The SEC vs. Private Credit ETFs: Can Illiquid Assets Work in a Liquid World?

But just because an ETF can hold an asset class doesn’t mean that it should.

That’s the gist with private credit. After launching with much fanfare, State Street’s and Apollo’s new active private credit ETF seems to be running into trouble with the SEC and pundits. This begs the question, “Should private assets be included in ETFs in the first place?”

For years, high-net-worth investors, institutions, and endowments have sought the private markets to boost returns, reduce volatility, and enhance their portfolios. At first, this access was mostly on the ownership/equity side of things. But after the Great Recession and higher lending standards placed upon banks, credit/loans have quickly become the go to for these investors.

Private credit is essentially loans or pools of loans made by non-bank lenders. These can include small business loans, venture debt, consumer loans, accounts receivable loans, law financing, fleet financing—the sky’s the limit. The win is that because they aren’t publicly traded and feature lock-up periods, private credit funds and loans often have lower volatility and much higher yields than standard corporate bonds or even junk bonds.

And while there are some newer private credit vehicles and private business development companies (BDCs) that invest in these, they still require larger upfront investments and lock-up periods.

This is where ETFs come in.

Like many asset classes, private credit is now available in an ETF. Partnering with alternative asset giant Apollo, State Street, the third largest ETF provider, recently launched the SPDR SSGA Apollo IG Public & Private Credit ETF (PRIV). The ETF would own both public debt as well as private credit/loans issued by Apollo through its various subsidiaries. In the filing, Apollo has agreed to quote and provide so-called ‘firm bids’ on all the debt it has issued for the fund. This creates a layer of liquidity to the underlying assets. Remember, ETFs use the creation-redemption mechanism to function, and you need that to help market makers in the secondary market.

The ETF was considered groundbreaking for getting private assets into the public’s hands. Since then, BlackRock’s Larry Fink has talked about packaging private equity/credit into liquid ETFs that anyone could own to “index the private markets”, while Capital Group, KKR, and Invesco have all expressed interest in bringing private assets to the public space by replicating State Street’s model and using ETFs.

But with its launch just a few months old, PRIV has hit a few snags.

Even though it has already approved the fund, the Securities and Exchange Commission (SEC) has now expressed concerns on several fronts. This includes the fund’s underlying liquidity, its name, and its ability to comply with various valuation rules. In a letter to SSgA and Apollo, the SEC has asked for more clarity.

What the SEC is asking about are big issues. Take liquidity, for example. Apollo did sign an agreement to provide firm bids on deals it sourced on a daily basis and at various other intervals. The SEC is now questioning whether or not Apollo can actually do that effectively, especially if the firm runs into trouble on other fronts.

Second, Apollo is only willing to do this for the debt/loans it has issued. If PRIV expands, it will most likely have to get other issuers to follow suit; if they aren’t willing to do that, then the liquidity factor is gone. Moreover, if the ETF grows large enough and experiences net redemptions, the sheer volume would put a strain on the liquidity arrangements.

Finally, what the fund can hold can be seen as misleading as well. The SEC limits open-end funds, which include ETFs, to only have a max of 15% of assets in illiquid holdings. An illiquid investment is defined as “an investment that the fund reasonably expects cannot be sold in current market conditions in seven calendar days without significantly changing the market value of the investment.”

That definition is proving to be a headache with PRIV. Getting enough private credit/equity into a fund in the first place is a challenge. And now, the firm is looking at public loans and even BDC shares to fill the void.

Then there is the name issue. Apollo isn’t a manager, sponsor, or advisor to the fund. Nor does it have an obligation to sell any loans to the fund. The SEC has said this is misleading for the fund’s name.

In response, SSgA removed Apollo from the name of the fund and has now reconfigured some of the wording to include ‘less liquid’ assets. These are assets that could be sold within seven calendar days without generating a significant change in price. This includes broadly syndicated bank loans, some high-yield corporates, and niche structured credit. They are not exactly private credit assets.

With the SEC now questioning private assets in ETFs, it may be a long while before we see the asset classes of the private world available for average joes. That might be a good thing.

The appeal of private assets is that they operate beyond the scope of the regular markets and it’s that illiquidity that provides them with their returns. By having them available for everyone, they could lose much of that appeal. A long time ago, sampling ownership of international stocks provided amazing diversification and even negative correlation to the U.S. stocks. Now, as they have gained popularity, they often move in lock-step with the S&P 500. Time and popularity of an asset class do ruin some of its benefits.

For now, investors have plenty of choice when it comes to getting alternative credit and other bonds outside investment-grade bonds into their portfolios. For most of us, this could be all we need.

These funds were selected based on their ability to tap into non-traditional bonds and the opportunistic credit asset classes. They are sorted by their YTD total return, which ranges from -1% to 3.1%. They have expense ratios between 0.19% to 2.65% and have assets under management between $47M to $22B. They are currently yielding between 4.3% and 9.2%.

In the end, PRIV is an experiment that may not work and could stretch the limits of what an ETF can hold. With that, investors may want to focus their active and alternative income investments elsewhere. There are plenty of other bond funds that provide similar high yields and opportunities without the hassle.

ETFs have been wonderful for bringing asset classes to the masses. But when it comes to private credit and equity, more work has to be done. The recent launches covering the asset classes have started to get questions from the SEC, and that could spell trouble for future active ETFs within the space.