Private Debt: Don’t just leap in
Pension funds should ask themselves important questions before entering the private debt market
Pension funds stand to benefit considerably from expanding their credit portfolios into private debt.
While private debt has become more widespread, it has been concentrated in certain pockets. These include corporate middle-market direct lending where value is being stretched by competition for capital. With this in mind, it is worth examining several questions that pension funds should consider before building or expanding upon a private debt portfolio.
• Where is the pension scheme in its journey plan, and given this, how best should it spend its illiquidity budget?
One of the advantages pension funds have had over other institutional investors is a genuinely long time horizon. This is supported by the returns achieved from those that have embraced investing in private markets. Even as pension funds mature, there is still tolerance for illiquid assets. Too few make full use of their scope to lock capital up and earn an illiquidity premium for doing so.
However, an increasing number of pension plans are beginning to consider their end game. This has meaningful implications for the types of assets a fund should own. Alternative credit broadly, and private debt particularly, can offer an attractive cash-flow profile for pension schemes in this situation. Characteristics including higher yields, floating-rate returns and fast amortisation mean that these assets can form an attractive growth element of cash-flow focused portfolios.
• What role do trustees envisage for private debt investments?
The breadth of the private debt universe means it can play a role in different parts of pension schemes’ portfolios. There are opportunities of varying credit quality and tenor providing scope to add diversity and additional returns. Is the goal simply to assume similar levels of risk and look to pick up an illiquidity premium, or is there tolerance for assuming greater risk for greater expected reward? Both have merit depending on specific scheme circumstances.
If the former is the case, there are numerous secured-lending opportunities which appear to offer an attractive premium over high-yield bonds and loans. This is what has driven many to embrace middle-market direct lending. However, with spreads compressing and credit risk rising, we have long adopted a broader approach encompassing specialist strategies that in our view offer better rewarded senior secured lending opportunities. Others should also approach the topic from a more comprehensive standpoint.
If the pension scheme is willing to assume greater credit risk or complexity, then this is where greatest value can be found in private debt at present. This leads to the conclusion that alternative credit is an attractive place to de-risk from equities without sacrificing return.
There is far less competition chasing opportunities in niche areas of private debt. High-quality and often specialist asset managers can therefore underwrite greater credit risk to achieve meaningful reward in certain pockets of the private-debt market. This is particularly true in areas too small or complex to attract large capital inflows.
An example of this approach is lending against value-add property where regulations have genuinely led to a reduction in lending from banks. Along with higher yields, the relative lack of competition means documentation has not deteriorated in the same way. Covenants and controls continue to be favourable for the lender (something lacking in public high-yield and loan markets today).
In short, it is important to understand in advance what the investments are hoping to achieve, as well as the tolerance for risk (perceived and actual). Critically the illiquidity premium and security of capital varies significantly across investments according to the supply of capital in these areas. To earn the best returns it is essential to lend selectively and avoid the crowds.
• What else does the pension scheme own?
Many pension schemes already own a lot of large-cap corporate risk via their equity and fixed-income portfolios. Alternative credit, inclusive of private debt, offers a wealth of options to help diversify this risk across different borrower types (smaller corporates, consumers, real assets). Corporate balance sheets look extended and, as such, diversity in credit is of paramount importance today.
As such, what a pension scheme already owns should be considered when building a private-debt portfolio. For example, many are looking for a replacement for high-yield and loans, hence increasing demand for direct lending (notwithstanding our valuation concerns). If private debt is viewed as a complement to existing high-yield and loan exposures, direct lending is a less obvious place to add incremental capital as it will add very limited diversity.
Alternative asset classes such as securitised credit or asset-backed direct-lending strategies are more likely to be better complements to what pension schemes already own.
• Do the trustees have the decision-making framework in place to build and maintain an appropriately diversified portfolio?
Private debt portfolios, like private equity portfolios, need to be carefully built and monitored over time, given how the cash-flows work (capital drawn down by managers over time, then returned at unknown times). To maintain an allocation to private debt, new investments must continue to be made, given the often fast run-off of the loans. Pension funds need to ensure they have appropriate diversification across geography, vintage year and strategy, similar to private equity portfolios. Investors also need to consider other important factors such as the requirement to look across multiple underlying asset classes to identify where credit risk is best rewarded and engage in regular manager selection and monitoring.
The upshot of the on-going commitments required is that it allows pension schemes to continually tilt the portfolio to reflect a view on what is most attractive. The downside clearly is the much greater oversight, research and management required.
Building a private-debt portfolio, similar to other private markets, will take two to five years – making commitments and then managers deploying the capital. Any quicker commitments can lead to unintended vintage, strategy or geographical concentration. Given the time taken to build the portfolio, we recommend including private debt within a broad, well-diversified alternative credit mandate.
As such, before commitments are made, trustee boards should discuss whether existing resources can do this, whether governance can be adapted or there is a need to leverage external resources.
Private debt is an attractive asset class for trustees willing to embrace its full breadth. However, the asset class is broad and an on-going management is required. As such, the pension fund will need to either dedicate the resources required to manage it, or outsource its management. The four questions highlighted above should provide a good starting point for investors new to the asset class.
Greg Disdale is head of alternative credit at Willis Towers Watson