It's a good time to be in the 'volatility laundering' business

Oh to have private marks

• replicating BDC performance is easy

• Private Capital, minding those capital inflows

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Publishing note: posting will be a bit more sporadic over the coming weeks. I’ve got some planning to do, plus some other commitments, but then I’ll be away for Passover. So, there will be posts, but not every day.

It’s a good time to be in the ‘volatility laundering’ business

Very brief today.

The long-running joke around these parts is The Marks Are Too Damn High.

In the private markets, where assets do not trade regularly, managers get to decide what they’re worth. Unsurprisingly, values are not nearly as volatile as publicly traded assets, but sometimes private marks are a bit too steady.

It’s almost like being not volatile (or the appearance thereof) is the point. This is what Cliff Asness has coined ‘volatility laundering.’

Replicating BDC performance is easy

Anyways, I came across this fun little research blurb that takes aim at the Business Development Companies (BDC), which is a technical term, but let’s just broadly say it’s the public companies that invest in private companies, which would include the vaunted Private Equity Credit firms, like Apollo, Blue Owl, etc.¹

The blurb makes the argument that you can replicate BDC performance by using leverage to buy a basket of high yield bonds—and then here’s the trick—only check prices every quarter:

The Problem with Large BDCs

It is surprisingly easy to replicate large-cap BDC performance using public markets:

• Start with high-yield bonds, convert them to floating-rate exposure

• Layer on about 50% leverage

• Reprice only 30% to 40% of the loans each quarter

Running this approach from 2020 to now explains 88% of the variance in large BDC performance.

In fact, the replication slightly outperforms most BDCs - likely because of hefty fees. These large BDC managers typically charge a 1.25% to 1.5% management fee plus 12.5% carry, on top of other expenses that can add up to another 0.25% to 1.5%. Meanwhile, you can assemble the building blocks (T-bills, credit spreads, leverage) far more cheaply in public markets.

I didn’t check the math, but I like the concept.

Truthfully, it’s not so simple, because part of what BDCs and private capital firms do is expand the scope of investable assets. There are worthy credits out there—that take substantial time time and effort to find, underwrite, service, etc.—that wouldn’t make it to the public markets.

So, you can’t just “buy the HY bonds” because someone has to do the work of creating that loan in the first place.

Private Capital companies take a beating (with everyone else)

Anyways, public investors have not spared the PE firms in the latest downturn:

Bloomberg

The biggest PE firms have tumbled double-digits with everyone else.

Naturally, investors are concerned about the slowdown in dealmaking, rising high yield spreads, and presumably, future capital inflows (perhaps most of all).

Apollo

New loan issuance tumbled, once the Trump Traded faded.

But while the public co valuations took a dive, how have the values of their portfolio companies performed?

Random Walk can’t help but resurface this banger from the FT:

“In the private markets, no one can hear you scream.”

Still probably true.

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Other links

• Wall St. worries about job cuts. Volatility is not good for dealmaking.

• Harvard borrowing $750M after potential funding cuts. A follow-on to Higher Ed is Passing Around the Hat.

• Tariffs create an ‘urgent’ problem for Germany. Exports to the US are ~4% of GDP.

• Consultants who devise tariff end-runs and workarounds in hot demand. The downside of the more “phased” approaches (assuming one is on-board with tariffs), is that the “phase in” period is used to learn how to evade tariffs, and not rebuild supply chains or whatever.

• Close look at the hard data. Hunting for changes to the real economy post-Liberation Day.

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Previously, on Random Walk

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1. Technically, those contain BDCs