Unpacking the Hype and Hazards of Private Credit ETFs

ETFs remain the fund structure for innovation and access, democratizing strategies previously inaccessible to a broad swathe of investors. But just because the fund structure allows for capturing niche, sometimes lucrative, often higher-risk corners of the market doesn’t mean every investor should pile into these types of strategies. Private credit ETFs are all the latest rage, but investors should be wary – and incredibly informed – before considering adding them to portfolios.

Private credit is the type of debt relating to entities other than banks that loan money to private companies. It’s divided into a number of categories, depending on the type of loan and the way investors are exposed to that loan. From direct exposure to private credit loans, to investing in a pool of loans, to investing in the businesses that invest in private credit, investors don’t lack for choices amongst private credit ETFs. If you’re looking for a full explainer on the types of private credit and a detailed breakdown of current ETFs on the market, go here.

It’s an asset class that holds appeal for the diversification potential compared to public markets, higher yields to accommodate the illiquid nature of private credit, and interest rate protection in the form of floating rates. It’s also an asset class that is booming, growing from primarily institutional investors (think pension funds, insurers, and the like) to increasingly more retail investors in the mix. Morgan Stanley estimates that private credit will grow from $3 trillion at the beginning of this year to $5 trillion by 2029.

New opportunities can be great for investors, and I’m all for greater access to strategies through the ease of the ETF wrapper. However, investors need to understand the risks and be very educated on more complex asset classes like private credit. This is difficult when so much of the space is opaque to outside parties. The issue with gaining private credit exposure via ETF is twofold: that of transparency and liquidity.

Problems of Transparency

The core risk around private credit is arguably the lack of transparency. Because the assets aren’t publicly traded, it’s difficult to determine an accurate valuation, as there is no price discovery. And often, the valuation of the loan doesn’t reflect the underlying company’s performance. The private credit sector also lacks supervisory oversight.

This means that private companies can, and do, go from a rating of par for their debts to bankruptcy within the span of a month. BlackRock just declared that the private debt it provided to Renovo Home Partners, a home improvement company based out of Dallas, amounted to zero, as Bloomberg reported. The firm held the majority of the $150 million private debt.

Renovo had struggled for much of the year, deferring payments and converting loans into equity in order to recapitalize. Despite this, BlackRock still determined the debt to be at par as of the end of September, meaning investors should expect full repayment. By the beginning of November, Renovo filed for bankruptcy and the private debt assessment for investors fell to zero.

Because of the opacity of private credit, stakeholders must extend near-total trust to fund managers. Renovo’s story isn’t an uncommon one within private credit, particularly this year. A number of private companies have succumbed rapidly in recent months, leaving lenders to eat the loss and investors to suffer with little to no warning.

Issues of Liquidity

The liquidity mismatch between private credit and the ETF structure with daily liquidity is notable. Private credit is, by nature, highly illiquid. The infrastructure is one largely designed to lock up investments, serving as a reliable source of funding for private companies across market cycles. The balance to this is that most maturities are on the shorter end, averaging around five years. ETFs, on the other hand, need liquidity as they trade intraday in markets. 

Because ETFs cannot hold more than 15% of net assets in illiquid assets (SEC Rule 22e-4), private credit ETF issuers solved for this by using more liquid proxies for the rest of the portfolio. From Business Development Companies (BDCs) to Collateralized Loan Obligations (CLOs), investors gain varying levels of access to private credit lenders, loans, and more. This means that some ETFs offer more direct exposure to private credit while others invest a few layers removed from the source. Therefore, private credit ETFs range greatly in the level of transparency and liquidity they actually offer for investors.

CLOs, that invest in diversified pools of below-investment-grade loans, offer some mitigation for liquidity concerns. CLOs break down into tranches from AAA through BB on the debt side, and then a tranche for equity at the bottom. Each tranche represents a payment order in case of default, with its own associated risk profile and yield potential. Investors can buy into these segmented loans, earning higher potential yields for the riskier tranches. However, the lower you go in rating, the greater the liquidity concerns become. For ETF investors, it means that only some CLO tranches are likely appropriate with the fund structure as it stands today.

“Triple-A is great, top of B, but once you're in B and C, that's not a daily liquid product,” Jennifer Grancio, Global Head of Distribution at TCW, explained recently. “Our investors would tell you, things can happen in the market. You can't always get in and out of those products, so those should be funded. Could be something that's in a mutual fund, could be an interval fund, or we may start to have ETFs that don't have liquidity.”

Innovation Is Already Underway

The old adage goes that necessity is the mother of invention. As investor demand continues to grow, I imagine that we’ll see increasingly more creative takes on private credit investing via ETF. And should regulation change around ETF liquidity or transparency, expect a wave of new funds with new risks. However, investors don’t need to wait to find innovation already happening.

Over the summer, VanEck launched the VanEck Alternative Asset Managers ETF (GPZ) that invests in the public equity of the private credit managers. It’s an approach that allows for liquidity and transparency by staying firmly on the public market side, while indirectly benefiting from the profits of private credit, even in down markets.

“It provides exposure to those big brand-name private managers, KKR, Brookfield, Blackstone, of the like,” Ed Lopez, Head of Product Management at VanEck, recently shared. “The managers actually tend to do really well because they continue to earn fees, where the LPs [Limited Partners], depending on who you go with, you have to be very selective, obviously, are just getting okay returns. And maybe not the returns that they really expected from that kind of investment.”

Private credit ETFs offer a number of possible benefits, but as with any complex strategy and asset class, they come with a myriad of risks and steep educational needs for investors. Similar to options, this is an asset class best left to sophisticated investors for now, given the nuanced nature of the private credit market itself. Innovative funds like GPZ may help to bridge that gap, and it will be interesting to see what’s next for the category.