The Decibel - The dark side of Bay Street’s hottest finance funds

Episode Date: March 19, 2024

Private debt funds are one of the hottest commodities in the world of investing. High rates of return and low management fees made them popular among investors. However, some recent redemption freezes and the allegations against Bridging Finance Inc. have put these funds under scrutiny.The Globe and Mail’s finance reporter and columnist Tim Kiladze, explains what these private debt funds are, how they operate and why some investors are reconsidering their big bets.Questions? Comments? Ideas? E-mail us at [e-mail]

If you have money to invest, you probably know about stocks, mutual funds, hedge funds. But there's a lesser-known area of investing called private debt funds. Basically, you give your money to a private lender and then get monthly checks back. This kind of investing has been around for a while, but it's recently become a lot more popular. And everything seemed great until a company called Bridging Finance ran into trouble. And then what happened is in 2021, Bridging Finance out of nowhere was put under the control of a court-appointed receiver, which basically means someone else takes control. That's report on business reporter and columnist Tim Collatz.

At the same time, the Ontario Securities Commission leveled fraud allegations and accusations against the firm and its leaders. And all of a sudden, people were like, what is going on? This surprised investors because, until then, things seemed to be going well in the world of private debt. Investors were making good money and funds were growing. And all of a sudden it was like, oh, there's something to see here, maybe. These funds are built around privacy. They're literally called private debt funds. And we don't really know what's going on inside of them. Legitimately so.

It's for confidential reasons with clients. It's also for competition reasons. And while what's playing out now in the private debt industry is quite different than what allegedly happened with bridging finance, the nature of their, well, privacy doesn't give us a clear window on how these funds operate. But it made a lot of people question, you know, could there be another situation like this? Fast forward, you know, eight months, a year later, things really cooled and then interest rates started rising. And that's when the problems began to show themselves.

For the last three years, Tim has dug into this world. He's on the show to talk about the promise and pitfalls of private debt funds. I'm Maina Karaman-Wilms, and this is The Decibel from The Globe and Mail. Tim, thanks for being back on the podcast. Happy to be here. Tim, right off the bat, I think we should just establish what kind of investment we're really talking about here. So what exactly are private debt funds? They are essentially like a bank. So you don't have to overcomplicate it. I

always say this to people, like it sounds very intricate and it's not. It's very similar to a bank which takes money, takes deposits from us and then lends them out, whether it's to businesses that need to borrow money or to people like us who need to borrow money to buy a house in the form of a mortgage. These are just institutions that instead of taking deposits, they take in retail investment money. That money is put into a fund and then the money from that fund is just lent out often to small and medium-sized companies. Okay. And how popular would you say they are today? They're quite popular in large part because banks over the past 15 years or so have had to scale back the risk in their loan

portfolios. And that's because of regulations and things like reforms after the 2008 global financial crisis. Globally, they've really taken off. In Canada, it's still big or growing, but it's not massive. But globally, particularly in the U.S., they've become like the sexy sector. I cannot tell you how often you hear about private credit these days, which is just another name for private debt. And it's really seen as like the new way to make real money. Interesting. So that's kind of, I guess, like big picture here, but how popular are they amongst investors? It's a tough one to answer because they are quite popular

among a segment of the population, particularly baby boomers, who were really looking for a way to get yield or a good interest rate on their investment as they either approached retirement or went into retirement. Because the way that investing usually works is the older you get, the safer you need to be about your money because you can't risk having the market correct 25% in a single year, which is effectively what it did in 2022 with the S&P 500. So you tend to move it more and more to what they call fixed income or to debt, which pays a fixed amount of interest each year usually, and you get your money back. So it's safer. These things were really catered to that population and to anybody really, but really to that population. And for a long time, they really worked. Like there's a long track

record of good returns, stable returns. So there was no reason to really question it. And then all of a sudden things started to change. First, there was bridging finance, that subsided, and then the economy changed. And what's playing out now is more of an economic function or change of market dynamics. So when you say they're seeing a safe, guaranteed return here, what, I guess, what kind of return are we talking about? Usually targeted around 8% to 10% a year. That's not bad. It's good. I mean, what you need to

remember too is that, you know, after the financial crisis and then after the immediate aftermath of the pandemic, central bank interest rates were basically at zero. And then government bonds, which are kind of the safest forms of investment, particularly in Canada and the US, were paying like 1%, 0.5%. So 8%, 10% seemed like a crazy good deal and it was stable and all that kind of stuff. So it was really, really enticing. Okay. And so who can actually put their money into this kind of investment? Like can anyone invest in these funds? So this is an important point. For most funds, you need to be what's called an accredited investor. And there are lots of ways to qualify to become accredited, but they basically boil down to two things. One,

you either have to have a certain level of income or a certain level of financial assets. So it's usually about a million dollars of financial assets as a household. And as an income, you have to have about $200,000 annually in income. What has kind of gotten lost over time is that it's arguably getting easier to qualify for those things, particularly with financial assets. You know, if you are in your, say your forties, you've got older parents, they happen to pass away. You know, the average house price in the greater Toronto area, for instance, is like $1.1 million now. Assume your parents' house is paid off or whatever. You could inherit that. That doesn't mean you're sophisticated. That doesn't mean you know what to do with it.

But you would qualify to invest. Exactly. Exactly. And so the way the rules are set up is that even if you don't have the sophistication, the idea is that if you've got a million bucks all of a sudden, or just in general, you probably have enough of a financial buffer so that if you were to lose some money in these investments, you won't be really hard done by. Okay. How do investors actually make money from this investment? Walk us through this.

So you put money in. Often you need to put in $50,000 or $100,000. There's kind of like a minimum investment amount. So let's say you put in $100,000. You put it in. They take that money. They pool it with all the other investors. And they just lend it out.

And the loans are often short-term loans, often under one year, sometimes one to three years. At least that's how they're marketed. And, you know, so let's say they make a year loan. They get repaid. And the interest rate on the loan, because they're to riskier kind of medium-sized companies that can't often get bank financing. So that's why they come to these firms. And so therefore they're charged a higher interest rate. And I'm making numbers up here,

but let's say they're charged 12% a year. That's kind of a common one that you'll see in these funds. They make 12% a year on the loan if it's repaid. They promise you 8%. So that leaves 4% in the middle. And that's what the fund makes. That's a very broad way of looking at it. But you basically make money off the interest that is charged to the borrower. Okay. And when do you see that come back to you? Like, are you getting installments basically?

Yeah, a big draw to these funds. And this is also why it was big for, you know, retirees, especially, or people kind of getting older, is that they pay monthly distributions, which are like dividends, or just think of it as monthly cash. So you could get 300 to 600 bucks a month based on whatever amount you put in. And it was pretty stable for a long, long time. So you could count on it. Yeah. So this is like on the individual level, but again, the big picture here. So how big do these private debt funds tend to be? I should actually back up for a second because there are two types of funds. Historically, they were really catering to institutional investors or investors that are investing like,

you know, pension funds or like on behalf of like retirees or something. The funds that we're largely talking about are ones that started to cater more and more directly to individual retail investors. And those are what have become more popular in Canada over the last 15 years or so. Globally, all that growth that I was talking about, a lot of that, again, is still institutional money, but there also is a lot of retail growth as well. But the large ones can manage like $100 billion. The ones in Canada tend to be, you know, one to three billion each. And then you add them all together and you could be at like, you know, $20 billion, $30 billion. The thing is, it's really hard to track because there's not kind of like one conglomerate group that measures it all. Yeah, it sounds like you're kind of piecing together based on the information that's out there, but it's not really clear exactly what's there.

Right, exactly. All right. So let's say there's a loan in the fund has been paid back by a company. What happens to someone's investment? Once that has happened, do they get their money back? In a normal situation, yeah, you get your money back when you want to cash out. Plus you make that monthly distribution or payout while you're in the fund. What has happened lately, though, is that it hasn't been easy to cash out. And in some cases, you can't cash out at all. To get your money back, there's normally what's called like a redemption process, which is where you basically go to the fund and you say, hey, I'd like to get my money out.

It's not like a mutual fund or an ETF that's traded on the market where you can get your money back immediately. You have to kind of go through this process. And then once a quarter, or maybe once a month, they go through all the redemption requests. And then they pay out at the end of the quarter at the end of the month. But still, it was a pretty steady stream of paying out. So there was never really any reason to question it. Lately, though, a number of these funds have gated, which means that you actually can't get your money back. And they're allowed to, like under their rules, they say we're allowed to temporarily gate for four months. Or sometimes they can just temporarily gate until

they get stability. But it's because of the nature of the loans. In this situation, then you want to get your money out, but you can't. So what's happening? What's going on there? So when you buy a mutual fund, okay, the mutual fund owns often stocks. So you want to get your money out. The fund can just go sell the stocks, a portion of their stocks on the market, get that money, return the money to you. It's a short version of how it works.

But these funds, because they're private loans, they're illiquid, which basically means- They're illiquid, okay. They're illiquid, yes. They're not traded. And often the terms stipulate that the company that borrows the money does not have to pay back early. You can't just go demand it and then force them to pay back. Because think about it, they may be building something, you know, they don't have the cash right away to be able to return the money. So when you have this rush of what are called redemption requests, people wanting to get their money out, you can have this mismatch, which you don't exactly have the money just yet. In six months, you might have the money or in a year, you might have the money as loans

are repaid, but right now you don't. So that's why a lot of these funds permit these temporary gates to go up, to kind of buy time. That doesn't always mean that things are bad and they can fix themselves. So, you know, during the pandemic, the first few months of, you know, March, April, 2020, some of these funds did gate. But then because the government stepped in with such forceful stimulus, they were able to kind of reopen and things went back to normal. If anything, growth took off again. So it's not always like gating is bad, but right now it's been going on for quite some time. And that's why it's drawing our interest. And I mean, this could be a real problem, I guess, if you're an investor and you kind of want to take your money out or maybe you need that money. Tim, I know you talked to people for this story. Is there anyone that you spoke to who was kind of stuck in that situation? There's a lot of them. So I don't

want to single anybody out as if they are the only one that's been hard done by. There's thousands of people. And in Bridging Finances' case, although that's an extreme form of it all, because again, there's alleged fraud, et cetera, they had like 26,000 retail investors. And that was put under the court appointed receiver in early 2021. It's been three years and there's been nothing. And in that case, the receivers actually said, the portfolio was so bad that they estimate that two thirds of the money is gonna be gone.

Just gone. Gone. So you're just sitting there waiting for years, not knowing how much you're going to get back. At the same time, you know, markets have been pretty good overall. But one of the people I talked to from my story, her name is Barbara Tate. And she was really interesting because a lot of people think that,

you know, if you're buying into this stuff, you're very sophisticated. You really know what's going on. Again, all the accredited investor stuff. She is a retired teacher and she didn't invest blindly. And again, I don't want to put too much on her because there's lots and lots of people like her who are, you know, they do the work. They really try to understand it.

They get to a level of comfort. And for a long time, it really was a good investment for her for over a decade. But then the problem is things can shift. And when they shift, like those gates go up for redemptions, and then you're just kind of trapped. So she's one of these investors who wanted to get her money back, didn't realize the gates had gone up, called the company one day and was like, hey, I got to buy a new car, actually. It would be great to get my money back now. And they were like, actually, I got to buy a new car, actually. I just, it would be great to get my money back now. And we're like, actually, you can't.

We'll be back in a minute. I think we should talk a little bit more about the situation you say, like, you know, when the gates go up, when the money is frozen. I guess what has to happen, Tim, for a private debt fund to do that, to freeze the money? It often comes down to a cash shortfall. And again, that doesn't mean that the money is not going to come in a six-month time or in a year's time. It's just that at that moment in time, they have more demand for cash out than they have cash coming in. And so historically, there was two ways to have cash coming in. One was either through loans that are being repaid. So you get the money back from the borrower. Or two, you had new investor money coming in. So, you know, these were sexy investments. People

were like, oh, I want to invest. So you just had this steady stream of new money coming in. Like if you saw the chart of it, it's just constantly going up. And basically, both of those things dried up. So as soon as, you know, some of the funds had to gate or even early after the bridging finance scenario happened, some investors were just like, I like my fund, but I just don't really trust it anymore. Or so they wanted their money out. And new investors weren't going to put money in because they just kind of wanted to wait and see. At the same time, because of the state of the economy, borrowers aren't repaying as well or as frequently as they used to. So how common is it for funds to freeze redemptions? Uncommon, but it does happen.

It's rare, I would argue, to see this many funds gate at the same time with so much uncertainty going on. And to give you an example of a fund that did have to gate in the past, there was a fund called ROI Capital here in Toronto that did the same type of business, lending to small and medium-sized companies. 2012 or so, they just had a huge run on redemptions, which means a lot of people wanted their money back. They couldn't make it work financially. So they gated, and it took two years to come to a resolution. And they basically had to end up being acquired by another company to make it all work. Like the company just ROI just could not last on its own.

I'm wondering what the effect of high inflation and high interest rates have on the other side of the equation, right? The retail investors, the people who are investing their money here, how's this affecting them? For them, it's more a sense of comparing returns. So, you know, after the crisis and after the early stages of the pandemic, when interest rates were like zero, you know, 8% sounded great. Nowadays, you can buy a GIC and get like 5% a year. And so all of a sudden comparing eight to five doesn't look so good. You know, the number one thing that I found as, you know, over a decade as a financial reporter and having worked on the street before that people miss is the kind of the risk return calculus is how I would describe it. You know,

if you're going to take more risk, you need to be compensated for it. So you should technically be getting a higher return, but the inverse is happening now. And because they're experiencing losses last year, there's a number of these funds where their returns were actually low single digits. So under a GIC return, and then at least one case, there was a negative return. So you're losing money now at the same time, in some cases, your money's trapped. So you're like losing money. You're not comparing to what you could from an ultra safe thing. You know, it just raises all this angst. And I think that's where we're at right now. You know, investors are just like, well, when can I get my money out?

Like I want answers. But because of the nature of these funds and how they know the privacy is a kind of a bedrock principle, they're not getting money. And it's just kind of spilling over and over and over. So how would an investor know if their fund, the fund that they have their money in is actually in trouble? So if you are halting redemptions, you need to disclose that. And a lot of them have. So it's that part of it's not secrecy. But it's really hard to get information about the state of like loans in their portfolio. So, you know, for the past three years, really,

I've been covering this space, but really in the last year when things went wrong, I've written about a number of the largest borrowers in some of these funds filing for like creditor protection. And the only reason we know it is because when you do that in Canada, it becomes a formal public court filing. So we're able to get court documents. But that's often the only way you know. They don't have to disclose it to their investors. With these funds, because they're like direct loans and they're private, not only do you not get a rating, you don't even get names of who's been lent to.

So you literally couldn't even go do the research on your own. So as an investor, you don't know who the, like which companies have those loans. All you often get are a list of say the top five or top 10 borrowers, but there won't be a company name. It'll just say like energy sector, Canada, 12% of the portfolio. It's literally that basic. Quite vague. Yeah. Yeah. So there's, there's no way, no way to track. Wow. Are there, I guess, regulations that people are calling for here, like to have a little bit more transparency? To be honest, at this point in time, it's a pretty loosely regulated sector.

There have been over time people who've called for more kind of hands-on governance. But it's this gray area of regulation where it's kind of like, oh, you wanted a good return. Well, this is what the trade-off is. And the trade-off is you don't get much insight. And so what it really boils down to is a level of like, you're going to have to trust us. And listen, it has existed with other types of funds before. So hedge funds, which invested often in stocks, you know, 20 years ago, that became a big thing and they didn't disclose that much. But yet at least once a quarter, they have to put out like in the U.S., there's a filing they have to put out where they list their like top 10 holdings or whatever. And you do get specific names.

And so you do get a sense. But in Canada in particular, there just really wasn't a reason to demand more oversight, more rules, whatever you want to call it, because nothing had blown up just yet. And now all of a sudden, it kind of is. Okay, so there's no credit agency rating for these funds. But I guess, is there anyone else, though, vouching for it? There definitely are auditors. So a lot of them are audited annually by accounting firms, you know, who stamp their financials and things of that sort.

And in some cases, they actually bring in kind of third-party consultants, auditors to study individual loans, things of that sort. The tricky thing is valuations are more art than science because if you really believe a loan's going to be repaid, you can massage the information you use to justify that. Is there any recourse? So people, investors who lost their money this way, I guess, is there any recourse for them? Not really. That's the other part of it that is really tough. Over time, as I read about these things,

we'll get notes from investors saying, like, how can they do this? And it's like heartbreaking, but you have to write back to them and you say, well, actually, if you go to the formal investment document, it's called the OM or offering memorandum. If you look through buried in there somewhere, there's actually a paragraph that says the fund is allowed to do this. And in some cases, listen, with gating, where they pause redemptions, it can be beneficial. I really want to stress that point because a lot of the funds will say, listen, it doesn't make sense right now to sell this loan to somebody else at half price because

we know that in six months time or in a year time, they're going to pay us back in full or they're very likely to. So to sell it now, just to be able to get cash, to be able to pay some investors out would be a detriment to the entire portfolio or the entire investor base. The real question now though, is investors are so frustrated depending on the fund that even if things do settle, they may not want to stick around. You know, after six months, a year, two years of being gated, at some point you just say like, in the end it worked out, but it's just not worth the stress. And so you just want to get your money out. And at some point you just say like, in the end it worked out, but it's just not worth the stress. And so you just want to get your money out. And at that point in time, it's tough for a fund,

unless they have new money coming in that can kind of, you know, add new, a new pot of cash, you're, you're really stuck. Just lastly here, Tim, we talked earlier about how these funds have been seen as safe in the past, especially, you know, this is why baby boomers are putting their money into them as they approach their retirement. But I guess after everything we've just talked about here, are these investments still seen as safe by a wide range of people? They can be quite safe. The structure can work. One of the things I often argue is the lending itself actually probably isn't that big of a risk factor. As long as you know that these are riskier companies and that they can default things

of that sort. For me, the big question is, does the structure of the fund actually work? And when I say structure, what I mean is, can you have the promise of ongoing redemptions or ongoing cashing out when you have loans that only get repaid, you know, once a year. It's just this mismatch. And so some of the reforms that have been changed or not even reforms because they're not like government mandated, but just other funds elsewhere in the world have changed how they structure their funds. So for instance, one example could be you only are allowed to cash out, you know, $50,000 a year. So that way, you know, smaller investors might be able to get their money out, but you know

that like you can't just do a big withdrawal and kind of send everything into chaos. So you go into it knowing that, I guess. Yeah, exactly. You know, when I look at this entire sector, I understand the potential. And I do think that there is a very legitimate business case. There are some funds that do really well and they're very legitimate. And, you know, there are funds that are certainly worth considering. For me, the bigger thing is that right now funds have a lot of leeway when it comes to

disclosure, when it comes to valuations and things of that sort. So whatever the reforms may be, the key underlying principle is adding a bit more information so that investors are less in the dark and they aren't flying blind the way they are right now. Tim, thank you so much for taking the time to be here today. Happy to do it. Before we go today, we want to let you know that The Globe has launched The Globe Leadership Institute. These are online classes that offer insights from educators, business experts, and Globe and Mail journalists like Robin Doolittle and James Bradshaw. You can learn more at theglobeleadershipinstitute.com. That's it for today. I'm Maina Karaman-Wilms. Our intern is Manjot Singh.

Our producers are Madeline White, Cheryl Sutherland, and Rachel Levy-McLaughlin. David Crosby edits the show. Adrienne Chung is our senior producer, and Angela Pachenza is our executive editor. Thanks so much for listening, and I'll talk to you tomorrow.