Irregular Roundup, 24th June 2024

We begin today’s Irregular Roundup with private debt.

Private Debt

Joachim Klement looked at the true return on private debt.

Private credit has become the hottest asset class in 2024. This boom is fuelled by pension funds, family offices, and other institutional investors chasing uncorrelated and stable returns with low to medium risk. 

I think we’d all like some of that.

• Unfortunately, the asset class can’t deliver that.

A recent study found that the average cumulative return (above the risk-free rate) of a private credit fund was 34%.

• With an average life of 5.5% years, that’s a very handy 8.6% pa, but:

Comparing returns to the risk-free asset is not fair because private credit is essentially high yield debt structured by banks and specialist asset managers. One needs to adjust the outperformance by the risk factors inherent in bond investments. If one does that, the lifetime cumulative alpha is still 10.5%.

That’s a lot less when spread over 5.5 years. But Joachim is not done:

Private credit are high yield loans, so they are riskier than normal bonds and effectively lie somewhere between stocks and bonds. One can adjust the alpha by the risk factors in stocks or, even better, the combined risk factors of stocks and bonds. The resulting alpha over the lifetime of a fund is… drum roll… -0.1%.

So private credit doesn’t really offer much to a portfolio that is already diversified between stocks and bonds.

• And the current popularity of private credit (more money chasing limited opportunities) means that future returns will probably be worse.

Private equity returns

Joachim is in good form at the moment, and a second article looked at private equity returns.

• He was interested in the way the fee structure changes.

After five years of grace to invest the funds (during which time managers charge a fee on uninvested assets), fees are only charged on assets that have been invested.

What is a fund manager to do when after three years or so, a large part of the committed capital is not invested yet? The incentive then changes to invest as much money into any project, whether it is viable or not. One would expect that investments made in years four or five of the life of a fund are worse than investments made earlier.

Certainly, the returns are worse.

The chart uses EBITDA margin growth as a measure that is difficult to manipulate. Investments made at a later stage in the fund’s life have a higher likelihood of being unprofitable and create a drag on fund IRR and money multiples.

The effect is stronger for more experienced general partners of firms.

It’s almost as if experienced private equity managers have learned that fee income is more valuable than performance.

There’s also a larger effect for firms with a lot of pension fund money, indicating that these investors don’t look too closely at what’s happening.

What should investors do?

If a fund hasn’t made a lot of investments in the first two to three years of its life, investors should increase oversight and (if possible) reduce capital commitments. 

Maybe they should also steer clear of funds run by experienced GPs and with a lot of pension fund money inside them.

Labour Watch

I must apologise in advance for a large amount of politics in this week’s roundup, but it’s mostly about taxes.

• At the time of writing, we’re at that awkward stage of the general election campaign where a new policy leaks or is announced every day, but the manifestos are still unpublished, so we can’t assess a party’s policies in the round (assuming that you believe the manifesto’s that is).

In his Bloomberg column, John Stepek looked at what might actually happen if Labour win.

First up is the LTA (more on that later), but restoring it won’t be easy:

Nothing in pensions is easy. For a start, Hunt got rid of it partly because of its role in putting off senior doctors from continuing to work beyond retirement age. For another thing, getting rid of it has proved
complicated.

A carve-out for doctors would be tricky to operate, and even bringing back a £1M limit would mean new protections for those who have taken advantage of the two-year gap in penalties.

• Steve Webb thinks the simplest thing would be to bring it back at £1.5M (still much lower than the index-linked value of the peak LTA, which is now around £2.7M) – but that wouldn’t raise as much tax.

Next up is 40% income tax relief on pension contributions.

• Just before Brexit, George Osborne was toying with leveling the relief at 30% for everyone.

But it never happens, because of the public sector.

Higher earners in DB schemes would either find themselves paying a lot more tax or having benefits reduced significantly every year in order for the scheme to pay the tax.” (There are similar issues with reducing the tax-free lump sum).

The tax-free lump sum has now been frozen at £268K, so that’s another stealth tax (and another reason for people not to save for their retirement).

• Another feature of fiscal drag is that there are a lot more higher rate taxpayers than there used to be, so these moves will be less popular than ten years ago.

Idea number three is another LTA on ISAs.

• The Resolution Foundation (whose former head is now standing as a candidate for Labour) wants to cap ISAs at a laughable £100K per person.

Since ISAs are much more popular these days than pensions, a lot of people might be against it.

• And as we know from the pensions LTA, admin is a nightmare.

I just don’t understand why people think that tax shelters need a lifetime cap when they already have an annual contribution limit.

John also makes a more fundamental point about the politics of taxation:

No politician wants to admit to taxing anyone except “the rich”. But not only do we need “the
rich”, but the trouble is, “the rich” (however you define them) don’t have enough money.

Raising real money from taxes means hurting a lot of people.

• Which means stealth taxes, carve-outs, and unnecessary complexity.

All because nobody dares to say that maybe we each know how best to spend our money – certainly better than the government does.

• Which means lower taxes, and hence lower public spending.

One day, someone should try getting elected on such a platform.

LTA Watch

The Institute for Fiscal Studies put out a paper this week calling for the swift return of the LTA:

The pensions tax regime is still overly generous to those who already have big pensions,
those with high retirement incomes and those getting big employer pension
contributions.

The good news is that they agree that a higher limit would simplify reintroduction:

The last Labour government set the lifetime allowance at £1.8mn in April 2010; it could, for example, reintroduce it at that level — or the equivalent adjusted for inflation, which would be around £2.7mn today.

I don’t know how many people would be affected by a £2.7M LTA (especially if it were indexed), but it can’t be too many.

• It’s also hard even for me that £5.4M between a couple isn’t enough pension to get by on.

I think £1.5M is a lot more likely, however.

To counteract this generosity, the IFS wants to see the tax-free cash lump sum cut back, and the amount of pension that can be bequeathed tax-free reduced – ideally to zero.

• The bequest limit seems fine, but I think it’s already unfair that the tax-free lum has been frozen – many people are part way through their pension journey and invested on the basis that 25% would be tax-free.

Punishing people for decisions they made according to tax law in past years can never be right.

Tory Watch

All I could find from the Tories was a pledge to freeze stamp duty (on houses) and then a later announcement that it would be cut for first-time buyers.

• Transaction taxes (including stamp duty on shares) are a bad idea in general, and the high SD rates on expensive homes (and in particular on expensive second homes) just block the top end of the market.

An illiquid market is a market in which resources are not optimally allocated, which is something that all parties claim to be against (though they might use more direct language).

Being child-free, I don’t follow the child allowance very closely, but Dan Neidle at Tax Policy Associates helped me out:

The Conservative Party has just proposed moving the point at which child benefit is phased out from income of £60k to £120k. This will greatly reduce the marginal rate for parents earning £60-80k.

But it means that a parent earning £120k who has three children will face a 70% marginal rate. And they’ll face a long stretch of earnings (£100k to £160k) with a marginal tax rate of over 50%.

These high transitional rates need to be fixed.

• Tax should go up with income, but smoothly, with no temporary peaks.

And if we are to have handouts like the Child Allowance, they should be blended into the tax system.

• Not putting people off working harder (and earning more) should be a priority for any government.

Quick Links

I have just one for you this week:

1. Trustnet explained Why Scottish Mortgage has discouraged its private holdings from listing

Until next time.