Many investors have been tempted to take on additional risk to get higher returns in a persistently low interest rate environment. It’s led to an increased focus on private debt and private markets, which can be tricky to understand. The Financial Pipeline spoke with John Carswell, Chief Executive Officer and Chief Investment Officer of Canso Investment Counsel Ltd., about the origins, the draws and potential pitfalls of private markets. (Note: This interview has been edited for length and clarity.)
FP: We’ve seen increased interest in private markets, private debt, private equity – basically anything that people think is going to make them more money in what’s up until recently been a very low rate environment. Can you take us through the origins of private markets and who they’re really meant for?
JC: All stocks and bonds were (originally) private, but in 1933, U.S. regulators decided to force disclosure of investments so people could form a judgement on the value of anything they were investing in. Markets used to be all pump and dump; anything went. But after the Securities and Exchange Act, you had regulation, and you needed to meet certain requirements to get a prospectus for a stock or a bond issue. The private markets are what’s called ‘exempt markets.’ A bank, for example, can make a loan without fulfilling prospectus requirements for a public bond, but they operate under the Bank Act. So private markets coexist with the public markets and are supposed to be for sophisticated investors — those with more than $150,000 to invest at any one time, or who meet certain financial standards in terms of their financial assets and/or income.
FP: How is it that it’s no longer just “sophisticated investors” dabbling in private markets?
JC: In the low interest rate environment inflicted upon us by central bankers, people were looking for ways to make more money. The purveyors of financial products meet the demand for that, but not everyone who offers a private debt fund knows about private investments. Look at Bridging Finance. A lot of those loans, a bank, insurance company, or a proper private lender would’ve never made. It takes a long time to aggregate so many small loans – and a lot of people started doing bigger and bigger deals with fewer and fewer controls.
FP: So you think the motivation to seek out private debt or other private investments was an attempt to reach for yield?
JC: The craze for private mortgages, private debt, private equity really was a result of the low interest rate environment we found ourselves in. Now you can get four per cent by putting your money in Treasury Bills or bonds, but when you could only get 0.48 per cent for putting your money away for five years with the federal government or zero in your bank savings account, many people didn’t like those options. If you truly understand public investments, between a private and public investment that are equally risky, you should favour the private investment – but only if there’s a sufficient premium above the public investment to make it worth your while to take on the additional risk. For a large company’s private placement versus their public bonds, (that’s) probably a half percent. But if it’s something that you could never get out of and never trade, you’re probably looking at two to three per cent, at least, to be properly compensated.
FP: What does getting properly compensated for that risk look like?
JC: Well, a lot of people rushed into private investments to make eight per cent like (Bernie) Madoff – but they missed that while managers and funds can promise anything they want, delivering the eight per cent is very hard to do. At Canso, we invest in private debt when it’s attractive compared to public debt. I don’t prefer a cheap single B security to a cheap AAA. For a cheap single B, I might want to get five per cent above a government bond with equal term (to consider it). For the cheap AAA, I’m happy to get 0.5 per cent above the government bond.
FP: So, it comes down to really understanding what you’re investing in, what its value is and whether the risk is worth taking?
JC: To get up to speed on a private loan, to understand the risks in, for instance, second mortgages, the devil is in the details. Banks have special teams to do it, because it’s not something you can day trade or make a quick buck on. What modifies risk is the security for your loan, the covenants in the loan agreement, the controls you have over what the person can and can’t do. There’s a lot of work that goes into structuring a bond deal properly. The private markets basically attracted people who saw the returns and didn’t worry about the risks. My partners and I started working in private markets in 1985; I was in private placements at a life insurance company and (two of my partners) in banking. We were amazed at some of the things people were investing in. We thought, how could you do that? But people did it, and had to live with the consequences.
FP: Is this a trap investors only fall into around private debt or is it a broader problem where they get excited about the next best thing without thinking about the consequences?
JC: When it comes to investing, I don’t believe anything comes easy; you have to put in the work.You see people mesmerized by the money their friend made in crypto, and so they throw money into crypto. Crypto (positioned itself as something that) was supposed to protect against inflation, and a lot of people said, ‘I don’t want to have my money taken away in fiat currency. I’ll buy crypto.’ They bought at $2 or $4 or $5, but when it was getting up to $120,000 (and they) were selling, they weren’t selling because they were protected against inflation. They were selling because the opposite person on the trade wanted to buy. When you look at something that is ‘no-lose,’ the first people usually get rich, then someone else buys it off them thinking there’s more upside. But it usually ends with the really small investor getting hurt.
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