| Maybe the hottest topic in finance in the last few years has been private credit, and we’ve talked about it a lot around here. I often think of private credit as fundamentally a story about matching assets and liabilities. The story is something like: - Traditional banking involves banks, which are funded with short-term liabilities (deposits), making long-term illiquid loans (mortgages, corporate loans, etc.). This has obvious risks: The depositors can all ask for their money back at any time, and if they do, the bank won’t have it, since it can’t rapidly turn the long-term loans into cash. Much of the modern banking regulatory system is about mitigating this risk of bank runs, but it still comes up in various forms.
- Meanwhile there are other firms that have very long-term liabilities. Pension funds, for instance, tend to have a good sense of how much they will have to pay out each year and a long time horizon. Life insurers, annuity providers, university endowments, sovereign wealth funds, etc. Also many individual investors saving for retirement. These investors traditionally bought bonds, which promise some defined payout years in the future.
- Once upon a time it was sort of hard to turn bonds into cash: They didn’t trade that often, because most bondholders were these sorts of long-term investors with long-term liabilities, so they would just buy bonds and hold them to maturity. But over time this shifted, and now bonds are actively traded and there are all sorts of firms that are in the business of holding bonds for the short term. And there are retail products built on that idea: Bond exchange-traded funds, for instance, allow investors to day-trade in and out of a bond portfolio, because bonds are thought of as essentially liquid tradeable things.
- Still, those long-term investors with their long-term liabilities exist. The structure of their liabilities has not really changed: An endowment or pension or sovereign wealth fund or 40-year-old saving for retirement really does have some reasonably predictable need for cash reasonably far in the future. Those people don’t really need instant liquidity from their bond investments.
- It turns out that you can often get paid more interest by making private loans that don’t trade than you can by just buying regular traded bonds. So “private credit” developed: Big alternative asset managers take big pots of long-term money (from pensions and insurers, from their own annuities businesses, etc.) and use it to make long-term illiquid loans to companies.
- And to some extent private credit firms have been able to out-compete banks to make loans, in part because they have a more sensible business model for making loans: Banks have short-term funding and so sometimes can’t make loans because they or their regulators get nervous, but private credit funds have long-term funding so are free to make loans that banks can’t.
- Seems good, no?
That’s the idea, but now we talk a lot about the exceptions. One important exception is that a lot of private credit firms get leverage from banks — instead of just using their long-term investors’ locked-up money to make loans, they also borrow some money from banks to fund those loans — and thus the run risk of banking sneaks back into private credit. But also this? Investment giants including Apollo Global Management, BlackRock, Capital Group, KKR and State Street are jostling to launch private-credit exchange-traded funds and other retail products. The funds would allow anyone to buy into the $1.7 trillion market for loans made by Wall Street’s nonbanks to corporations and consumers. The winner will be whoever can offer a fund with shares that can be easily bought and sold and get the green light from government regulators. Their prize: full access to mom-and-pop investors when many sophisticated institutions are filling up on private credit. The toughest problem is how to turn rarely traded portfolios of private loans into shares of funds that individuals can dip in and out of. That is a key requirement for regulators—and a task that many market veterans are skeptical can be achieved. ... “There is a mismatch in terms of the liquidity profile between private credit as an underlying asset and the daily redemption of an ETF,” said Aaron Filbeck, a managing director at the Chartered Alternative Investment Analyst Association, a professional group for money managers. “There is a question as to how exactly that is going to work.”
In principle offering private credit to “mom-and-pop investors” makes a certain amount of sense: Many 40-year-olds saving for retirement really can lock up a portion of their money for a period of years, so they can invest in high-yielding illiquid credit. Put them in a private credit fund, why not? But offering private credit to retail investors via an ETF with daily liquidity kind of undoes the advantage.: State Street is proposing the most ambitious ETF in a filing involving Apollo that was made to the SEC this month. The ETF managed by State Street would invest directly in a mix of liquid debt traded in public markets and private corporate, consumer and mortgage loans purchased directly from Apollo. At least 80% of the debt would have investment-grade ratings from credit-rating firms “or be of comparable quality” in the opinion of State Street, according to the filing. To ensure the fund’s smooth operation, Apollo is committing to repurchase any of the private debt it has sold to the fund on a daily basis.
Modern finance definitely makes it possible to make long-term loans funded by money that can vanish in a day, but I thought private credit had found a way not to do that. Imagine that you are the chief executive officer of a public company. There are three projects you could do: - Project 1 will increase the value of your company by $10.
- Project 2 will decrease the value of your company by $5, but increase the value of your main competitor by $10.
- Project 3 will decrease the value of your company by $5, and also decrease the value of your main competitor by $10.
Which project(s) should you do? Conventional corporate finance theory would tell you to do Project 1, because it increases the value of your company, and not Projects 2 or 3, because they don’t. Your job is to maximize the value of your company, so you should do things that do that and not do things that don’t. There are other theories. We have talked a lot around here about a controversial theory that is sometimes referred to as “common ownership,” and which I sometimes describe as “should index funds be illegal?” In this theory, (1) big diversified institutional shareholders are collectively the main owners of all of the public companies, including the main competitors in many industries, (2) the shareholders prefer to maximize the collective value of their holdings, rather than the value of any individual company and (3) the CEOs know all this and try to act in the shareholders’ best interest. In this theory, you should probably do Project 1 (increasing the value of your company is good for shareholders), but you should also do Project 2. Increasing the value of your competitor is also good for your shareholders, because they also own your competitor; they are indifferent between $1 of value at your company and $1 at your competitor. Project 2 maximizes your shareholders’ overall welfare and so is good. Project 3 is still bad. This theory is controversial in part because it often seems like corporate executives do not think or act this way. It certainly seems like most CEOs want to win, want to beat the competition; clever academic theories of shareholder value and diversification might not have entirely penetrated into the psyches of hard-charging CEOs. Also, on a pragmatic level, a lot of CEOs are paid based in part on how their company performs relative to its competitors. So sacrificing your company’s performance to help out a competitor is, for you, counterproductive: You will underperform, so you will get a lower bonus. Which suggests a third theory? If you are a CEO who is paid based on your performance relative to your competitors, sacrificing your company’s performance to hurt a competitor could be smart. If your pay structure is like “you get a bonus if your stock price goes up more than your leading competitor’s stock price,” then there are two ways to achieve that: Make your stock price go up, or make theirs go down. In that theory, you should do Project 1 (make your stock price go up), avoid Project 2 (make yours go down and theirs go up), but do Project 3: Sacrificing your own company’s performance to make your competitor’s performance even worse is, for your selfish purposes, good. I should say that the previous theory — “CEOs sacrifice their own performance to help competitors” — is popular in some quarters but quite controversial; this theory — “CEOs sacrifice their own performance to hurt competitors” — is, uh, not popular at all. No CEOs go around being like “we blew up our factory, but the fire spread and caused two of our competitors’ factories to burn down, so we came out ahead.” Nonetheless! Here’s a fun paper on “Executive Incentives and Strategic Talent Acquisition: Evidence from Poaching,” by Matthew Bloomfield, Thomas Bourveau, Xuanpu Lin, Guoman She and Haoran Zhu. In recent years, relative performance evaluation (“RPE”) has become a common feature in CEO pay plans, used by the majority of S&P 500 companies as of 2017. While in most cases, RPE is used to shield risk-averse managers from common sources of uncertainty (à la Holmstrom, 1982), theoretical work shows that RPE can also have an incentive-distorting effect: it encourages agents to take actions that harm the performance of the peers against whom they are compared (e.g., Lazear, 1989). … In light of the central importance of human capital in generating and sustaining company value, we posit that poaching RPE peers’ labor talent could be a viable approach that an RPE-using focal firm can use to harm its peers’ performance—without having to sacrifice much of its own—thus bolstering its relative performance. … RPE-motivated poaching could occur even when poaching erodes the poaching firm’s absolute performance, as long as it is even more detrimental to the peer from whom labor talent was poached. For example, suppose there is a highly productive employee at a peer who is generating considerable economic surplus for that peer. An RPE-using focal firm could potentially lure that employee away by overcompensating them. Doing so would cost the firm by the amount of the overcompensation, but would cost the peer the entire amount of the employee’s surplus to them.
And they find that “firms hire significantly more labor talent away from their RPE peers than from their (otherwise fairly similar) industry
rivals that are not their RPE peers” and that “focal firms’ tendency to poach labor talent from RPE peers is most prevalent for higher skilled and longer-tenured employees,” findings that “are consistent with deliberate peer-harm driven by executives’ RPE incentives.” (They’re also consistent with “it is good to hire skilled employees from similar firms,” though they do some tests to argue that “deliberate peer-harm” is a plausible explanation.) Anyway I like this mechanism as sort of an antidote to the common-ownership-is-bad-for-competition theory: In this theory, executive pay incentivizes competition, even when the competition is bad for shareholders, even when it is bad for shareholders of that firm, because the executives are paid to win, not to maximize value. Also though there are obvious parallels to the financial industry? If you run a hedge fund, you are mostly paid based on your absolute performance, though having higher returns than your competitors is probably good for attracting investors. But even your absolute returns are in large part a function of competition: If you are trading against idiots, you’ll make a lot of money, but if you are trading against sharp competitors you mostly won’t. Hiring away your competitors’ best employees can be a good business decision even if they don’t do anything for you; they can add value to your firm even from their year-long gardening leave. The value they add is not working for your competitors. I’m sorry but this does not go far enough: OpenAI has asked investors to avoid backing rival start-ups such as Anthropic and Elon Musk’s xAI, as it secures $6.6bn in new funding and seeks to shut out challengers to its early lead in generative artificial intelligence. The San Francisco-based group, led by chief executive Sam Altman, announced on Wednesday it had completed its latest fundraising at a $150bn valuation, the highest in Silicon Valley’s history. During the negotiations, the company made clear that it expected an exclusive funding arrangement, according to three people with knowledge of the discussions. ... OpenAI can command unusual terms and an outsized valuation because investors believe the company could dominate the next wave of AI innovation, which they argue will be as significant a shift in consumer behaviour as the internet or mobile. “Because the round was so oversubscribed, OpenAI said to people: ‘We’ll give you allocation but we want you to be involved in a meaningful way in the business so you can’t commit to our competitors,’” according to one person with knowledge of the deal. A partner at one leading VC firm noted that ride-hailing app Uber had a similar policy “when they were in full world-domination mode”, adding: “If a company holds all the cards, they can force people to do things unnaturally.”
I mean I do sympathize with the business ask here: If you are in a capital-intensive winner-take-all race to dominate some economically important new technology, you will want to (1) get a lot of capital and (2) deny capital to your competitors. (See above!) It totally makes sense for OpenAI to ask for this. And then the investors have to choose: Bet on OpenAI to win the race, or sit out the round and bet the field. But come on, I have argued that OpenAI’s best fundraising move is Altman’s performative nervousness that AI, if developed carelessly, could kill us all. “Ooh our product is so powerful that it could enslave humanity, aren’t you a bit curious” is a great pitch. But it also fits seamlessly with this ask! “Our product is so powerful that it could enslave humanity, so give us money to build it carefully, but don’t give money to Elon Musk to build it, have you seen that guy’s X account?” OpenAI has a hilariously good, like, business and ESG case for exclusive funding; it’s weird that they just relied on “the round is oversubscribed.” It’s almost like they’ve stopped believing in the stuff about developing AI for the good of humanity. The usual way that a business pays an invoice is that the business tells its bank to subtract $100 from its account at the bank and add $100 to its supplier’s account at a different bank. And then the payor’s bank tells the Federal Reserve to subtract $100 from its account at the Fed and add $100 to the supplier’s account at the Fed, and tells the supplier’s bank to add that $100 to the supplier’s account at that bank. This is a somewhat stylized story but close enough. Sometimes the supplier and customer have the same bank, and the process is simpler: The customer tells the bank to subtract $100 from its account and add $100 to the supplier’s account, and it does. Various efficiencies are enabled if two companies, or many companies in a related industry, share the same bank. We talked once about the Silvergate Exchange Network, where the basic point was that a lot of crypto companies all banked at Silvergate Capital Corp., so Silvergate could offer them services like “we can subtract money from your account and add it to your supplier’s account at midnight,” instead of keeping normal banking hours limited by when the Fed is open. And so I imagine that sometimes crypto companies would get bills from suppliers and would say to them “you know, we can write you a check or whatever, but it would really be a lot more convenient if you would open an account at Silvergate, because moving money to you at Silvergate is so much easier than using the general-purpose US financial system.” And I suppose sometimes that worked; if the supplier was also a crypto-y company then it probably got that request a lot, and probably did want the ease of transacting with its crypto-y customers through the Silvergate Exchange Network. On the other hand, if the supplier was delivering, like, printer toner, it might find that request annoying. “Sure it would be easier for you if I opened an account at your bank, but for me, opening a new account at a new bank would be pretty inconvenient.” “But we can disintermediate the broader financial system and just rely on Silvergate,” the crypto company might say, but that is not a very good argument. Why rely on Silvergate? (Silvergate eventually shut down.) Anyway here’s this: PayPal Holdings Inc. completed its first business payment using its proprietary stablecoin as a way to demonstrate how digital currencies can be used to improve often-clunky commercial transactions. PayPal paid an invoice to Ernst & Young LLP on Sept. 23 using PYUSD, the stablecoin the firm launched last year, relying on an SAP SE platform to complete the transaction. SAP’s platform, known as the digital currency hub, allows enterprises to send and receive digital payments instantly, around the clock. The invoice amount wasn’t disclosed. … While the consumer-facing benefits of stablecoins often dominate conversations, this payment demonstrates other use cases for the digital currency, according to Jose Fernandez da Ponte, PayPal’s senior vice president of its blockchain, cryptocurrency and digital currency group. “The enterprise environment is very well-suited for it,” he said. “It’s a very rational conversation to have with the CFO.” Business-to-business transactions – especially those that cross borders – can be drawn out, expensive and, in some cases, risky, given the requisite reliance on third parties. The speed and availability of settlement with this use case is far more attractive, Fernandez da Ponte said.
Okay sure right. Instead of paying an invoice with dollars on the ledger of your bank, which requires the involvement of (1) PayPal’s bank, (2) your bank and (3) possibly the Fed, PayPal can pay an invoice with dollars on the ledger of Paxos Trust Co., the issuer of its PYUSD stablecoin, which requires only the involvement of Paxos. I suppose that has less “requisite reliance on third parties” (not none!), and is probably faster than sending you dollars, though it leaves you with PYUSD rather than dollars. And then if you want dollars I suppose you can sell PYUSD on a crypto exchange and withdraw the dollars, or just, uh, I mean if you have an account at PayPal then you can sell PYUSD for dollars there? PayPal is a payments company? It could in theory pay all its invoices by crediting the money to its suppliers’ PayPal accounts. That seems like an annoying way to pay invoices. This seems like a slightly more complicated form of that. New CPA Paths Emerge as States Try to Stem Accountant Shortage. Mortgage Rates Near 6% Are Enough to Start Up a Refinancing Wave. Ghana Bondholders Overwhelmingly Support Debt Restructuring. Saudi Minister Warns of $50 Oil as OPEC+ Members Flout Production Curbs. TSMC Gets Single-Stock ETF as Direxion Funds Allow Leverage Bets. Korea Zinc Teams Up With Bain Capital to Thwart Takeover Bid. Schools Make Millions Offering Degrees That Double as Work Visas. Steinhoff’s Ex-CFO Sentenced to 10 Years in Prison for Fraud. “Forty percent of cybersecurity executives said they are covered by their companies’ directors’ and officers’ liability insurance.” CEOs turn to podcasts to control their message. Flying cars. Laughing heirs. Deseasonalized Aperol. Poopcopter. If you'd like to get Money Stuff in handy email form, right in your inbox, please subscribe at this link. Or you can subscribe to Money Stuff and other great Bloomberg newsletters here. Thanks! | 
