Credit Markets in Transition: Public–Private Credit Portfolios

>> You're listening to all the credit, a monthly podcast series brought to you by PGM and active global investment manager. >> Welcome to all the credit. I'm Brian Barnhurst, global head of credit research, PGM public fixed income. The growth scale and sophistication of private corporate and securitized credit asset classes as necessitated an evolution in approach to construction and management of multi-asset portfolios. We've highlighted this topic in recent podcasts on asset-based finance and direct lending to name a few and now take a deeper look at how private instruments can enhance multi-asset portfolio characteristics and outcomes. I'm very fortunate to be joined by co-chief investment officer and head of multi-sector investment, Greg Peters and senior multi-sector portfolio manager Tom McCartan. Greg Tom, excited to have you on the podcast. >> Thanks, good to be here. >> Thanks for having me, Brian. >> Compare with only a few years ago, fixed income investors now have far more options and access to private corporate and securitized credit. Naturally, investors are increasingly asking, how do we combine and optimize liquidity, yield, return and durability within a single portfolio? Greg? >> Thanks, Brian. That would zoom out first. So there's been tremendous growth in the credit markets the past 10 years. But the growth has been really on the private side, not the public side. As an example, you look at the high-yield bond market, it's virtually unchanged, actually a little smaller over the past decade. At the same time, private credit is three and a half times larger. So that's where the credit is in the overall system. And the way investors have kind of prosecuted that opportunity was very much in a set allocation siloed approach. And so if you wanted access to, let's say, middle-market direct lending, you would have a middle-market direct lending fund. And that allocation was set. I think the world is rapidly shifting into this multi-dimensional, multi-asset realm where publics and privates will be managed together. And we think of it less of a binary public-private demarcation and more of a continuum. And so what we're doing and what we're looking to do is to build portfolios that incorporate both public credit and private credit and optimize around that. We think it leads to better outcomes, more levers to pull, and ultimately higher alpha. It's one of the more interesting topics to discuss internally. Tom, it also aligns with the way in which we're calibrated around relative value and risk considerations. I think that's right, Brian. Think about what Greg was talking about there and in terms of combining these different opportunities into single portfolios, it's naturally leading you into an asset allocation framework. And once you do that, that's going to be an exercise in trying to compare these different assets on a relative value basis. And they're in the challenges start to emerge because the big differences in the public and private asset classes is that the liquidity and secondary market trading within public asset classes gives you the ability to observe and measure the risk premium or the risk adjusted return. And the lack of secondary market trading or price discovery and the inability to observe that in private markets means you don't really have that as much. And so it becomes more of a challenge to compare the relative value across the two. Yeah, you touched on some of the challenges. Of course, I framed it as very simplistic, just incorporating private assets into a multi-asset framework, but there are a myriad of challenges. And one of the big sort of level sets is this myth of a single optimal portfolio constructor allocation. It's probably worthwhile to delve into some of the reasons as to why a single asset allocation or a one size fits all approach is increasingly a challenge when incorporating less liquid private assets. Yeah, there's a bit of a shrodinger's box here with when you start to think about the liquidity premium, a little bit of a tenuous analogy, but stick with me and I'll try and make it work. So you have this strong belief in an liquidity premium in some of these private asset classes, but there is no ability to observe the markets trading that risk premium and to actually see what the volatility is. So you can't really look inside the box and use some of those traditional approaches to try and establish any statistical significance around the risk premium. Now there are some methods you can employ, some listed structures of private market assets that are trading in the public markets that can give you a little bit maybe more transparency on the box without actually having to open the lid. Tom, you're talking about the dangers of basically a vol wash, of ignoring volatility because maybe optic or headline asset behavior in private or illiquid instruments isn't consistent with actual underlying volatility. And I think what you're describing is moving beyond just maybe headline vol which can be underappreciated and underestimated and trying to build a framework around true vol based on the myriad of maybe imperfect inputs. Yeah, exactly because your original question was around what is optimal and how do you get to an optimal allocation. And I think we're trying to take a pretty large slice of humble pie as we address that question and really say listen, actually establishing what the differences in risk premium here is challenging. If you take as you mentioned those vol wash numbers and put me into an optimizer, anybody knows what the results of that optimizer are before clicking solve, right? It's just going to load up on the perceived incredibly high sharp ratios of assets that don't have any vol. So we're trying to avoid falling into that trap, trying to use our understanding and insights of the public asset classes risk to create mappings to the private assets so we can get better estimates of the vol. And then also bringing in our clients liquidity needs and liquidity tolerances and their risk tolerances and trying to use those a little bit more to inform what the allocations will be rather than some kind of questionable mean variance approaches. Let's stick with the theme of data because one of the more interesting differentiators and way in which we approach topic is recognizing the imperfectness and then building a framework of investment around that imperfect data you talked about taking a humble approach. I just think that's so important in this construct. Yeah, I would say humble for sure and I would also add more honest. I think a lot of investors have allocated to the more private side of the aisle because of the imperfect data and the infinite sharp ratio as it kind of made their lives easier. But as we move into this world where private assets are trading on secondary exchanges so on and so forth, it's evolving. So our approach has been as Tom mentioned to map these private assets to public volatiles and have a truer approach. But the data are an issue. The good news is there's no data. The bad news is there's no data. So you could do whatever you want. You can basically have any answer. So we very much adjust for that and I will tell you that when we speak to our end investors they're very appreciative of that. What we also found is that a lot of end investors are making those adjustments on their own as well. And there's actually some really interesting examples in the markets where this kind of chasm of difference between the valuations that are being applied and how the market actually views the risk is really evident. So BDCs are one of those examples whereby you do have indices of the collateral within the BDCs that are marked based on the valuations, the valuation processes that they have. And then there are listed BDCs that are actually traded by the markets and you can compare those two things and you're going to see wildly different results in terms of the end analytics that speaks to the point that Greg was making. So we think of BDCs as the gateway into private asset and valuations and the recent news around those BDCs. I think if anything just accelerates this more transparency on the private side. So I actually think transparency is going to happen in private, whether private investors wanted or not. And the BDC piece is really the accelerant. I couldn't agree more on my own personal view as private service, private as they're going to be and given exactly what we talked about on the opening, which is the growth of these markets, Greg gave the stats is only going to force more liquidity into the market. There will be trading slowly at first, it's already starting and then once the gates are open, it's going to continue. And so I really think there'll be more transparency and more data over time, which is only natural given the scale and sophistication of the market. Not unlike, let's say bank loans 25 years ago from a nascent, nichey market into effectively a core part of global credit markets. Bank loans is a great example, but I kind of liken it to opening of the Schrodinger's box that as you start to get the more liquidity and secondary market trading, are you effectively opening the box and you're going to see the convergence or adjustment on either the risk premium side or on the risk side, like you saw on the loan market, where it really has kind of converged with high yield bonds in terms of the risk and return and you don't really know whether the cat was alive or dead. I love that our resident actuary is the one using the philosophical analogies. Very on brand, Tom. So if I look from the bottom up very Simplistically public versus private credit. What's a right way to think about an illiquidity premium for a less liquid or illiquid private? Yeah, so I was start up by saying that the illiquidity premium is not a static function and I think a lot of investors Just arbitrarily put 150 basis points as an example the way we think about it is getting that additional premium for a less liquid asset depends on your overall portfolio stated differently if you have 0% in privates and you move it to 1% that premium matters a lot less or is very different than if you go from 99 to 100 right and so I think that's important as I do believe there's too much of a generic kind of tag put on to it But where we see value typically is a lower down to credit stack and credit scale See more value from a multi portfolio multi sector standpoint and below investment grade Corporate credit on the private side versus public and then as you mentioned on the ABF side That's where we find the most value at this point in time It's also less correlated and you have access to different types of credit where in just the sector credit side If I have a public auto parts company and a private auto parts company, it's basically the same sector, right? So you're not getting any diversified benefit but on the asset-based Finance side obviously the structure the collateral the subordination all those factors in different industries Different areas like solar as an example where you don't have access into public or private credit markets as much So we look at that and when we do we see a little more value on the ABF side I think it's true on the ABF side that you can better isolate a variable you want to invest against versus as a very generic statement Corporate credit in general. I want to come back to liquidity because I think it's a critical point in thinking about Comangling public and private instruments in a portfolio or a vehicle and Greg you mentioned it liquidity isn't static we think of it as a continuum and I think it's important because it isn't one-size-fits-all There isn't a standard Illiquidity premium to apply and as you point out Constantly all public assets aren't liquid or have similar liquidity and vice versa all private assets aren't illiquid with similar liquidity correct so it's not binary it's not private asset illiquid public assets liquid like you said It's a continuum or a spectrum even within the private assets think about the experience within private equity right now where Cash flows are being pushed out and not realized over a longer periods of time versus in private credit There is this self-liquidating aspect to the asset class. We have Emeritizations and prepays and coupon and maturities that are providing liquidity to the underlying investors Then as you keep going down the spectrum into public bonds You don't have a consistent and similar liquidity even across public bonds think about the difference between an on-the-run Recently issued corporate bond from a large issuance is going to be far far more liquid than Five-year-old Season bond that has had a large portion of a tender and a lot the rest of its locked up in a buy and hold account Those are going to be two very very different securities in terms of liquidity the season bond is going to be much closer In liquidity actually potentially to a private asset It may not have traded for the past month or two and you really don't have the same Discovery in terms of the prices there so the whole thing is a spectrum and I think it gets back to Greg's original point of Why some of the advantages of why you want a manager thinking about that continual liquidity and why clients are starting to think about Combining these assets into single portfolios. Yeah, and that's happening whether you like it or not in some respects in our existing portfolios We see our bonds are loans getting refinanced into pure privates We see the privates getting finance in the more publics So this real-to-value process is being thrust upon managers Regardless and that's why we have such a strong view on thinking about this more holistically from a pure real-to-value At the end of the day Credit is credit. We are deep credit investors and it's incumbent upon us to monetize and take advantage of the best form of credit and not be so siloed and thinking about well this particular type of credit is very different than the other we have to think of it as a continuum holistically in order to take advantage of the value chain Couldn't agree more want to pivot to another sort of well-advertised challenge in Co-mingling public and private assets and that's valuation I'll prompt it by saying the challenges of building a vehicle with assets that have a lot of price discovery Daily marks a number of transactions around them versus the Stale-ness. Let's call it of more private assets less liquid less traded assets is well known How do we approach the challenge of valuation and how does our approach to valuation Impute into the way an investor should look at portfolio behavior in returns because in the very short run Portfolios with a large allocation to less liquid or private assets can behave very differently than those with public assets That might give you a bad read on how that portfolio of things may behave over the medium or certainly the longer term I don't think there's such a thing as a free lunch, but if you map those private asset behaviors They map very well to the public side and that's what we do so you look at let's say a typical portfolio of private investment grade Corporates it maps really well to the triple B index of the public side So this is evolving as well. I think price discovery will continue to be more already and often on the private side But for us we think it's important to map those privates to the public side to get a more honest, true or asset allocation Tom mentioned before if you just take those lag marks or the volatility that's being imputed You have the like this infinite sharp ratio that leads you to like a hundred percent of that asset, right? And we know that's not the right answer And so we're tackling the issue by mapping those private assets to like public side and empirically that fits pretty well The other important topic that I think the issue of valuations brings up I think it's a good one that you raise a Brian is around This pluriferation of investment structures to explore more channels for more investors So the drawdown vehicle was clearly a grace the perfect investment vehicle for private assets where you could mitigate both liquidity risk But also valuation risk across all the investors by just having consistent investment and divestment consistently across the whole pool of investors The industry is now clearly moving more towards more investment structures to get more access to more channels And that means interval funds and bdcs and coming-old investment trusts And I think therein lies a little bit of a challenge in valuations whereby you're going to have open-ended Unitized vehicles with investors entering and leaving at different times And that's going to make the valuations really really critical Such that you have fairness across those different investors So I think it's a really important topic that you raise and one that the industry really needs to get right that you have Really robust valuations that you can stand behind if your clients are going to trade on those prices One thing I like about having kind of a public private portfolio is the ability to offset the j curve effect You can replicate your risk in other ways that's a in the public markets that kind of achieves The return objective during the time as you're investing in those privates Whereas if you're just in a private only vehicle you have that j curve effect and you're missing out Let's say so I think this is a much more elegant and efficient way to manage that j curve effect Candidly, I think valuation is only going to evolve and become more sophisticated Just like we talked about as private markets grow and as public and private assets are increasingly commingled It's just natural that the valuation piece is going to come into focus and become more sophisticated and dynamic Greg you touched on Something that I want to probe which is always interesting for my standpoint So you build a portfolio at a point in time day one Let's say I invest in the portfolio at the time of portfolio construction you the portfolio managers make a decision consultation with me about what the mix of liquid and eliquid should look like However, once capital is allocated into an eliquid sleeve it is locked capital for an extended period of time So there is a trade-off between allocating to a less liquid asset with a specific profile and having the ability to rotate or act when liquid markets and illiquid markets dislocate. There's not a great way to ask this question, but what is the optimal construct between an illiquid allocation recognizing that over the course or life of that allocation, there's going to be market opportunities that you'll want to be well positioned to take advantage of? Yes, so I'd answer that question in two ways. The first is coming up with a set allocation around your liquidity or illiquidity tolerance and your risk tolerance. I think that drives the strategic asset allocation of how much of your portfolio do you want in private assets. So if you have a high risk tolerance and no real need for liquidity, then you can have a much higher proportion of that portfolio on the private side. On the flip side, if you have cash flow needs that you need to meet with that portfolio, it's a lot less. So that, I think, is the first step. You're quite right. These types of allocations are a little more static, but I also think it's underappreciated and Tom mentioned it. These are amortizing. They're paying coupons and they're maturing. There's a lot more cash flow being generated from these portfolios, like private equity, is not cash flowing, right? So oftentimes investors think about private credit and private equity in the similar vein. I think that's categorically false. The fact that private credit cash flows matters and matters a lot. And it allows us and asset allocators to be much more tactical than I think is perceived by the markets. Greg, that's really well said. I think we very clearly articulated that co-mingling public and private assets in portfolio construction isn't one size fits all. There aren't static considerations or inputs. It's a very dynamic process. I really want to bring that to life in a tangible way. Tom, if I want to talk through constructing an asset allocation to co-mingles public and private and incorporates a dynamic strategic approach, how do we start? What's that process look like that incorporates our framework and approach? So getting very specific on our framework, we made this really profound innovation on the two by two matrix by adding one row and one column for a three by three matrix exactly in the vectors that Greg just described. The first is illiquidity tolerance, low medium high of how much public and how much private do you want to have in your portfolio? And the two by two would be liquid illiquid. Exactly. Sure. But the reason for that is pretty important, which is that clients have the best perspective on what their liquidity needs from the liabilities or objectives that they're trying to pay for. That needs to be a really important input into the strategic asset allocation construction. The second vector is their risk tolerance. Again, three low medium high and that roughly maps to when you think about credit is the low is going to be more of an investment grade portfolio. The high is going to be more fully below investment grade portfolio and the medium is going to have aspects of both. So within those we're looking at investment grade private placements, core real estate deaths, core asset back finance, large cap private credit, middle market direct lending and the whole suite of different asset classes and opportunity sets that PGM invests in right through the spectrum of lower risk up to higher risk. While it is a simple framework, it has been very helpful in just setting the conversation and providing some focus on what type of portfolio the client is thinking about building. So I'm going to put myself in the box and say that I have above average risk tolerance, but below average liquidity needs, is there a rough, rough, rough construct for how you might approach the public private dynamic? Yeah, I mean, this is where we have this kind of customized approach. So we'll work with the client, but as a starting point, let's just say that would be kind of a portfolio that could have up to 70% privates as an example. And then how do you kind of allocate within that private box as well? So there's the multi-dimensional asset allocation scheme here. It's setting what we think working with our client, a decent asset allocation percentage of public private mix, and then underneath the surface is where we do the relative value where we think about portfolio construction on the private side. Do we want X percent of ABF, middle market direct lending real estate? How do we kind of fit that together? And I think that's a key piece. We talked a lot about the lack of data. You just can't pop in some algorithm to spit out an answer. And the way we do it is quote unquote, the old fashioned way, which is working together as a team. So we set up this council where we talk amongst ourselves in a very pointed and direct manner around valuation, deal flow, all the components that help us come to an asset allocation for a portfolio. OK, so I'm going to continue with my hypothetical example where I have above average risk and lower average liquidity need. Greg, you said my portfolio could include up to 70% in private. So let's say I then decide, yes, and allocate capital to the strategy. Obviously to build a portfolio that's heavily weighted towards private, so I'm dependent on good origination to build the portfolio. So how should I think about as an investor and how do you think about as a manager, the portfolio construction piece that sort of predates getting to that optimal asset allocation when it's heavily weighted towards private. So you are dependent on that cadence of origination. I think this is where the real compliment on the public side is going to shine through and where we're really going to see the benefits of combining these two quite different and historically quite siloed approaches into one portfolio because the real strength on the private side is the access to these type of assets that you can't access in the public markets. These are decentralized networks of originators that by their presence in the local markets are getting access to these very unique investing opportunities that you can't buy in the public markets. So it really is this pure bottom up process. Now because of that decentralized nature, there's going to be a little bit less focus on portfolio construction, right? The portfolio is what you originate, but that is the compliment of combining with the public side because access comes for free in the public side. You just need a Bloomberg login or a trade web login and you can go in and buy bonds. So really we have to add our value from the portfolio construction side and that's what we are focused on. These adding value through portfolio construction. So you're going to have the compliment of the one side really focused on origination and access and then the public multi sector side bringing the know how in terms of portfolio construction to build the ultimate portfolio. Greg already mentioned this about the ramping and latency and amortizations and self-liquidating nature, which is that as we have those deviations from the strategic asset allocation, the public side is able to kind of fill in the gaps and complete around where the private assets are either paying down or ramping back up to get the overall portfolio where we want it to be. So I think that's going to be the real compliment and strength in combining these two is bringing together those two schools of thought of investing. Yeah, the alpha is the origination on the private side and the alpha on the public side is the relative value and asset allocation piece. So I think it's a really strong marriage of skill sets and investors get the best of both worlds. I think we have capabilities across public and private that not many have and I think that's something that we're excited about and leaning into. And I actually think on the private side, alpha is the origination plus underwriting which does differentiate us from many of our participants given our heritage and capabilities in that space. And similarly, on the public side, Tom, I agree that on a generic basis, you're sort of a taker of what's available, but I do think our scale and sophistication and breadth of resource differentiates us from other large liquid peers and that we do get some unique differentiated origination opportunities. So there is a melding of the two in the middle and that's where this dynamic asset allocation process can really bring the best ideas out of the organization and coexist in really attractive portfolio constructs. There definitely is. I definitely agree with those comments, Brian. I was generalizing to a certain extent, but I think to your point, securitize and asset backfinality. the great example of that, of where the real integration of the public and private sides on those teams does lead to very unique origination opportunities as well. So that's another important part of the integration. Absolutely. And Greg talked about it, the asset allocation council, the way in which we communicate internally, across asset classes, around relative value, opportunity set, et cetera, only strengthens the overall value proposition of the portfolios we ultimately construct. Guys, this has been a super neat conversation. I think it's an incredibly interesting topic, much like multi asset portfolio construction that incorporates public and private assets. As a very dynamic process, I think this topic itself is going to evolve considerably over time alongside a lot of the challenges we identified today around data, around valuation, around liquidity considerations. And I look forward to continuing this conversation in coming years. Tom Greg, thank you so much for joining the podcast. Thank you. Thanks, Brian. If you'd like more thought leadership on multi asset portfolio construction or other topics, please visit peegem.com. Thanks again for listening to all the credit. Pass performance is not a guarantee of future results. Views and opinions expressed may not reflect peegem's and are subject to change. This is not a solicitation. Copyright, 2026 PFI and its related entities registered in many jurisdictions worldwide. Please visit the terms and conditions page on www.peegem.com. 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