The Dangerous Illusion of Safety in Private Credit: Why Investors Should Be Wary
On a recent episode of The Long View podcast (https://www.morningstar.com/podcasts/the-long-view), Mark Higgins, author and senior vice president at IFA Institutional, delves into pressing financial concerns. Higgins discusses the alarming rise of the deficit, the historical performance of active management, the importance of central bank independence, and the lessons financial history offers for the U.S.’s future. Drawing from his book, Investing in U.S. Financial History: Understanding the Past to Forecast the Future, Higgins provides a sobering perspective on where we might be headed. Here’s a breakdown of his conversation with Morningstar’s Christine Benz (https://www.morningstar.com/people/christine-benz) and Amy Arnott (https://www.morningstar.com/people/amy-c-arnott), packed with insights that every investor should heed.
The Cycle of Unrealistic Returns: Why Retail Investors Are Now in the Crosshairs
Amy Arnott kicks things off by addressing the current market environment, particularly the dangers of unrealistic return expectations. She notes how institutional investors in the 2010s suffered by overloading on asset classes like hedge funds and private equity. But here’s where it gets controversial: Higgins argues that the situation is even worse today. He traces the issue back to the early 1980s, when alternative investments like venture capital and buyout funds thrived due to declining inflation, falling interest rates, and rising equity valuations. These conditions created monster returns, famously exemplified by David Swensen’s success at Yale University’s endowment in the 1980s. Swensen’s 2000 book, Pioneering Portfolio Management, inspired many to chase similar returns by allocating heavily to private equity, hedge funds, and private credit.
But this is the part most people miss: Swensen’s success wasn’t just about asset allocation—it was about timing, talent, and access. Fast forward to today, and trillions of dollars are poured into these asset classes, with clear signs of overallocation. Distributions have dried up, and institutions are offloading assets in the secondary market—even Yale has considered selling. Now, these investments are being marketed to retail investors through 401(k) and defined-contribution plans. Higgins warns that this isn’t the start of a cycle—it’s the end. And at the end of the cycle, retail investors are the targets. Is this the next big bubble waiting to burst?
The ‘Lack of Fear’ in Private Credit: A Red Flag for Investors
Christine Benz highlights Higgins’ skepticism about private credit’s return prospects. Higgins points to a glaring issue: the lack of fear in the market. While there’s been some unease after the First Brands bankruptcy, the prevailing belief is that private credit is a surefire way to make money. Higgins debunks the narrative that private lending is still filling a gap left by the 2008-2009 financial crisis, arguing that this rationale no longer holds water. Instead, he sees a herd mentality driving investments, with yields declining and risks being underestimated. Are we nearing the end of this cycle, or is there still room to run?
Amy Arnott adds that investors are often blinded by the high yields of private credit funds, ignoring the fact that default rates can be as high as 10%. Will the First Brands bankruptcy serve as a wake-up call, or will investors continue to chase returns at the expense of risk?
Loopholes and Illusionary Returns: How Private Markets Are Being Artificially Inflated
Arnott brings up Higgins’ analysis of asset bubbles, particularly in private markets. Higgins highlights the rise of evergreen funds, which invest heavily in secondary positions of private markets. These funds exploit an obscure accounting rule from 2009, allowing them to mark up secondary investments to NAV immediately, creating the illusion of high returns. But here’s the catch: to maintain these returns, funds must keep buying more secondary positions, leading to a dangerous cycle. Is this a sustainable strategy, or a house of cards waiting to collapse?
Higgins also criticizes the practice of funds paying themselves incentive fees based on these markups, as exposed in a recent Wall Street Journal article about Hamilton Lane. This raises serious questions about the legitimacy of reported returns and the risks retail investors are being exposed to. Are these loopholes a necessary part of the system, or a recipe for disaster?
As Higgins concludes, the patterns are clear, and the risks are real. But the question remains: Will investors heed the warning signs, or will history repeat itself? Let us know your thoughts in the comments—do you agree with Higgins’ assessment, or do you see opportunities where he sees risks?
