‘Private’ Parts: Explosion In Private Debt Market Cements ‘Liquidity As The New Leverage’

Back on November 16, 2017, Goldman outlined their “top ten themes” for the coming year.

Number 10 on that list was “Illiquidity Is the New Leverage”. The bank’s point was simple: Having learned a lesson from the crisis, market participants have eschewed levered exposure to compressed risk premia in favor of “leaning harder into liquidity premium”. There is, Goldman warned, voracious demand for “anything without a Cusip”.

Smart people can argue about whether investors have indeed avoided employing leverage in order to squeeze out yield in a world where there is no conceptual difference between trades. It’s all one trade, and each option is distinguished only by the amount of carry on offer. What isn’t debatable, though, is that the QE-inspired global hunt for yield has forced investors into less liquid assets.

When you dump trillions in liquidity at the top of the quality ladder, it forces everyone down that ladder and out the risk curve. Eventually, everything becomes priced to perfection. Invariably, the chase leads folks into less liquid assets.

This isn’t confined to the “smart” money. Retail investors have been similarly herded into corners of the market where they might not otherwise have ventured thanks to, for instance, high yield and emerging market debt ETFs. Those vehicles mask an underlying liquidity mismatch. Proponents will tell you the “miracle” of the creation/destruction process and the AP middleman mitigates that mismatch, but the inescapable reality is that those vehicles offer intraday liquidity against a pool of inherently illiquid underlying assets. It is not a matter of whether that could snap (it can), rather, it’s a matter of whether a fire sale acute enough to break the model will materialize.

Before I get off on a tangent, let me steer this discussion back onto the highway and off the ETF debate rumble strips. In the same note cited above, Goldman wrote the following about the type of assets that have benefited from investors chasing illiquid assets:

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Disclosure: None of what I write here is to be construed as advice to buy or sell any kind of asset. It is merely my personal and not my professional opinion. Any asset can go to zero.

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