New ETF Accelerates Democratization of Private Assets

Overview:

• The first ETF with a significant portion of direct exposure to private assets has launched in the U.S.
• The SEC responded on launch day with concerns in an unorthodox move, but comments may have been satisfied with a quick response.
• A private asset giant provides intra-day bids and repurchases, enabling the new ETF to hold 10%-35% private credit while maintaining a 15% cap on illiquid assets.
• A similar private credit ETF could now launch in Canada or other markets with progressive regulatory environments.

A large U.S. ETF issuer recently launched the first ETF in the world to provide direct exposure to private assets in a significant portion of the fund's net asset value (NAV). The newly launched ETF targets a 10-35% allocation to private credit (to start) with a management fee of 0.7%. Although the ETF has seen decent trading activities and some asset accumulation since its inception, the real feat of this ETF is in its launch. It may become a gateway for the ETF industry into the very large private assets space and lead to the further democratization of this asset class.

The ETF specifically invests in private credit. This refers to a wide range of credit instruments, such as instruments that are directly originated, issued in private offerings, issued to private companies, and/or issued to borrowers by non-bank lenders (i.e., non-bank lending instruments), including, but not limited to, asset-backed and corporate finance instruments sourced by a private asset giant (Sourced Investment). Based on the prospectus, private credit will generally range between 10%-35% of the fund's portfolio. Notably, although the fund has capped its allocation of illiquid assets to 15% the rest of the portfolio is invested in public credit.

We would be remiss if we failed to mention the rollercoaster that the Securities and Exchange Commission (SEC) took the industry on shortly after the fund's launch. As the private credit ETF dominated headlines on its launch day, the SEC issued a public letter to the issuer raising concerns around the fund's name, liquidity and valuation. This is a very unorthodox move for a regulator after giving the nod to the issuer to go ahead and list the fund. As part of the filing process, the issuer would have had many conversations with SEC staff regarding their concerns. Nevertheless, the issuer promptly responded to the letter the next day. Shortly afterwards, a Bloomberg report highlighted that the SEC had no further comments, potentially ending the saga that stole headlines on launch day.

Let's call this growing pains.

What is Unique About the new ETF?

Although ETF industry participants have knocked on the door of private assets for many years, it is the first time an ETF has had a substantial portion of its assets directly in private assets. There are already ETFs investing in assets with limited liquidity, such as collateralized loan obligations (CLOs) and bank loans. Such ETFs are popular with investors given they offer higher yields, especially in a rate cutting cycle. There are also several funds in the U.S. and Canada providing indirect exposure to private assets through investments in private equity (PE) firms or business development companies (BDCs). The new ETF carries a sizeable direct exposure to private credit. The issuer outlines the assets the ETF may invest in, most of which historically have never been in an ETF wrapper.

How does the issuer make it possible to include these assets in the ETF wrapper? Per the fund’s prospectus, a private asset giant has contractually agreed to provide intra-day, firm, executable bids on all sourced investment held by the fund and is contractually obligated to repurchase sourced investment held by the fund in accordance with the bid quotation and purchase agreement between the private asset giant and the fund. This contractual agreement aims to mitigate some liquidity concerns embedded in the ETF and is a creative way to get around the 15% cap on illiquid assets for an ETF. This 15% does not represent the majority of the fund's assets. However, it is important to understand the complexities of what the issuer has solved for and the runway the fund has opened for future innovations including, perhaps, an ETF holding 100% private credit in the future.

Groundbreaking Moment

This is a groundbreaking moment for the industry for the following reasons:

• ETF investors now have direct access to the US$30 trillion private asset market.
• The ETF issuer's partnership with a private asset giant creates an innovative way to get around the cap which limits an open-end fund’s aggregate holding of illiquid assets to no more than 15% of the fund’s net assets. Other ETF issuers may quickly follow suit.
• This ETF will encourage more private market players to consider ETFs as a potential wrapper for their existing and new strategies.
• This fund sets a precedent for all ETF markets globally to allow private credit ETFs.

Now that the U.S. has its private credit ETF, the Canadian ETF industry and other markets globally are likely to follow suit with similar products. Given the progressive regulatory environment in Canada, it shouldn't be a surprise if a similar private credit ETF soon launches in Canada.

Growing Pains

When the filings appeared in September, industry participants had many questions around liquidity, NAV calculation, the private asset giant's role and market making. Some of these concerns were raised by the SEC but were promptly addressed by the issuer in its responses the next day. The primary concerns included:

• Liquidity: The ETF issuer proposes 10%-35% holding in private credit given its contractual agreement with the private asset giant while still compliant with the 15% cap on illiquid assets. However, the SEC does not believe that it would be sufficient to rely solely on bids from the private asset giant under the agreement to find a sourced investment from the private asset giant not to be illiquid.
• NAV Calculation: The ETF issuer confirmed that they have multiple sources for determining fair value. However, based on the COVID experience, public credit and now private credit ETFs may see significant NAV dislocations as the executable prices of those securities diverge from the calculated NAVs.
• The Private Credit Issuer's Role: The private asset giant's support is critical to the launch of the ETF. Without its contractual agreements to supply private credit assets for the fund, provide firm bids and agree to buy back up to a certain limit, the ETF might not be able to overcome regulatory hurdles. The private asset giant's role is as a liquidity provider. The SEC requests the fund to revise its name to reflect the limited nature of private asset giant's relationship with the fund, which the issuer agreed upon.
• Market Making: The absence of a trading market can make it difficult for market makers to accurately quote illiquid holdings of the fund. As a result, market makers rely heavily on the issuer to provide proxy or cash estimates to provide real-time quotes. In addition, market makers may be subject to creation and redemption fees for the cash portion. These can expose market makers to risks such as basis risks and NAV dislocation. Given the nature of the ETF, market makers have to bear these risks when quoting the ETF.

The ETF's launch is a groundbreaking moment for the ETF industry. Although uncertainties remain, the ETF is live and trading on the market as the first to hold a substantial amount of private credit. Like all disruptive innovations, there will always be growing pains and challenges. However, the ETF is likely to open doors for the industry to access the US$30 trillion private asset market. It is no doubt one of the largest breakthroughs in the ETF industry in recent history.