One of the primary reasons private credit investments historically have been limited to institutional investors and high-net-worth individuals is because the asset class is relatively illiquid, in comparison to publicly-traded stocks and bonds. In typical private credit deals, investors are often subject to lengthy lock-up periods that may range from two to five years. For the largest institutional investors such as mutual funds, pension plans, and insurance companies, locking up capital for extended periods of time may be advantageous; however, for smaller investors that may need shorter-term access to their capital, a two to five year lock-up period is often untenable.
We recognize that liquidity is an extremely important topic for our clients, and in this post we describe our approach to liquidity, what that means for you, and what we do to improve liquidity in comparison to other private credit investment opportunities.
Private Credit is Inherently Illiquid
Before we discuss our approach to liquidity, we need to emphasize from the beginning: private credit as an asset class has unique liquidity characteristics that distinguish it from traditional fixed-income investments like publicly-traded bonds. The illiquidity of private credit is a crucial aspect for investors to understand, as it directly impacts the flexibility and risk profile of their investments. This illiquidity arises from several intrinsic and market-related factors, which are essential to consider when evaluating private credit as part of a diversified investment portfolio.
- Nature of Private Credit Instruments: Private credit typically involves lending to companies outside of traditional banking channels and public markets. These loans are often tailored to specific borrower needs and lack a standardized structure, making them inherently less liquid. Unlike publicly-traded bonds, private credit instruments are not listed on an exchange, leading to a limited secondary market. The bespoke nature of these loans, coupled with the absence of a standardized trading platform, makes it more challenging for investors to quickly buy or sell these assets.
- Limited Investor Base and Information Asymmetry: Private credit markets generally attract a smaller, more specialized investor base compared to public debt markets. This limited pool of potential buyers and sellers reduces the frequency of transactions, contributing to lower liquidity. Additionally, private credit transactions often involve a higher degree of information asymmetry. Lenders have access to detailed private information about the borrowers, which is not readily available to outside investors. This lack of transparency can deter potential buyers, further reducing the liquidity of these assets.
- Longer Investment Horizons and Restrictive Covenants: Private credit investments are typically characterized by longer maturities and investment horizons. Borrowers in these markets often seek capital for medium to long-term projects, leading to extended loan terms. Furthermore, these loans may include restrictive covenants and prepayment penalties that deter early exits, aligning the interests of borrowers and lenders over a longer period. While this structure can offer higher returns and more stable cash flows, it also means that investors in private credit are usually committed for the duration of the loan, resulting in reduced liquidity.
- Market Dynamics and Regulatory Factors: The private credit market is also influenced by broader market dynamics and regulatory factors. For instance, regulatory changes can impact banks’ lending practices, subsequently affecting the flow of capital into private credit markets. In times of economic uncertainty or market downturns, the appetite for riskier assets like private credit diminishes, leading to a further decrease in liquidity. Moreover, private credit often involves dealing with smaller or niche companies whose financial health might be more susceptible to economic shifts, adding to the illiquidity risk as investors become more cautious in such environments.
Our Withdrawal Policy in Plain English
We are committed to offering our clients an exceptional experience, designed to provide greater flexibility and access to the private credit market. With respect to liquidity, our goal is to process withdrawal requests as efficiently as possible, with the aim of returning client funds in as short as 30 days from the date of their request. It is important to note that we cannot guarantee 30 days from the date of a request, and there can be instances where the process may take longer. However, as short as 30 days is our target, and we work very hard to expedite this process wherever feasible.
Key aspects of our liquidity policy include:
- There is no "lock-up" period, which means clients can request a redemption immediately after their deposit, providing unparalleled flexibility in managing their investment;
- There are zero penalties for redemption; and
- We enable redemptions of up to $100,000 per quarter.
In the unlikely event that we anticipate a delay in fulfilling a redemption request beyond three months, we will proactively notify our clients.
It is also vital for our clients to consider that the "worst-case" scenario to complete their withdrawals could extend to approximately 18 months. This time frame aligns with our investment strategy of targeting loans with maturities no longer than 18 months. The diverse maturity dates of the loans in your portfolio, generally ranging from 6 to 18 months, also influence this timeline.
Finally, it is important to be aware that Heron Finance reserves the right to modify the liquidity policy. Should there be any material changes to our policy, we will ensure all our clients are promptly informed of these adjustments. This policy underscores our commitment to maintaining transparency and safeguarding our clients’ interests in varying market conditions.
How Heron Finance is Trying to Improve Liquidity
In building Heron Finance, we have designed the product offering with a focus on improving the holistic client experience, and improved liquidity has been a central focus.
1. A Liquidity-Optimized Portfolio Strategy
At Heron Finance, we have strategically honed our approach within the private credit sector by concentrating on a bespoke "credit box" that emphasizes shorter duration loans. This strategy is primarily aimed at boosting the frequency with which principal is returned, marking a significant departure from traditional practices in the field.
Our focus is on identifying–and investing on behalf of our clients–in opportunities where the maturity period is targeted at less than 18 months. Additionally, we seek out investments that come with unique "liquidity features," allowing us the option to recall capital that has already been loaned at regular intervals - three, six, or twelve months.
These durations are considerably shorter than the typical 3-7 year terms found in standard loan agreements and greatly enhances the turnover rate of each client’s individual portfolio, enabling a swifter and more dynamic investment cycle. This accelerated turnover is pivotal in augmenting the liquidity of our clients' portfolios and in providing us with the agility to reallocate capital more frequently, thereby aligning closely with client needs and market opportunities.
In the past, a focus on short-term investments could have limited our reach in terms of potential borrowers, as the market predominantly catered to longer-term financing needs. However, in recent years we have witnessed a remarkable expansion and diversification in the private credit sector. This growth has broadened the range of economic activities and investment durations available, making it feasible for investors to explore and capitalize on shorter-term credit opportunities.
The diversification in the private credit market is a reflection of the changing economic landscape and evolving borrower needs. Businesses today, especially small and medium-sized enterprises, increasingly seek flexible financing solutions that align with their dynamic operational requirements. By focusing on shorter-duration loans, we not only cater to the immediate financial requirements of businesses, but also provide our clients with a more fluid and responsive investment portfolio.
2. We Use Our Own Capital
In developing our approach to liquidity, we've taken a proactive step to improve our client’s experience by setting up an internal liquidity reserve. We have allocated a portion of our own balance sheet capital specifically for the purpose of “smoothing out” potential liquidity challenges. This internal liquidity reserve is used to purchase a portion of our client’s investments, allowing us to quickly respond to certain liquidity needs, and ensuring that our clients have the option to liquidate a portion of their portfolio.
Furthermore, this strategy demonstrates our commitment to a client-first approach. We understand that investment needs and priorities can change, and our ability to offer an exit route through internal capital allocation underscores our dedication to flexibility and client satisfaction. By prioritizing liquidity and stability, we're not just managing investments; we're cultivating long-term relationships based on trust and reliability.
While we strive to offer clients the best possible withdrawal experience, there are external or internal factors that may limit our ability to fulfill withdrawal requests (whether in full or partial). It is important for prospective clients to understand these scenarios as part of their investment decision-making process.
- Regulatory and Legal Constraints: Withdrawals are also subject to regulatory and legal constraints that may arise from time to time. Changes in laws, regulations, or legal rulings can impact various aspects of our operations, including asset liquidation and asset transfer processes. In certain cases, these legal and regulatory requirements might delay or restrict our ability to execute withdrawal requests. We continuously monitor for such changes and adjust our operations accordingly, but there may be instances where these external factors hinder our ability to process withdrawals.
- Market Liquidity and Economic Conditions in Private Credit: In the realm of private credit, our ability to fulfill withdrawal requests is closely tied to market liquidity and broader economic conditions. Private credit markets, known for less frequent trading and lower liquidity compared to public markets, can experience significant shifts during economic downturns or periods of heightened volatility. These shifts may result in reduced liquidity for private credit assets, thereby impacting our capacity to liquidate these assets without substantial value erosion. This dynamic market environment can challenge our ability to process withdrawals swiftly, especially in times of market stress specific to the private credit sector.
- Impaired Loans and Valuation Challenges: In our portfolio, any loans that become impaired–indicating a reduction in the likelihood of full repayment–are not eligible for sale at their face value. Impairment of a loan can occur due to various factors, such as the borrower's deteriorating financial condition, or adverse changes in the market, or economic environment affecting the borrower's industry. When a loan is classified as impaired, its valuation is adjusted to reflect the expected recoverable amount, which may be significantly lower than its face value. This reduction in valuation can affect our ability to liquidate such assets at their original value, thereby impacting our liquidity position and our ability to meet withdrawal demands based on the face value of these loans.
- Unforeseen Operational Challenges: Despite our robust operational infrastructure, unforeseen challenges such as technical issues, system failures, or disruptions in third-party services can affect our withdrawal processing capabilities. While we have contingency plans in place to mitigate these risks, there may be situations where these operational challenges delay our response to withdrawal requests. We are committed to resolving such issues promptly and efficiently, but there may be instances where these problems impact our normal operations.
- Excessive Withdrawal Requests: In the event of an unusually high volume of withdrawal requests within a short period, our ability to meet these demands may be strained. Depletion of our internal liquidity reserve could lead to a temporary suspension of withdrawals. During such periods, we would take all necessary steps to restore normal operations and meet our clients’ needs as quickly as possible, but the immediate fulfillment of withdrawal requests may not be feasible.