Gail Moss explains why the Church of England Pensions Board is putting its faith in the US private-debt sector

Earlier this year, the Church of England Pensions Board (CEPB) made its first foray into private debt, allocating £80m (€96m) to private loans for smaller companies in the US, managed by Audax Senior Loans (ASL). The allocation makes up 5% of the £1.6bn of return-seeking assets in the CEPB’s £2bn total portfolio, which funds pension schemes for over 35,000 beneficiaries, including clergy and church workers, for service from 1998 onwards. 

Pierre Jameson, CIO at CEPB, says: “Private debt is an attractive asset class for us, because, paradoxically, the market for it is at the same time both well developed and inefficient, when compared with other asset classes and the markets for broadly syndicated loans and high-yield debt in the US.”

The US private-debt market is well-developed, widely invested in by public pension schemes and family offices. Managers of private loan portfolios have much experience of investing in the asset class, and the channels through which loans are made are well established. 

However, those channels lead to most loans being arranged as club deals, which creates barriers to entry for new participants. At the same time, lenders are withdrawing from the market because of regulatory pressure on loan quality.  “As a result, on a risk-adjusted basis, potential returns from our investments are good, with such loans being arranged at average spreads over LIBOR of about 650bps,” says Jameson. “There is also some protection against rising interest rates, as the loans are at floating rates.” 

ASL, a division of the Audax Group, an investor in middle-market companies, was established in 2007 and has achieved net annualised returns of between 6.5% and 8%, while total losses are 0.4% of the sums loaned, or 0.06% a year.

CEPB chose ASL as the provider because it has a substantial in-house capability for assessing companies’ abilities to pay interest and repay loans. Its debt analysis covers 40 or so key metrics, from labour relations to long-term profit projections.

In the process of making the investment, the CEPB met ASL twice in the US and a considerable number of times in the UK. 

Church of England Pensions Board

Church of England Pensions Board

“Our investment consultant was also interested in them for a fiduciary product it was developing, so we received a full assessment of the firm’s investment and operational capabilities,” says Jameson. “We looked at other managers lending privately in other markets, but could not find the right combination of good managers, attention to ethical investment principles and investment opportunity.”

The CEPB’s loans are generally to small and medium-sized, privately owned companies in the US, with earnings before interest, taxes, depreciation and amortisation (EBITDA) of under $50m (€45m) a year. 

Most loans are to fund intergenerational wealth transfers within families or from one generation of management team to the next within a company, allowing existing owners to withdraw equity without creating an impossible financial burden for their successors. The companies are backed by private-equity investors and are mature, cash-generative and entirely conventional businesses. 

The CEPB’s portfolio contains only first lien loans and does not apply leverage in the portfolio.

ASL has a long track record in managing funds for faith investors and public pension plans in the US and is fully understanding of the CEPB’s ethical requirements. The manager double-checks with the CEPB before making any loans that might be a problem.

The CEPB chose to employ a complex segregated-account approach, rather than the simpler option of investing in a pooled fund, so it would have control over the types of business it lends to. It has a segregated account with ASL and needed to have this owned through a fund of one structure. It chose to establish a UK-registered general partner to be the owner of its investment, to be completely transparent. 

Partly because of this complexity, it took over two years from the initial meeting with ASL to the start of investing. “What I learned – and what surprised me – was the time it took to decide the right ownership structure for the investment, and then to establish it,” says Jameson. “The CEPB had no experience in these areas so it was all new to us, but we were helped enormously by our legal advisers at Osborne Clarke.”

The CEPB’s in-house team is made up of three investment staff, supported by external investment consultant advice from Mercer, ethical investment advice from the Church’s Ethical Investment Advisory Group and internal tax and accounting support. The CEPB also uses 16 external fund managers. 

Within the CEPB, there is no investment team dedicated to private debt. Audax manages the allocation and reports formally each quarter to the CEPB.

Overall, 45% of assets are in the UK, 10% in Europe, 33% in North America, and 9% in Asia Pacific. However, currency hedges raise the exposure to sterling to about 64%.

The ASL investment forms part of the CEPB’s growth assets portfolio, sitting in the allocation to “growth fixed income”. This is because the overall return is equity-like in its scale, but without the volatility of equities.

Growth fixed income also includes investment in emerging market sovereign debt, and has a target allocation of 8% of the return-seeking pool. 

Jameson says: “We want to increase the illiquidity of our investments, believing there is a premium to be earned from that. Handily, private loans offer medium illiquidity, somewhere between infrastructure – at the longer end – and property, in the short to medium region. The loans are held until maturity, as there is no secondary market for them, and typically the loans are redeemed in four years, even though the terms are typically between five and seven.”

The investment is expected to deliver stable returns of about 7% a year. This compares with a 2.5% return over 2015 for the return-seeking pool, and 2% for the portfolio as a whole, and 9.1% a year for total assets over the three years to the end of 2015.

“The loans are not mark-to-market, as there is no market as such for them, but they are reassessed quarterly based on the fortunes of the borrower’s business,” says Jameson. “The variation in valuation is therefore realistic, unlike the pricing of assets that have to rely on volatile public markets to provide their valuations.”

There are as yet no plans to increase the allocation to private debt.