(Bloomberg) -- State Street Corp. seemed to perfectly time the private-markets wave, debuting a private credit exchange-traded fund in February months ahead of an executive order that aimed to push more investors into alternative assets.
It had a coveted ticker: PRIV. It had a blue-chip partner: Apollo Global Management Inc. And it had a straightforward goal: "democratizing access" to investment-grade private credit.
In less than a year, though, the fund has faced scrutiny from the US Securities and Exchange Commission and struggled to attract money. What's more, the ETF is mostly not actually invested in private credit: The vehicle's documents acknowledge such debt will generally make up between 10% to 35% of the fund. Its top three holdings are an agency mortgage bond and two US Treasury notes.
The challenges, even for the third-largest ETF issuer State Street, make it something of a cautionary tale for those seeking to push retail investors into private markets. At a minimum, it suggests the so-called liquidity mismatch between private assets and ETFs, which price on a second-by-second basis, may be too much to overcome, threatening to close off private markets to one of the most popular ways to invest.
"Just because they figured out the legalese of everything doesn't mean that people care about it or want it," said Sam Huszczo, founder of SGH Wealth Management. "It's more about selling product and trying to solve this late cycle issue that private credit is in."
Since its launch, PRIV has attracted a fraction of this year's ETF boom, raising $45 million of the industry's $1.5 trillion intake. This is despite the fact that the fund is outperforming its bond-market benchmark, according to data compiled by Bloomberg.
A representative for State Street said it disagreed with any characterization that the fund's performance had been underwhelming.
"We are finding great enthusiasm for PRIV and continued, increasing interest in access to private investments," the spokesperson said. "PRIV's daily trading volume in particular reflects this and demonstrates the industry taking notice of it as a liquid investment vehicle for investors."
A representative for Apollo, which sources the private credit investments, declined to comment.
Market Challenges
The fund's muted flow levels come amid challenges that intensified in the private credit industry in the latter part of the year. Fierce competition, public scrutiny, underperforming business development companies and high-profile corporate failures have fueled concerns that illiquid, hard-to-sell assets aren't suitable for the everyday investors the industry is trying to sell to.
The exact nature of the funds holding's has also sparked some debate. According to its website, the Apollo-sourced investments account for almost 21%. But there are differing views on what constitutes private credit. CFRA analyst Aniket Ullal estimates the fund's private credit assets account for nearer 15%. Conor MacWilliams, the owner of Outer Beach Consultants, says just 8% of the assets resemble closely how a limited partner would be able to invest in private credit.
The rest is mostly a mix of publicly-traded debt including Treasuries, corporate bonds and mortgage-backed securities.
Owners of the fund, with nearly $97 million of assets, pay a 0.7% fee annually on their holdings, which is about 21 basis points or 43% more expensive than the average ETF in its Morningstar Direct category. All in, that's likely made PRIV a tough sell for some.
"These products have always struggled to gain traction with financial advisers," said Michael O'Riordan, founder of ETF consultancy Blackwater. "The more complex the story and how the performance is generated, the higher the chances you lose the investor along the journey."
Illiquid Cap
PRIV's documents say private credit will generally account for 10% to 35% of the fund and that it will cap investments deemed illiquid at 15% to conform with US Securities and Exchange Commission requirements.
The actively-managed fund handed investors more than 5.6% since its February launch, while the passively managed iShares Core US Aggregate Bond ETF, which gives investors direct exposure to the main bond benchmark for 3 basis points, is up roughly 4.7%.
"They are going to need to have to reduce the expense ratio to really get better adoption," said Nate Raabe, a financial adviser with Nebraska-based Wealth Management, who owns a small allocation of PRIV for his clients. He doesn't see the fund as a viable "core holding" in portfolios, he said.
Regulator Scrutiny
The fund's debut was immediately overshadowed by SEC scrutiny, with the agency raising concerns about issues including its liquidity risk management.
Liquidity mismatch is a risk because the underlying loans are typically more difficult to sell quickly, raising fears that fund managers could struggle to return money in a downturn. For PRIV, Apollo provides a liquidity backstop by offering daily bids. State Street, in response to the SEC's concerns, has clarified that other broker-dealers can provide quotes for the private debt as well.
The mismatch between illiquid private assets and ETFs was enough to help prompt investment management firm Capital Group to opt for an interval fund format — vehicles which aren't subject to the SEC's 15% cap — an executive told Bloomberg in June.
Still, this hasn't dissuaded State Street — which doubled down with a second ETF to invest in public and private credit investments, including, but not limited to, those sourced by Apollo. The fund began trading in September.
Currently, the PRIV ETF has a roughly 13% weighting to asset-backed debt sourced by Apollo, and an 8% weighting to other private-credit instruments sourced by the investment firm. Those include a preferred equity investment in BP Plc's stake in the Trans Anatolian Pipeline, senior unsecured notes in an Australia's AGL Energy, and a structured investment in an Air France-KLM operating affiliate.
"Private credit can make sense for certain investors, but we believe it's better suited as a dedicated allocation rather than something folded into a liquid portfolio," Adam Phillips, a managing partner with EP Wealth Advisors in Torrance, California, said. "Recent pricing discrepancies in private credit loans also underscore how difficult it is to value these assets on a daily basis, which is a core requirement for an ETF structure."
--With assistance from Olivia Fishlow.
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