A design flaw in some of Canada’s most popular private debt funds has sparked a reckoning for the sector, with retail investors realizing the promises made to them about cashing out do not always hold up.
Private debt funds use investor money to make short-term loans to high-risk borrowers. They have exploded in popularity in Canada over the past decade because of marketing that promises 8-per-cent annual returns to investors desperate for higher yields in an era of ultra-low interest rates.
A number of these funds are popular with retail investors – and that’s by design. Some of Canada’s best-known private debt managers assure the mass market that their funds are run by experts who demand strong collateral to backstop the loans. Investors are told they have the freedom to cash out at any time, subject to short holding periods. Private equity funds, by contrast, lock investors in for a minimum of five years.
And yet last week Ninepoint Partners LP, which made its name by marketing private debt to the retail masses, halted redemptions on four of its funds. For two of the funds, the freeze will last indefinitely. The other two are subject to a 90-day pause.
The decision has exposed the mismatch between illiquid loans and the promise of easy redemptions for investors. Private loans are often made for terms of one to three years and cannot be repaid quickly on demand, while retail private debt funds often allow investors to get their money back in a matter of months. One of the two funds Ninepoint has frozen indefinitely, the Alternative Income Fund, promised “30-day liquidity,” according to the fund’s marketing materials.
In a statement to The Globe last week, Ninepoint said its decision to suspend redemptions, which affects $2.1-billion of assets under management, according to its internal calculations, was “due to tensions in the marketplace and the illiquid nature of the asset class.”
In another statement on Sunday, Ninepoint added that its decision to halt redemptions “was driven by a need to take time to engage with our dealer partners and investment advisers to address their concerns around the sector that had clearly driven a recent rise in redemption requests. Taking this action was a very difficult decision but one that we felt was in the best interest of all unitholders.”
Fears about liquidity mismatches in the sector have lingered for years, but an influx of money helped mask these concerns. It was only after the collapse of Bridging Finance Inc., which used to be one of Canada’s largest private debt managers for the mass market, that retail investors and their advisers began turning much more skittish. Ninepoint, when explaining its decision to investors, cited heightened investor anxieties after Bridging’s recent receivership.
It’s reasonable to provide continuous redemptions for funds that invest in securities such as public equities, noted Greg Racz, president of MGG Investment Group, which manages private debt funds. “If you’re in private, illiquid loans, it just makes no sense whatsoever,” he said.
To compensate for the fact that private loans can’t be repaid on short notice, MGG permits its Canadian investors to redeem their money as each loan is repaid, which usually takes two to three years.
Liquidity mismatches were an acute problem in Canada in the early 1990s, when a number of private real estate lenders ran into trouble after investors tried to redeem their money during a terrible downturn for the real estate market.
The mismatch has also flared up in other countries. In 2019, a prominent British fund with exposure to illiquid assets had to freeze £3.7-billion of investor money after investors tried to flee. At the time, then-Bank of England governor Mark Carney told a parliamentary hearing that funds that offer easy redemptions but invest in illiquid assets are “built on a lie.”
In the hearing, Mr. Carney spoke specifically about funds with illiquid assets that offer daily redemptions.
In Canada, retail private debt funds tend to offer what are marketed as “monthly” redemptions, but the fine print often explains that investors are subject to a short holding period, often 90 or 120 days, before their redemption is processed on the last trading day of the month.
In Ninepoint’s case, each of the four affected funds have different redemption rules, with the normal holding period ranging from 30 days to 180 days. But even that wasn’t enough to prevent the company from needing to halt redemptions. For the two funds frozen indefinitely, Ninepoint said it has the right to do so if market conditions make it impractical to sell the funds’ assets.
Private debt funds can be attractive to investors of all stripes. The sector is also attracting some of the world’s largest asset managers because of its potential over the near future. In the fall, Brookfield Asset Management chief executive Bruce Flatt said private credit is replacing fixed income for investors, which has prompted Brookfield to build out a private debt division.
The redemption risk lies mostly with funds that cater to retail investors, because the mass market tends to prefer products that resemble mutual funds. “Institutional products rarely run into this issue,” said Dan Hallett, vice-president of research at HighView Financial Group.
There are ways to make retail funds less susceptible to redemption disruptions. Real estate investment trusts, for instance, own scores of illiquid commercial properties and are beloved by retail investors. What makes these funds different from private debt funds is the way they are structured. Most REITs trade on public exchanges, so anyone who wants to exit their position can sell to another investor. For private funds, the money manager has to return the money.
A subcommittee of the U.S. Securities and Exchange Commission was set up last year to review retail investors’ access to private investments. It ultimately recommended that these buyers should be given access to a wide range of private funds.
But the committee’s report called for measures to be put in place to ensure there would be sufficient investor protection. One of the top recommendations was that government regulators favour investments that offer “at least limited redemption opportunities, or that can be traded on secondary markets without needing to liquidate an underlying private investment.”
A number of Canada’s private debt funds, however, have been “Frankenstein hybrids” that promise both easy redemptions and high returns from illiquid loans, Mr. Racz said. “You can’t have it all.”
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