Summary
State Street Corporation and Apollo Global Management, two prominent entities in global financial services, have proposed an innovative Private Credit Exchange-Traded Fund (ETF) that could potentially democratize access to private credit markets. This move is seen as a significant step forward in the finance industry, as private credit has traditionally been out of reach for most investors due to high investment minimums and long lockup periods. The ETF aims to provide direct exposure to private credit, changing the dynamic of long-term investment. Despite this groundbreaking approach, it has been met with both enthusiasm and scrutiny due to the inherent liquidity constraints of the market and the various risks involved. The partnership’s impact is set to be substantial, with potential to revolutionize how investors access private credit and other alternative asset classes. Nonetheless, concerns about market, operational, financial, and regulatory risks have been raised, highlighting the need for careful evaluation and oversight in this evolving financial landscape.
State Street Corporation
State Street Corporation is a global financial services and bank holding company with headquarters at One Congress Street in Boston and operations worldwide. It holds the distinction of being the second-oldest continually operating bank in the United States, tracing its origins back to its predecessor, Union Bank, founded in 1792. Currently, State Street ranks 14th on the list of the largest banks in the United States by assets.
Divisions
State Street operates through different divisions, each providing a range of financial services. The securities services division of State Street, also known as State Street Bank and Trust Company or State Street Global Services, provides asset owners and managers with securities services, including custody and corporate actions, fund accounting, and administration services.
Another division, State Street Global Advisors (SSgA), provides asset services like securities lending, investment research, and exchange-traded fund (ETF) management. SSgA is credited with inventing the ETF vehicle in 1993 and manages over 50 ETF products, including its flagship S&P 500, the Standard & Poor’s Depositary Receipts, or “SPDR” ETF. The investment research and trading arm of State Street is State Street Global Markets, offering specialized research, trading, securities lending, and portfolio strategies.
History and Evolution
State Street’s history is closely tied to the commercial history of Boston, going back to the days when the city was a bustling shipping port. The bank moved its main office to another part of State Street in 1911 and five years later, it purchased the assets and goodwill of the Paul Revere Trust Company.
By 1924, State Street had begun to embrace technology, evolving into more of a provider of information processing services than a traditional bank. Today, most of its revenue comes from fees for holding securities, settling trades, record-keeping, accounting (including multicurrency accounting), and net asset value computation.
A secondary stream of revenue comes from fees for managed asset accounts, leading to a balance sheet where income derived from selling fiduciary services accounts for 70% of overall revenues. Over the years, State Street has transformed from a traditional Massachusetts financial institution into a global banking powerhouse, achieved through aggressive diversification and advanced technologies.
State Street continues to honor its past, with its offices adorned with ship models, prints, harpoons, and figureheads recalling Boston’s maritime history. The bank has published more than two dozen monographs recalling Boston’s maritime history as well.
Apollo Global Management
Apollo Global Management, Inc. is an American firm specializing in asset management, primarily focusing on alternative assets. As of 2022, Apollo managed a whopping $548 billion in assets, with $392 billion invested in credit, encompassing mezzanine capital, hedge funds, non-performing loans, and collateralized loan obligations. Additionally, the company also has $99 billion invested in private equity and $46.2 billion in real assets, including real estate and infrastructure.
Since its inception in 1990, Apollo has marked a commendable success record in the field of alternative investments. The company has been consistently evolving and expanding its service offerings to better cater to its clientele. In May 2021, Apollo established the Global Wealth Management Solutions (GWMS) vertical within its Client and Product Solutions (CPS) group. This move aimed at improving service provision to individual investors, indicating the firm’s commitment to strategically enhancing its services.
In a significant move towards fostering diversity and inclusion, Apollo collaborated with Ares and Oaktree in June 2021 to co-found AltFinance. With an up to $90M commitment, AltFinance is designed to create opportunities for students and alumni of Historically Black Colleges & Universities (HBCUs), allowing them to explore and build careers in alternative investing.
Apart from its core business operations, Apollo Global Management, Inc. also features prominently in other investment and financial entities. For instance, Apollo Global Securities, a subsidiary of Apollo, serves as a liquidity provider for ETFs. As an industry leader in alternative asset management, Apollo continues to contribute to the evolving landscape of global investing.
Innovative Private Credit ETF
State Street Global Advisors and Apollo Global Management have recently proposed an exchange-traded fund (ETF) that invests in both public and private credit. This proposition is groundbreaking as it is the first of its kind, given approval by the Securities and Exchange Commission. This ETF proposes to directly hold private credit, which has historically been out of reach for most investors due to high investment minimums and long lockup periods.
Private credit exposure has been offered through public investments by other ETFs in the past, but the State Street/Apollo product is designed to change this trend by providing direct exposure. This innovative approach comes with its unique set of challenges. A similar product, a private credit CLO ETF, was unveiled by BondBloxx, a credit-oriented ETF issuer, shortly after the proposal from State Street and Apollo.
Private equity sponsor ‘backing’ typically involves PE funds owning equity in companies, usually through leveraged buyouts. In this arrangement, sponsors, who control the firm’s equity, are involved in strategic decisions related to the company’s management, operations, and capital structure.
Investment industry chatter about private credit and active ETFs has been prevalent, and the partnership between State Street and Apollo could be seen as a marriage of these two hot topics. Their innovative ETF will be a significant step in the ‘democratisation of private assets’, opening up opportunities previously reserved for high-net-worth investors to a wider market.
The innovative product can provide exposure to investments similar to those associated with private equity or venture capital firms, thus offering the potential for high yields but with added risk. The management of these investments requires significant investment expertise, sourcing relationships, due diligence, and portfolio management. These factors collectively serve as the greatest competitive advantage for private credit managers to achieve attractive risk-adjusted returns.
The business development companies (BDCs) involved offer tax advantages to investors. They provide tax reporting from 1099s instead of K-1s, which are often received late in the tax season and can be complex to read and understand. Additionally, investors can benefit from the distribution of dividends from realized gains at the lower capital gains tax, which is immediate value to private credit investors.
The Role of Business Development Companies (BDCs)
Business Development Companies (BDCs) were created as a result of the Small Business Investment Act of 1980, with the initial intention of helping small and middle market companies access capital. BDCs are a hybrid type of closed-end funds that invest primarily in private U.S. operating companies, usually through debt investments, and share similarities with both operating companies and registered investment companies.
Investment and Financing
BDCs invest in private companies and small public firms that are in financial distress or have low trading volumes. They raise capital through initial public offerings or by issuing corporate bonds, equities, or hybrid investment instruments to investors. The capital raised is used to provide funding for the struggling companies. Many businesses seeking alternative financing solutions turn to BDCs for asset-based lending services, which provide tailored credit options based on collateral value rather than traditional credit metrics. For smaller, more highly leveraged borrowers, private credit may be one of the few available sources of debt funding, particularly in risk-averse market conditions.
Types of BDCs
There are three main types of BDCs: publicly traded BDCs, publicly offered but non-listed BDCs (non-traded BDCs), and privately offered BDCs. The choice between these is largely determined by the asset managers’ preferences for market timing and target investors, including investors’ liquidity needs, and the receptiveness of the distribution channels to the asset managers’ product offerings. Over time, privately offered BDCs may evolve into non-traded or publicly traded BDCs.
Risks and Opportunities
While BDCs can provide exposure to investments similar to those associated with private equity or venture capital firms, they also carry added risk. This includes the potential for high yields. BDCs are generally more suitable as part of an equity allocation, not as a substitute for fixed income. They often invest in illiquid debt securities with high credit risk, which can lead to increased volatility and potential large price drops during market downturns. Once traded in the listed market, BDCs adopt the volatility of common stocks and may deviate from their fundamental value because of changes in investor risk aversion and market liquidity. They can be riskier than the assets they hold, a problem compounded by their use of high amounts of leverage. These factors, combined with their relatively high fees, make investing in BDCs a decision to be taken with careful consideration.
Regulatory Compliance
To qualify as a BDC, a company must be registered in compliance with Section 54 of the Investment Company Act of 1940. It must be a domestic company whose class of securities is registered with the Securities and Exchange Commission (SEC), and must invest at least 70% of its assets in private or public U.S. firms with market values of less than US$250 million.
Key Motivations for the Partnership
The partnership between State Street and Apollo aims to merge the strengths of two market leaders to democratize private assets, allowing a wider range of investors to participate . This initiative marks a significant step in the evolution of how investors can access private markets, providing more flexible liquidity and diversification options .
One of the key motivations behind this collaboration is to allow General Partners (GPs) to tap into the retail distribution networks of their partner managers while facilitating access to high-octane investment offerings often unavailable to liquid managers . State Street, a pioneer in the exchange-traded fund (ETF) industry, sees the partnership as an opportunity to originate assets rapidly and efficiently. This ability is a critical success factor for any product seeking to bridge the liquidity gap, such as the innovative product proposed by State Street and Apollo .
The product that these two entities aim to introduce would be the first to hold private credit directly . Private credit is usually out of reach for many investors due to high investment minimums and long lockup periods. The State Street/Apollo product could change this dynamic by offering unique private credit investment opportunities with lower investment minimums as low as $2,500 .
This partnership also aims to support underlying companies by providing capital and managerial assistance, thereby aiding their future development. These companies may also benefit from additional capital and operational oversight provided by a private equity sponsor .
Addressing Liquidity Constraints
The partnership between State Street and Apollo introduces an innovative approach to address the liquidity constraints often associated with private credit investments. A key concern raised about the increasing liquidity of investment vehicles is whether this undermines the benefits of long-term investment. Cinthia Murphy, an investment strategist at VettaFi, noted that the inherent liquidity of the ETF structure could pose challenges when dealing with underlying securities that lack liquidity.
However, State Street and Apollo have sought to overcome these challenges through a unique liquidity agreement. Apollo has committed to providing intraday executable bids on all of its private credit offerings held by the ETF, thus arguably rendering these instruments liquid. In the agreement, Apollo also commits to buying back these instruments from the fund upon State Street’s request, up to an undefined daily limit. This arrangement ensures the ETF has a reliable mechanism for valuing its holdings daily and trading those securities in and out of the ETF.
Despite this approach to addressing liquidity constraints, it is important to note that the partnership’s private credit ETF still faces a range of risks. These include market risk, operational risk within portfolio companies, financial risk due to high debt levels or financing challenges, regulatory risk from changing laws or regulations, and reputational risk from negative publicity or unethical practices. Furthermore, private equity-backed companies, like those financed through private credit, often display worse credit quality than public companies, raising financial stability concerns.
Impact and Implications of the Partnership
This innovative partnership brings together the strengths of two market leaders, State Street and Apollo, to facilitate increased investor participation in private credit markets. Notably, State Street was instrumental in pioneering the exchange traded fund (ETF) concept with an S&P 500 fund back in the 1990s. Meanwhile, Apollo has made significant strides in serving individual investors and promoting financial inclusion through initiatives such as the Global Wealth Management Solutions vertical and the AltFinance program.
The collaboration allows general partners (GPs) to access the retail distribution networks of traditional asset managers like State Street, thereby providing liquid managers with access to higher-octane investment offerings. This is particularly beneficial given Apollo’s acquisitions of proprietary origination platforms, which are a crucial success factor for any product seeking to bridge the liquidity gap.
On the operational level, the State Street-Apollo partnership will offer private credit investment opportunities with minimum investments as low as $2,500, opening up unique investment options to a wider range of investors. Business Development Companies (BDCs) in particular are poised to provide capital and managerial assistance to underlying companies, fostering their future development. The growth of private credit markets, which currently exceeds $1 trillion, demonstrates the potential impact of this partnership.
In the broader context, this partnership is in line with State Street’s strategy of aggressive diversification and advanced technology use. Over the years, State Street has transformed from a traditional financial institution to a global banking powerhouse, primarily through providing information processing services. On the other hand, Apollo is renowned for its investments in alternative assets, managing assets worth over $548 billion as of 2022.
Given these factors, the partnership between State Street and Apollo is likely to have profound implications for the future of private credit ETFs, potentially revolutionizing the way investors access these asset classes. The partnership also underscores the growing significance of private markets, which offer financing to companies through private equity, private credit, and real assets.
Criticisms and Controversies
Despite the partnership between State Street and Apollo being seen as a pioneering move
Future Prospects and Direction
The proposed private credit exchange-traded fund (ETF) by State Street Global Advisors and Apollo Global Management is a significant step forward in broadening access to private credit for investors. Traditionally, private credit has been out of reach for most investors due to high investment minimums and long lockup periods. The introduction of these more liquid vehicles could potentially alter the dynamics of long-term investment in favor of satisfying the need for constant liquidity.
State Street has pioneered the exchange-traded fund (ETF) with an S&P 500 fund in the 1990s. This new proposal signifies their continued innovation in the field and signals a broader trend in the industry of creating more accessible investment vehicles. In recent years, private equity and other alternative investment firms have already ventured into the retail market, introducing instruments like “interval funds”.
The partnership between State Street and Apollo merges the strengths of both entities to enable more investors to participate in private credit markets. This is part of a larger movement in the industry to democratize access to alternative investments. However, as senior industry analyst Kirsten Chang noted, the performance and liquidity of such a complex structure will be closely monitored.
In addition to the State Street-Apollo ETF proposal, a similar private credit Collateralized Loan Obligation (CLO) ETF was announced by BondBloxx. Notably, in May 2021, KKR and Capital Group launched a similar public-private debt partnership. Such developments indicate a growing industry trend towards more accessible and diverse investment options.
Despite these advancements, some challenges exist in this new direction. Private credit, while offering unique investment opportunities, is a market that has grown dramatically since the 2007-09 global financial crisis. Risks to financial stability stemming from characteristics of investors, portfolio companies, the structure of intermediaries, and links with the banking sector need to be thoroughly evaluated. Therefore, while the future seems promising with innovations like the proposed ETF, the financial industry needs to proceed with caution to ensure stability and mitigate risks.
The content is provided by Blake Sterling, Financial Pulse Now
