LP perspectives: European pension funds on private credit strategies

A new strategy, with further growth on the cards

PGB made its first investment in private credit in 2023 on the back of the thesis that the risk/return aspect is more attractive in private credit than in liquid markets. The reasons are manifold and include bank regulation and higher spreads than in liquid markets, leading to an attractive illiquidity premium. Fundamentals have improved after COVID-19 and the subsequent interest rate increases, leading to stronger balance sheets – lower leverage – against higher spreads.

As our first investment into private credit, sub-investment grade, was intended to explore the asset class and not necessarily aim for the highest risk, PGB invested in a senior loan fund with moderate leverage. We felt this would give us an attractive risk/return, while still benefiting from the high illiquidity premium. Our private credit portfolio is 100% European, roughly 30% in the UK, 20% in the Benelux, 20% in the DACH region and the remainder elsewhere across Europe.

We see private credit as part of a new strategy, where allocations are substantial enough to avoid too much fragmentation. Our target allocation is between 1-1.5% of the assets under management in the first instance, acknowledging that funding a private portfolio would take a couple of years. The current mandate is still in its funding phase. So far, the asset class has performed relatively well due to high coupons and generally low levels of credit losses.

However, we’re currently assessing further investments and potentially expanding the number of managers. One of the drivers behind this philosophy is that private credit is an asset class that may be relatively well suited to impact investments. As this thesis needs to be established, further investments have not yet been made.

We believe investing in (sub-investment grade) private credit is a very specialised area where manager selection is key. You need a large asset base to make it efficient to build a team that could manage those strategies, which for PGB is one of the reasons to outsource private credit investments.

In addition, access to sponsors and other parts of the origination channel is essential to be able to invest in good deals. Those relationships are often long-standing and broad, which is another reason not to start this on your own.

Private markets are, by definition, less transparent than public markets, but managers are relatively accessible, and PGB receives ample reporting and access to the portfolio management teams to stay on top of developments. Together with continuous due diligence and monitoring, this gives us enough comfort to invest. As we do not compromise on manager selection criteria when investing in private credit, we tend to avoid managers with short track records and lower AUM.

Strong due diligence needed in a competitive lending market

Private credit is an asset class that has gained a lot of interest over the years. Billions of investments have flowed to private credit managers. While there is a lot of dry powder left among private equity managers, the inflows into private credit are manageable. On the other hand, in some parts of the market, there is more competition from the broadly syndicated loan market or from high yield. Here again, it remains important to undertake strong due diligence and look for managers that can add value and so not invest in opportunistic parties that have just recently entered the market or don’t have a strong strategy and track record.

While the investment case for private credit remains intact, fundamentals have been deteriorating slightly over the past 12 months – especially in terms of the weakening of covenants – due to competition. Also, spreads are ‘past their peak’ and somewhat lower than before. But that counts for public markets too, where many assets are trading ‘rich’. Hence, the excess spread/illiquidity premium is still satisfactory.

“Getting the right deal with the right credit documentation at the right spread will be even more challenging going forward”

The biggest challenge is to build a strong and diversified portfolio in a timely manner. As private equity flows persist and competition for funding increases further, getting the right deal with the right credit documentation at the right spread will be even more challenging going forward.

Access to the better managers remains key – with some patience regarding how quickly commitments will be invested. Given the market structure, PGB believes that in the right set-up, private credit will remain an interesting asset class for balance sheet allocation. More market entrants may lead to pressure on loan terms and, therefore, a shrinking or less attractive opportunity set in the future, but time will tell how this develops further.

The drivers behind the attractiveness of the asset class – such as the financing needs of middle market companies, which are restrictive due to limited bank lending capacity – will prevail for the foreseeable future. Especially in Europe, corporates are still largely financed by banks, and if only a part of this is replaced by private markets, it will mean a huge additional boost to the market.

In the meantime, initiatives to provide ESG or impact financing are increasing, so new strategies will also arise. This is partly driven by (institutional) client demand. PGB believes private credit will remain an attractive asset class on a risk/return and ESG potential basis relative to other assets and plans to explore it further. While taking a step-by-step approach, we will see if the market indeed remains attractive or if opportunities are impeded by increased competition.

From tactical to strategic building block

PKA has been investing in private credit since the global financial crisis (GFC), but the portfolio has evolved significantly over the years. One major shift is our perception of the asset class. Initially, we viewed private credit as a tactical building block in our portfolio, but today, we see it more as a strategic one with the intention of investing for the long term. The liquid credit book holds delta [a key metric used to assess risk and manage exposure within a credit portfolio], where we are scaling risk up or down. This is important not only for private credit but applies across all our private market investments, which we see as strategic allocations on our balance sheet.

Everything we do is risk-adjusted, and there is a capital charge with everything we do. We only invest if we believe it gives us a better risk-adjusted return than on the liquid side. Internally, the same team oversees both the liquid and private credit books, enabling us to seamlessly optimise risk-adjusted returns regardless of the portfolio segment. Strategic implementation is something we continue to evaluate but we believe private credit continues to offer a positive performance contribution. 

Our commitment to ESG integration is another cornerstone of our investment philosophy. Historically, private markets lagged behind liquid markets in this area, but progress is evident. Direct lending managers are adopting ESG key performance indicators (KPIs) into loan documentation, promoting alignment with ESG goals. This shift reduces risks in target companies, enabling us to lower loan spreads. An important aspect of private credit is also that we can make a greater impact than in the liquid markets, which is another positive for the asset class.

PKA’s foray into private credit started post-GFC in 2008-09 through loans, which at the time were categorised as a private credit investment but which has since moved to our liquid portfolio, reflecting the evolution of the asset class. In 2017, when I joined along with the credit team, we established the current private credit framework, complementing exiting private equity, real estate and some infrastructure investments.

Private markets suit PKA’s model

The investment thesis behind going into private credit is our risk-based approach, similar to that of a bank, whereby all investments get a capital charge on the balance sheet. This means that private market investing, across the board and not just in credit, looks better from a risk/return perspective in our model. PKA’s balance sheet can accommodate higher illiquidity due to our stable member base, comprising public healthcare employees who rarely exit the fund before retirement.

“We are at a point where we are happy with the size of our allocation”

Our allocation to private credit has increased substantially, and today, over 20% of the balance sheet is invested in credit. Of that, roughly 50% is in private credit, which translates to over 10% of the total portfolio. We are at a point where we are happy with the size of the allocation, but while the percentage allocation remains stable, absolute investments in private credit continue to grow alongside our expanding balance sheet, fuelled by member contributions and returns.

The evolution of our private credit investments spans the broader risk spectrum from investment grade into higher yielding structured credit opportunities. These core areas are managed through a combination of internal efforts and external manager relationships.

Approximately 30% of our private credit exposure is in direct lending, managed entirely by external partners in Europe and the US. We deliberately avoid single-name paper selection, recognising that pension funds are less competitive in this area.

Our credit portfolio is geographically diversified: 33% in the US, 33% in Europe, and the remainder globally. Within private credit, European exposure (50%) outweighs the US (45%), reflecting favourable relative value and hedging costs. While we maintain significant exposure to the diverse US market, we continue to prioritise Europe due to strategic considerations. Emerging market exposure within private credit remains limited.

In the current environment with geopolitical and trade tensions, investors are starting to ask questions about the new US policies and while we have built our exposure based on risk/return aspects rather than political considerations, it is something that will be of greater focus going forward as there is a clear change in tone on how we view the world.

We understand the need for an extended focus on private markets and ESG, particularly in the context of Europe’s need to boost its defence capabilities and ensure its energy independence, so this is at the top of our investment agenda, and we are looking for opportunities in Europe.

Besides geopolitical concerns, entering a potential credit cycle presents challenges, including a likely uptick in default rates. We are not overly concerned that we will reach a 10-15% default rate, but maybe it will be 4-5% for a period of time. Documentation limitations in direct lending remain a concern, as they could hinder lenders’ access to capital structures. However, we remain confident in private credit’s resilience and potential for positive performance contributions