Pension funds on the record: Private debt is not all it’s cracked up to be

Targets missed

When I joined APK in 2008, we had a few direct investments in real estate and a few alternative funds, but we did not have a structured investment strategy for alternatives. My task was to set up an umbrella fund, which we could use to invest in alternative strategies. We chose Luxembourg as a domicile for the fund and in 2012 we started to develop the strategy. As part of the strategy, we invest in three main asset classes – real estate, private equity and alternatives, by which we originally meant hedge funds. 

Our strategy did not include a dedicated allocation to alternative lending. However, we did invest in a senior lending fund, whose function was to smooth out the j-curve effect caused by our private equity investments. 

The strategy worked. We chose a fund with a target return of between 8% and 10%. The returns came below expectations, but we received an income that helped us stabilise returns from the overall alternatives portfolio. 

We also had a legacy portfolio of hedge fund investments, but here again our expectations in terms of returns were higher than what we actually experienced. So one of the first steps was to reduce the allocation to hedge funds, and then to design a more structured allocation.

We decided to include corporate lending and infrastructure and designed a portfolio that consisted of hedge fund investments, corporate lending and infrastructure in equal parts. Having started with corporate lending in 2012, I think that puts us among the first pension funds in Europe to invest in this asset class.

Disappointing returns

However, the first fund we invested in, which was also focused on senior lending, has delivered a return that was much lower than the target. We were disappointed, and it was the second time that had happened, which makes us question whether corporate lending was the right type of investment for us. The target return was again in the range of 8% to 10% and currently the IRR is around 5.4%, with a cash multiple of around 1.13. It is a disappointing picture, particularly over such a long period of time.

The reasons for the underperformance were two-fold. There were credits within the portfolio that performed poorly. For these types of funds to deliver on what they promise, nearly everything has to go according to plan. At the same time, the fund has a very high fee load, which affects returns. Paying the right price for these funds was also a lesson we learned with time.

We first invested in 2012 and 2014, and then paused any further commitments to the asset class. Nevertheless, we still thought it made sense to invest in debt funds that allocate to a broader spectrum of assets and across the capital structure. These funds should be able to deliver income, but also equity upside at times. In 2020, we resumed investing in the asset class and currently have two managers running that more diversified strategy. They target an IRR of 10% to 15%, which seems an attractive return target considering the lower risk profile compared with private equity. These funds target mid-market corporate lending opportunities, focusing on companies that need capital in a flexible manner. 

Private debt less attractive than other alternatives

Whether or not it makes sense to invest in private debt depends a lot on what one’s overall objective is. Private debt tends to compare favourably with investing in public markets. However, if one has the ability to invest across a broader range of alternative asset classes, including private equity and real estate, then private debt seems a less attractive investment on a net risk-adjusted basis. 

“If one has the ability to invest across a broader range of alternative asset classes, including private equity and real estate, then private debt seems a less attractive investment on a net risk-adjusted basis”

At APK, we are inclined to take more risk with private equity and real estate, two asset classes that we have invested in for a long time. A cash multiple of 1.1 or 1.2 times after being invested for eight years in a senior lending fund does not compare well with a 1.5 to 2 times cash multiple over a similar, or perhaps shorter, period investing in private equity and real estate.

“Since we started investing in private debt, we have noticed a weakening of lending standards, particularly with regard to covenants. For that reason, we have always tried to focus on managers that were not involved in bidding processes”

There is no doubt, however, that private debt investments have a place in institutional portfolios – not just the riskier types such as mezzanine lending, but also senior lending. For us, however, it makes sense to focus on other areas. 

Since we started investing in private debt, we have noticed a weakening of lending standards, particularly with regard to covenants. For that reason, we have always tried to focus on managers that were not involved in bidding processes. 

We have had a dedicated allocation to real estate lending for some time. We always had a view that this type of strategy would benefit in terms of diversification. We currently have four mandates in place for real estate debt, two of them focused on the European market and two for the US market. This strategy is also working quite well. We get a stable cashflow, and we think that the risk-reward profile of real estate debt transactions is attractive. 

The real estate lending strategy focuses mainly on whole loans, which we feel is safer in the current economic environment, but the managers have some freedom to also provide mezzanine lending, which has proved beneficial in the past.