Until recently, Morgan Stanley’s high net worth clients likely believed that the firm’s proprietary North Haven Private Income Fund (PIF) seemed like such a lovely place to park their money and earn higher yields than U.S. Treasuries and money market funds were paying. Like the Eagles’ famous Hotel California, it must have appeared to be the sort of place where you could check out any time.
PIF offered a sweet 8–10% yield that seemed almost guaranteed. It was marketed as “semi-liquid,” giving investors the comfort of knowing they could request their money back every quarter without paying any penalties. The fund had the Morgan Stanley patina of legitimacy, and the firm’s wealth management advisors, many who get paid roughly a flat 1% fee on their clients’ investments for offering supposedly superior money management wisdom, were promoting the investment.
What could possibly go wrong? It’s understandable if Morgan Stanley’s clients didn’t bother reading the fund’s prospectus because PIF’s yield seemed as sure a thing as death and taxes.
Morgan Stanley’s clients increasingly these days want out of PIF and are seeking to redeem roughly 11% of the fund’s assets, according to published reports. They are fast learning that “semi-liquid” becomes “virtually dry” when fund holders panic and droves of them want out at the same time. The fund’s prospectus says quite clearly that quarterly withdrawals from the fund are limited to 5% of the fund’s asset value — a “redemption gate” as Wall Street likes to call the restriction.
Morgan Stanley singlehandedly determines the value of the fund’s assets. Industry analysts have raised concerns that the value of PIF’s private credit loans may be inflated.
To be sure, most, if not all, private credit funds are facing redemption requests exceeding their 5% limits, but Morgan Stanley’s investor redemption requests, on a percentage basis, are among the highest in the industry so far. Unlike Blackstone, whose management contributed about $150 million of its own money to allow investors in its private credit fund to help cover redemption requests totaling roughly $3.8 billion, or about 7.9 percent of net assets, Morgan Stanley’s top executives chose not to step up to the plate.
Meanwhile, Morgan Stanley continues to pocket a hefty 1.25% PIF management fee, plus a 0.85% servicing fee it charges on the retail class of the fund, while its brokers get paid a 1% advisory fee for putting clients into an investment where they can’t readily withdraw their money.
Those fees might be easier for investors to swallow if the value of the underlying assets were determined by a transparent market. But that is not how private credit works. The loans held by funds like PIF do not trade on public exchanges the way stocks and corporate bonds do. Their valuations are typically based on models and periodic estimates rather than continuous market pricing.
The only continuous element in PIF is Morgan Stanley’s 1.25% management fee and the 0.85% retail servicing surcharge.
Investors in private credit funds are increasingly uneasy about their holdings because the assets of these investments are high-yield loans to companies owned by private equity firms whose ability to repay their debt is becoming increasingly questionable. Some of them are software companies whose businesses could be disrupted by artificial intelligence. Another area of major exposure is healthcare companies that may also have difficulty meeting their debt obligations.
As private credit debt isn’t publicly traded, investors must rely on the judgment and integrity of fund managers, who are hardly disinterested parties given that their firms earn fees based on the assets’ reported value.
JPMorgan is hardly a disinterested party either. The bank provides financing to private credit funds so they can lend money at even higher rates to private-equity-owned companies. Recently JPMorgan marked down the value of loans that serve as collateral for the bank’s private credit fund lending, although it is not publicly known whether any of the loans JPMorgan marked down are in PIF’s portfolio.
In another shock to the system, Cliffwater’s flagship private credit fund, which is about four times the size of PIF, capped redemptions at 7% in the first quarter after investors sought to pull about 14% of shares in one of the biggest withdrawal requests for such a vehicle in the $1.8 trillion market.
Notably, Cliffwater’s fund is for institutional investors, who are considered more sophisticated than “dumb money” individual investors, as retail clients are sometimes referred to on Wall Street. S&P Global last November assigned an investment grade “A” rating to Cliffwater’s lending fund.
PitchBook reported that Cliffwater is trying to peddle about $1 billion of its most secure loans, an effort the publication said has been in the works for months.
Rising redemption requests can also create a dangerous feedback loop for funds like PIF. Private credit loans are difficult to sell quickly because there is often no active market for them. If a fund is forced to raise cash to meet withdrawals, it may have to sell loans at discounted prices. Those lower prices then force the fund to mark down the value of similar loans it still holds, which can trigger further redemption requests from investors worried that the value of the fund is falling.
PIF was supposedly marketed exclusively to ultra-wealthy investors, yet the minimum investment was reportedly only about $25,000. Those investors are painfully learning how long it can take to leave Hotel California. Because withdrawals are limited to 5% of the fund’s value each quarter, investors seeking to redeem their money must effectively wait in line.
If redemption requests remain elevated, it could take many quarters — potentially years — for some investors to fully exit the fund. And if the fund is eventually forced to sell loans or mark down their value, investors may discover that their final returns look very different from the attractive yields that first drew them in.
Some Morgan Stanley history is worth mentioning here.
In 2016, Morgan Stanley agreed to pay a $2.6 billion penalty to resolve Justice Department claims related to the firm’s marketing, sale and issuance of residential mortgage-backed securities (RMBS). As part of the agreement, Morgan Stanley acknowledged in writing that it failed to disclose critical information to prospective investors about the quality of the mortgage loans underlying its RMBS and about its due diligence practices.
Investors, including federally insured financial institutions, suffered billions of dollars in losses from investing in RMBS issued by Morgan Stanley in 2006 and 2007.
“In today’s agreement, Morgan Stanley acknowledges it sold billions of dollars in subprime RMBS certificates in 2006 and 2007 while making false promises about the mortgage loans backing those certificates,” said Acting U.S. Attorney Brian J. Stretch of the Northern District of California.
“Morgan Stanley touted the quality of the lenders with which it did business and the due diligence process it used to screen out bad loans. All the while, Morgan Stanley knew that in reality many of the loans backing its securities were toxic. Abuses in the mortgage-backed securities industry such as these helped bring about the most devastating financial crisis in our lifetime.”
Despite the DOJ’s thundering about Morgan Stanley’s alleged wrongdoing, not one executive faced any criminal charges, unlike Charlie Javice, who last fall was sentenced to 85 months in prison for inflating the number of customers of her company, Frank, to fraudulently induce JPMorgan Chase to acquire Frank for $175 million.
Javice was in her twenties when she allegedly snookered America’s biggest bank into buying her company.
In 2014, JPMorgan agreed to pay $614 million to settle DOJ allegations of fraudulent mortgage lending practices.
“For years, JPMorgan Chase has enjoyed the privilege of participating in federally subsidized programs aimed at helping millions of Americans realize the dream of homeownership,” then Manhattan U.S. Attorney Preet Bharara declared. “Yet, for more than a decade, it abused that privilege. JPMorgan Chase put profits ahead of responsibility by recklessly churning out thousands of defective mortgage loans, failing to inform the Government of known problems with those loans, and leaving the Government to cover the losses when the loans defaulted.”
Here’s another Starkman Approved maxim you can take to the bank. If someone defrauds a major financial institution of less than $200 million, they will face some serious prison time. When banks defraud investors or the U.S. government for billions of dollars, no one is held criminally responsible.