm not doing it since somebody else is doing it. We got a bunch of machines and stuff here, but in a single day, they basically ripped out everything on the property. Like outside. Grass was gone, all the trees, all the bushes, literally everything.

Cameron Passmore
Front and back. Front and back, sides, the whole nine. It's just gone. It's just gone. Yeah.

Mark McGrath
It's just my house now. On a pile of dirt. It's wild. It's impressive how fast they got that done. And as I'm looking out my window day to day and seeing it all come together, it's really exciting.

But my property is like a war zone right now. There's just stuff everywhere. It's wild. Mine is two, but the difference is I don't plan on fixing. That's its natural state.

Cameron Passmore
Ben's got the best yard ever for kids. It is so cool. Your kids run around on little bikes out there or just hang out in the trees. It's just an incredible property for fun like that. Yeah.

Benjamin Felix
They don't like to play outside, though. But if they did like to play outside, it would be great. How do they not like to play outside when you've got that as a yard? I don't know. They ride their bikes sometimes to go to the park.

They go out in the yard sometimes, but not that much. You need a new yard. I fully intend on doing that. Project, but it's going to be a big project that costs aside, I don't have the just mental capacity to take on that. Yeah, it's not a tiny yard either.

Cameron Passmore
It's not an urban or suburban type yard. This is very cool. Okay, guys, you good? I'm good. Okay.

As always, everybody, thanks for listening. Our.