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!

Key Points From This Episode:

(0:00:18) Today’s main topic, private credit, and our upcoming webinar on May 22nd.

(0:02:18) An introduction to private credit as an asset class.

(0:05:33) Private credit funds: how they work, interest rates, performance fees, and valuations.

(0:08:14) Who does valuations on private credit funds and related risks.

(0:10:01) Unpacking the underlying risks of private credit and how investors are compensated.

(0:11:02) Insights from the paper ‘Direct Lending Returns’ related to publicly listed business development companies (BDCs).

(0:16:15) Takeaways from the paper ‘Risk Adjusting the Returns of Private Debt Funds’.

(0:18:16) Private credit funds, equity exposure, how private credit gets misrepresented, and what investors need to know about high-fee investment products.

(0:25:09) Illiquidity and what retail investors can expect from private credit.

(0:30:15) Our aftershow segment, starting with the proposed changes to capital gains tax.

(0:33:55) Ben’s conversation with David Chilton.

(0:36:55) The value premium and why the death of value could be exaggerated.

(0:40:45) Unpacking the heated response to our conversation with Scott Galloway.

Read the Transcript

Ben 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 cue up the main topic today?

Ben Felix: 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. 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.

Mark McGrath: Yes, it's becoming very popular these days. I'm getting lots of questions about it as well, and definitely from wholesalers, and those types as well. But as well as from clients in the public. So, it should be a good one.

Cameron Passmore: May 22nd, we have a webinar coming up that's getting lots of interest. Mark, you're involved in this event, why don't you cue that up?

Mark McGrath: I'm involved now. Thanks, Cameron. I wasn't involved as of yesterday morning. Then, I got a message from Cameron saying, "Hey, you want to help out with the webinars?" "Yes, sure. I'd be happy to." It's on optimal compensation strategies for business owners. That would extend to professionals or anybody with a corporation who has a choice to pay themselves via different means, salary versus dividend, but it's going to get a lot deeper than that. For anybody out there that also listens to Money Scope, I know Ben and Dr. Mark Soth have done some really deep dives on this topic. I think, Ben, you said it's Episodes 12 and 13, if I'm not mistaken. So, we are going to present myself and my colleague, Brady Plunkett and Spencer from Hendry Warren, our friends at an accounting firm that we work very closely with. Are we at 500 registered guests yet? We were at 450 yesterday.

Cameron Passmore: We are flirting with 500 now, it's amazing.

Mark McGrath: Flirting with 500. Yes. There'll probably be a late push for the webinars, so it should be a good one. It's going to be very detailed. If you're a business owner or incorporated professional, it's going to be for you.

Cameron Passmore: We'll put a link in the show notes, but there's also a link on our homepage, pwlcapital.com. It's on the first page.

Ben Felix: It's going to be good content. Spencer is one of the two tax accountants who reviewed the notes for the Money Scope episodes. He's brilliant on this stuff.

Cameron Passmore: Beautiful. Okay, guys. Ready to go to the episode?

Mark McGrath: Let's do it.

Ben Felix: Let's go.

[EPISODE]

Cameron Passmore: Okay, 305. Let's get going, Ben.

Ben Felix: All right. Private credit. In my role as a portfolio manager, but also because I have the title head of research, that one of the implications of that is that I get pitched a lot. Because people look through our website or whatever, and decide that I'm the guy to pitch their product to if they want to get it on our –

Cameron Passmore: It explains why it gets so few pitches now. They're going right to you, which is awesome.

Ben Felix: Yes, basically changed my title. Like I said in the introduction, private credit is by far a long way. The asset class I've been pitched on the most in the last couple of years. So, what is private credit? It's loans, like bonds. Like a bond is a loan. But in the case of private credit, they're not publicly traded, not created by banks, or 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 not like bonds, which we'll talk about.

Now, this asset class gets promoted to retail investors and other investors for its high yields, a 9% yield and stable returns. 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.

Mark McGrath: It's pretty new, is it not, that it's been opened up to retail, 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. I think that's obviously why we're here talking about it today, it's because it's growing fast.

Ben Felix: Some validation. I listened to a [inaudible 0:03:49] interview, Aswath Damodaran, the valuation expert from NYU Stern. 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. It's not a bad asset class, like I don't want to be the guy out here disagreeing with Damodaran. You got to look at what are you actually getting. If you're Damodaran, maybe you can find good opportunities in the asset class. But in aggregate, this 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.

Cameron Passmore: Incredible.

Ben Felix: 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 they've 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 it's got higher yields than publicly traded fixed income. That's one side of it.

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. Those two things happen in the last kind of, I don't know, 20 or so years. It became increasingly prominent factors. That is what I've 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. 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 creditworthiness. 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 as 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.

Mark McGrath: Warrants, are they not like a long-term call option in a way?

Ben Felix: That gives you a version of equity exposure in the borrower, but 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 the private credit funds have to build their own fees into the rate that they're charging these borrowers, and their fees are high. 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. All in, it ends up being 3% or 4% in total fees that you would expect to pay. That ends up getting reflected in the pricing of the loans.

Cameron Passmore: That performance fee is widespread in private credit?

Ben Felix: From what I've seen, yes.

Cameron Passmore: Interesting.

Ben Felix: You take those two pieces. 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, 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. 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 don't 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 which the value is a different thing.

Mark McGrath: Who values them in a credit fund?

Ben Felix: It would be similar to private equity. I don't know the exact details, but I'm sure they would have some third-party evaluation, which is fine. But we'll talk about some of the research on the relationship between net asset value of private loans and market value of private loans. There's some really interesting research on that.

Mark McGrath: I saw an article somewhat recently, like in the past few months, that was arguing about valuations on private credit. I guess they had different evaluators looking at the same amount of bond with the same loan. 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 75 cents on the dollar, 50 cents on the dollar, 82 cents 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.

Ben Felix: I think I saw that article too. Yes. We don't have market pricing. If you took all of the private valuations like you're just talking about, Mark. 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 is important, and there's some of the research we're going to talk about is on this, the marked-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. 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 is similar to what we talked about private equity. You take return smoothing and generous valuations, especially during bad times on private loans. 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? 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. 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 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.

One really interesting perspective on this, that I found in a paper, in The Financial Analyst journal, titled, ‘Direct Lending Returns’, it's a 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 on the public market. It ends up being a really cool laboratory, and I'll explain why.

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. They've been shown in other research to be good benchmarks for the returns of private credit funds, a decent proxy for private credit. In the paper, what they do to evaluate BDC performance is they build a benchmark consisting of small-cap value stocks, and leveraged 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. 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.

There's another paper on this, we're going to talk about in a little bit. 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 on paper valuation when they do the regulatory filings, not a market valuation. So, measured from that, measure from net asset values. BDCs outperform the liquid benchmarks by 2.74 percentage points per year, and they have a very high Sharpe ratios. 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 a risk similar to publicly listed assets, similar to risky stocks and bonds, while earning a big alpha.

Mark McGrath: Is that before any fees are considered?

Ben Felix: This is the net return of the security.

Mark McGrath: It'd be after the fees of that security.

Ben Felix: But then, of course, the issue is that BDCs don't trade at their net asset values, particularly during times of market stress. They'll tend to trade at a discount. We know the market is this pretty efficient pricing machine that's taking in lots of information, and outputting a price. 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.

Mark McGrath: That's the argument, right? Is the market is irrational, the market underprices and overprices stuff all the time, and our valuation is more accurate. You get that in all all-private asset basis, right? Like private real estate, private equity, and obviously, private credit as well. Either the market is wrong, or the firm who's evaluating the price is wrong.

Ben Felix: There could be some validity to that. I would tend to trust market prices more. I think, from an investor 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 they're taking less risk. There's a paper from Antti Ilmanen, talk 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. It's not obvious that there's a benefit to holding illiquid assets from a financial perspective, but from a behaviour perspective, there could be which would actually drive down the expected returns of the assets, anyway.

Mark McGrath: It's interesting that 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. We were just chatting yesterday about it, and he was talking specifically about those behavioural 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 that's really – Cliff Assness would say volatility laundering. They're just not pricing it frequently and it's not being priced by the market in aggregate. But there may be a behavioural benefit to that, and I could see that for somebody retiring and drawing from a portfolio.

Ben Felix: It's not a crazy argument.

Mark McGrath: No, I don't disagree.

Ben Felix: 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 they're 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 it's not so easy to just buy an index fund, like we talked about with public markets. There's 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 don't know man, net of fees, the performance is – sure, say it's the same as public assets, so there's no benefit financially to owning these things. But if you get a big behavioural alpha from smoothing, who are we to say it's a bad idea?

Cameron Passmore: And some cool stories to tell.

Mark McGrath: This is all before tax, right? So presumably, private credit is taxes, interest income primarily.

Ben Felix: Assume so, but that's not something that I've looked into in any detail. But that would make sense.

Mark McGrath: Yes, so on an after-tax basis, depending on the situation, of course, and whether you're holding it in a non-registered or corporate account. Or you might get equity, like returns, gross of tax, but net of tax would probably be significantly worse.

Ben Felix: Okay. Back to BDCs, we talked about how on a net asset value basis, they outperform the liquid benchmark. On a market value basis, because remember, we're talking about securities that are publicly traded. We've 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. There's a 2024, it's a pretty new paper, it's a working paper. The other one was published in The Financial Analyst's journal. This one is a working paper, this one's called ‘Risk Adjusting the Returns of Private Credit Funds’.

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. 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. Again, back to the idea, if we properly measure risk, there's nothing really special going on here.

That means that investors are not getting any alpha, they're just getting compensation for the risks 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. If you benchmark private credit against its public fixed income, it looks very attractive. 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 the overall equity exposure while feeling good about it, which like we talked about earlier. Maybe that's fine, I don’t know.

Mark McGrath: Then, then this is similar to other corporate bonds, is it not? Where there is some equity risk in the issuer?

Ben Felix: I think it's a little bit more explicit in this case, because of the structured equity component to the long contracts. But yes, if you go into high yield, it'll start to look like there's equity exposure in there as well.

Mark McGrath: It's completely unreasonable to not have some equity exposure in the benchmark, then, is it not?

Ben Felix: I would argue so, yes.

Mark McGrath: People are probably using this as a bond alternative.

Ben Felix: That, I'm not sure about. I'd have to survey people that do this. But if they are, they're taking more risk than they realize. You wouldn't substitute this for bonds unless your intention was to increase the amount of risk that you're taking.

Mark McGrath: Given how many retail investors are getting interested, and how easy it is for them to access it now, and they're 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. Just replacing this with, like their bond allocation with something like this is significantly different than what they thought they were doing, potentially.

Ben Felix: That would be my hunch. It's only a hunch, but that would be my hunch. That's one of the reasons that I think this is an important topic, because there are firms in Canada that very explicitly target low investable asset, retail investors who are marketing this fairly aggressively, I would say, in terms of just showing off the high yield and the stability. It's not like it's not affecting anybody, and it's not like it's only being pitched to ultra-high-net-worth investors who can afford to take a little bit more risks than they may realize that they're taking.

Cameron Passmore: So, there's no free lunch.

Ben Felix: 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. None of this stuff should be too surprising. That's Berk and van Binsbergen, who we had on, I don't remember which episode, 200 and something. Jonathan Berk had the original theory on this in, and then Berk and Binsbergen have continued to develop it.

Basically, assets will flow up to the point where all of the benefits of the skill, of their skill are absorbed by the manager in the fees that they collect. And the investors in their funds earn returns that are in line with the risk that they're taking.

Cameron Passmore: Episode 220.

Ben Felix: 220, that was a great episode. The argument there is basically, there's an efficient market for managers skill. Some research on private equity. This is a paper from Ludovic Phalippou 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. 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, that's 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 investor. The investor just gets the expected return in line with the risk that they're taking.

Cameron Passmore: Ludovic Phalippou is Episode 210.

Ben Felix: That's another good one. 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. 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. 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 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. I think it's perfectly fine. We've said this a couple of times now. If investors are fully aware of all 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 can 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 don't love that. I think that there's probably cases, and this again is just my guess, I don't have data for it. But there are probably cases where retail investors probably don't have the tools or the knowledge to evaluate the risks that they're taking in products like this. Not even just retail. I've 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 we 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. Optimization routines are based on expected returns, correlations, standard deviations, all of which are probably not representative when we're dealing with private assets like this.

They also told me about the Sharpe ratio. Look at the Sharpe ratio in this fund, and I would argue that's 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 the smoothing of returns and other unique characteristics.

Mark McGrath: I just tweeted this morning that the Sharpe ratio on my house is like 37. It's just insane. But of course, there's zero volatility, there's no market for it. The only way I know what it's worth is if I look at the BC assessment they send me, and that's just a tax notice more than anything. 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.

Cameron Passmore: How did the conversation go, Ben, with the promoter?

Ben Felix: In that case, it was a third-party consultant, not a promoter. Didn't go very well. They thought I was a fool, because I didn't understand the benefits of private credit. 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 is optimal, and then saying, "Yep, I'm going to do that." Going to give you a head shake, I think.

To Mark's point with 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, that's 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. That's when the argument that I've seen for private credit having higher expected returns, but it's also the theoretical case that the premium is actually negative, because people are willing to overpay for the smoothing effect of illiquid assets. I don't know. I don't know how obvious it is that illiquidity is a benefit. Although, I've seen it pitch 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. It's going to make it hard to evaluate how much risk you're taking, and what kind of risk you're taking, and it's going to come with illiquidity. In return, for those generally unfavourable 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. Then, the reason in the research that I've read is that, any excess return gets absorbed by manager fees, which is not surprising, because that's what you'd expect in an efficient market for manager skill.

Mark McGrath: Fascinating. Presumably, if the fees are low enough, then this would be interesting, but there's just –

Ben Felix: That's an interesting point. I've thought about this. If we say, now, dispersion is still a problem, there's somewhat dispersion in private manager returns that you're still taking quite a bit of, I think, uncompensated risk there. 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 return to 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.

You start thinking about that, okay, how would you actually do that? How would you get low fees? You have to get going with scale, or know someone, maybe. You'd have to go on probably with scale. Now, if you're going to scale, it might be harder to have full access to the asset class. Because to go into 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 don't know, it's not obvious how you'd make that work. We don't touch it. So, the people who keep pitching me, you can stop.

Mark McGrath: Same. Please, and thank you.

Ben Felix: Probably won't use it. But is there a place for it? Like we said earlier, it's hard to say any asset class is objectively dumb when a lot of people invest in it. That doesn't mean that investors are always smart. People demand exposure to asset classes for some reason. There's some amount of revealed preference in demand for asset classes. That can be a lot of stuff that we would say is dumb, like demand for thematic ETFs. 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.

Cameron Passmore: Are you doing a YouTube video on this as well?

Ben Felix: Yes, I will.

Cameron Passmore: Great. Look forward to that. Anything else? You want to go to the after-show?

Ben Felix: I don't have anything else to add. Mark?

Mark McGrath: No, that was good. It's very fascinating. It sounds to me, I've spent a lot of time with. Very enlightening for me, it's great.

Ben Felix: 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." 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. 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. Like you said, there's almost zero volatility, consistent payouts, 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. Who's going to borrow, as a firm, at 10%, 12%, 14%. To your point earlier, I think you just go to the bank, and loan at 4%, 5%, 6%, 7%. By definition, there's got to be risk there.

I don't think that people, even at a basic level, understand. They get attached to the yield. Anything that's a shiny object, it's like a high-dividend fund with a 7% yield. They love the yield and it looks good. But risk happens slowly, and then all of a sudden. So, I'd be curious to see when or if this unwinds at some point.

Ben Felix: Another comment I saw in just reading about this stuff is that, at the current scale, that it's at, private credit hasn't gone through a full economic cycle. The floating rate debt is good from the perspective of the lender, because you can have less duration, so you're not going to be as interest rate sensitive, 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 they're already in a relatively precarious position, which is why they had to borrow this way, that just makes them riskier.

Mark McGrath: What is the duration on these things? Obviously, there's going to be some variants, but –

Ben Felix: I'm not sure.

Mark McGrath: Because these are shorter-term loans, and presumably, they're less risky than longer-term.

Ben Felix: The duration is going to be much shorter than an aggregate bond fund for sure, just by the nature of it being floating, right? But I think it is also shorter term, but definitely shorter duration than aggregated bonds.

Cameron Passmore: So, separate topic, how's the buzz around the recent budget proposed changes to 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. The tools on our homepage, much like the invitation we mentioned earlier. But he was telling me, he's up to 111,000 page views, and over 842,000 calculations.

Mark McGrath: Wow.

Cameron Passmore: Are you hearing that same kind of energy, Mark in your Twitter conversations?

Mark McGrath: Not specifically around the tool, although I have posted it a few times.

Cameron Passmore: Not the tool, but the whole capital gains.

Mark McGrath: Yes. I mean, especially with clients, we've got some big clients that have big decisions to make. There's so many tricky parts of this. Like one, it's just a proposal at this point. Two, 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.

With accounting or tax planning, 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 will 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. 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 25th." I've talked to two different accountants that have given me completely different opinions. One says, "Absolutely not, there's tax risk. Unless you actually sell and dispose of the asset, you can't do it." 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." There's just a lack of clarity, there's a lot of confusion, it's a complex topic, and the clock is ticking.

Cameron Passmore: Buddy of mine is selling his commercial building, and he moved up the closing date to just inside the window.

Mark McGrath: Yes. There's 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, and people trying to fire sell their property to get out of the new capital gains changes. I don't have the data in front of me, but it was quite obvious, that people are doing that. They're panic selling like cabins, and cottages, and investment properties, and that type of thing.

Ben Felix: I talked this morning to a very successful entrepreneur who himself is not happy that he could not do this because he's got illiquid assets. When you leave Canada, there's 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 realize the gain on that, you then have to raise 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. I know you've talked to a physician doing that too, so it's interesting times. Can't wait to see what happens.

Mark McGrath: I talked to a physician yesterday, or the spouse of a physician, I should say. They were saying, in the physician Facebook group, which has in tens of thousands of members. He said, there are some very serious conversations among them, and this is totally anecdotal, but very serious conversations. A number of them are leaving, confirmed are leaving. 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. We'll see what happens, of course. A lot of people may overreact and say they're going to leave and don't but –

Ben Felix: Or, maybe the legislation doesn't go through. We still don't know.

Cameron Passmore: 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. 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.

Ben Felix: Yes. Dave Chilton reached out to me through my YouTube channel, he left a comment. I get notifications when I get comments. I saw this comment, I was like, "No way." Couldn't believe it. I'm trying to find it. "Hey, Ben. It's David 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. You're well-informed, and very genuine. It's clear, you really want to help people. Well done." I was like, "Man, that's cool."

Mark McGrath: Super cool.

Ben Felix: Then, someone from his team messaged me not long after that on LinkedIn, and said, they wanted to chat. So, we got a call, which is also super cool. Super nice people. Anyway, they're just looking to do some video content, and so, they've kind of been surveying the Canadian market of content creators, and they just wanted to chat. It was pretty cool.

Cameron Passmore: The video that he describes this endeavour, he's not talking to any sort of economic part. It seems to be just giving back and creating some sort of intellectual foundation legacy of sorts.

Ben Felix: 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 about it [inaudible 0:35:06]. I'm sure it's going to be great content, and I may collaborate on him with some stuff if they want to do that.

Cameron Passmore: He said, he might come on the pod since we reinvited him. Turned us down the first time.

Ben Felix: 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.

Cameron Passmore: I first met him; I told you guys this story. He did a seminar for us, and I was back at Money Concepts in 1992, I think. The book had just come out, just as the mutual fund story was getting going in Canada. He did a presentation at the Talisman Hotel here in Ottawa, which has since been demolished. That's an old-time hotel, one of those classic old ballrooms. David did a great presentation. I think at the time, I remember he had the highest, at the time, highest mark for the CSE 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 says that he does it all by hand on loose-leaf paper.

Mark McGrath: He put some pictures up about that with the card table and him sitting at it, and it was really neat.

Cameron Passmore: 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, I think, Rick Mercer or something, where they showed him going to the diner, or maybe it was a story on Dragon's Den, because he was one of the dragons. But he goes the same diner for most meals. I don't think he cooks.

Ben Felix: This is a thing, I talked to a friend of mine who works for hedge fund in Toronto, he was in town visiting, we were chatting. I mentioned this, and he told me a story about how he was visiting a client where David Shelton lives, and they're at a diner, and the client tells him, "Watch. At exactly this time, Dave Shelton's going to walk in and order exactly this meal." My friend is like, "Yes. No way it's going to happen." Right on cue, right on time, walks in, orders the exact meal the guy said it was. Pretty funny.

Cameron Passmore: Seems like a great guy.

Ben Felix: Yep. Anyway, can we talk with the value premium for a second?

Cameron Passmore: I love to, always.

Ben Felix: 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. Do you remember in 2020 and 2021, the value was like dead, a horrible performance. It had been crushed by growth, did not do well through the pandemic. A lot of big managers were capitulating, giving up. Like some asset managers, value-focused managers were shutting down. Some robo-advisors gave up their allocation to value. 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's 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 curious, I don't know. I just decided to take a look. I was valued on since then. When that paper was published, January 2021, as the declaration of the death of value, and since then, so through until April 2024, in the US, value – 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. Again, and 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 over 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 market, 7%. EFI, 8% annualized. Crazy.

Cameron Passmore: Plus the spread, the value premium.

Ben Felix: That's value minus growth, indexes, long-only indexes. Yes.

Cameron Passmore: Well, you got to stay in your seat.

Mark McGrath: This confirms my biases, so I'm very happy to hear it. Thank you.

Ben Felix: Me too. Me too. And you know what, kicked it off, actually. 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. I was like, "Whoa, they have smoked XIC, like a Canadian market index fund." So, it just got me looking at how has value done elsewhere, and it's done quite well in recent history.

Mark McGrath: No kidding. Even in the US, I didn't know that.

Ben Felix: Over that period. But again, like if you go back any further in time, it's ugly in the US. I don't think I still have those data up.

Cameron Passmore: It's really surprising for the US, actually.

Mark McGrath: When you say it looks really ugly, if you go far back, you're talking like since the great financial crisis or further back than that?

Ben Felix: No, not even that far back. You go back like five years, 10 years. Rough go for US value. But, even over those periods, value in other places has done relatively well. The value drawdown was never quite as bad elsewhere as it was in the US. Now that it's recovered, the value actually looks pretty good again, other than in the US market.

Mark McGrath: So the death of value was, in fact, exaggerated then?

Ben Felix: It seems to be that way. 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.

Cameron Passmore: 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.

Mark McGrath: Ben, I must point out here that, the death of Bitcoin has occurred many times, and I don't know that you've invested at any of those times as a result of it being declared dead. So, I'll keep that in mind.

Ben Felix: I only buy Bitcoin at the peaks.

Mark McGrath: That's right. Don't we all?

Cameron Passmore: Scott Galloway discussion.

Ben Felix: Yes. We have that in the notes talking about that only. Man, the response to the Galloway episode in the Rational Reminded community, in 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 guest, who tend to be very methodical and evidence-based. Scott, I'm not making any claims about whether what he says 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. That's also not generally our style. The other interesting thing is that, I did hear feedback from quite a few people that love the episode. It was funny, right?

In terms of statistics, it's now edging up on being the best episode in terms of downloads from the last 10 episodes. That's a YouTube statistic. It was 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: Those are popular for the audio downloads too, top couple over the past dozen or so episodes. But he is a polarizing figure, so I think a lot of people have a private bias coming into it as well.

Ben Felix: He says some different stuff about masculinity, and gender, and it's inflammatory, seemingly on purpose at some level. Interesting, though. Interesting episode.

Cameron Passmore: Since we've had two us episodes in a row, there's no new reviews to read out this week, and no one's reached out on LinkedIn, so it's pretty quiet on that front. We haven't done an episode like this back-to-back, and a long – I don't think ever perhaps, are going back a few 100 episodes. Any other topics you guys want to cover of or mention?

Ben Felix: Not for me, I'm good.

Mark McGrath: I'm doing a huge landscaping project right now, full property. I say, I'm doing it. Not that I'm doing it. 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?

Mark McGrath: Front, and back, sides, the whole nine.

Cameron Passmore: It's just gone.

Mark McGrath: It's just gone. Yes, my house now on a pile of dirt. It's wild. It's impressive how fast they got that done. As I'm looking at my window day to day, 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.

Ben Felix: Mine is too, but the difference is, I don't plan on fixing.

Mark McGrath: That it's natural state.

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

Ben Felix: They don't like to play outside though. But if they did like to play outside, it would be great.

Mark McGrath: They don't like to play outside when you've got that as a yard.

Ben Felix: They ride their bikes sometimes; they like to go to the park. They go out in the yard sometimes, but not that much.

Mark McGrath: You need a new yard.

Ben Felix: I fully intend on doing that project, but it's going to be a big project. Cost aside, I don't have the mental capacity to take on that.

Cameron Passmore: Yes, it's not a tiny yard either. It's not an urban or suburban-type yard. This is very cool. Okay, guys, you're good?

Mark McGrath: I'm good.

Cameron Passmore: Okay. As always, everybody, thanks for listening.

Is there an error in the transcript? Let us know! Email us at info@rationalreminder.ca.

Be sure to add the episode number for reference.

Participate in our Community Discussion about this Episode:

https://community.rationalreminder.ca/t/episode-305-is-private-credit-special/29899

Books From Today’s Episode:

The Wealthy Barber: Everyone's Commonsense Guide to Becoming Financially Independent — https://www.amazon.com/Wealthy-Barber-Updated-3rd-Commonsense/dp/0761513116

Papers From Today’s Episode:

‘Direct Lending Returns’ — https://rpc.cfainstitute.org/en/research/financial-analysts-journal/2023/direct-lending-returns

‘Risk Adjusting the Returns of Private Debt Funds’ — https://www.nber.org/papers/w32278

‘An Inconvenient Fact: Private Equity Returns & The Billionaire Factory’ — https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3623820

‘Reports of Value’s Death May Be Greatly Exaggerated’ — https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3488748

Links From Today’s Episode:

Meet with PWL Capital: https://calendly.com/d/3vm-t2j-h3p

Rational Reminder on iTunes — https://itunes.apple.com/ca/podcast/the-rational-reminder-podcast/id1426530582.

Rational Reminder Website — https://rationalreminder.ca/ 

Rational Reminder on Instagram — https://www.instagram.com/rationalreminder/

Rational Reminder on X — https://twitter.com/RationalRemind

Rational Reminder on YouTube — https://www.youtube.com/channel/

Rational Reminder Email — info@rationalreminder.ca

Benjamin Felix — https://www.pwlcapital.com/author/benjamin-felix/ 

Benjamin on X — https://twitter.com/benjaminwfelix

Benjamin on LinkedIn — https://www.linkedin.com/in/benjaminwfelix/

Cameron Passmore — https://www.pwlcapital.com/profile/cameron-passmore/

Cameron on X — https://twitter.com/CameronPassmore

Cameron on LinkedIn — https://www.linkedin.com/in/cameronpassmore/

Mark McGrath on LinkedIn — https://www.linkedin.com/in/markmcgrathcfp/

Mark McGrath on X — https://twitter.com/MarkMcGrathCFP

Webinar May 22nd: Optimal Compensation Strategies for Business Owners — https://us06web.zoom.us/webinar/register/3317145039436/WN_GYudVJCYSnyF8HfUx9UbJQ

Money Scope Episode 12 — https://moneyscope.ca/2024/04/19/episode-12-paying-yourself-as-a-canadian-business-owner/

Money Scope Episode 13 — https://moneyscope.ca/2024/04/26/episode-13-optimal-compensation-from-a-ccpc/

David Chilton — https://thewealthybarber.com/

David Chilton on X — https://twitter.com/wealthy_barber?lang=en