A nuanced play

Pension fund interest in private debt is increasing. But just how are these institutional investors allocating?

Pension funds are making growing commitments to private debt strategies, PDI hears. In the UK, one of Europe’s most active private debt markets, pension fund managers are attracted to the risk-adjusted returns of the asset class, we’re told

It’s well-known that their brethren in the US are already allocating, but pension fund managers in the UK have been, shall we say, a little coyer. So PDI went to the National Association of Pension Funds’ annual investment conference in Edinburgh last week in search of clues that this might be changing.

With decreasing yields and increasing outgoings as pensioners live longer, how are pension fund managers going to meet future liabilities and are they considering private debt? Truth be told, they are considering many options, including invigorating their investment strategies.

Private debt is just one strategy to pique their interest, with key words like ‘infrastructure’ and ‘real assets’ frequently brought up during discussions too. ‘The Chinese are looking at UK infrastructure – why don’t we!’, to paraphrase one scheme manager in Edinburgh.

Amongst those to put their heads above the parapet in regards to private debt is local authority pension scheme the London Pensions Fund Authority (LPFA). It created a framework for procurement recently to secure the services of an alternative credit manager, a route not typically traversed by public pension funds when allocating to private debt.

Four managers – Apollo Global Management, Ares Management, Babson Capital and GSO Capital Partners – have been shortlisted to co-manage the LPFA’s £100 million to £150 million mandate.

Making the grade is quite a coup for these four managers given that within the new framework all 99 of Britain’s local authority pension fund plans affiliated via the Local Government Pension Scheme and overseeing roughly £180 billion (€249.2 billion; $267.4 billion) can appoint any of them to manage segregated accounts during the next three years. Whether they will or not remains to be seen, but the LPFA is expected to pick at least one by the end of March.

The chosen four have made it as a result of the multiple vertical strategies they offer, LPFA chief investment officer, Chris Rule said. And an impetus for investment from LPFA’s perspective is to learn more about the private credit asset class, he added.

This is food for thought, as it appears to confirm that pension fund managers are getting more hands on with their funds. The UK industry-backed Pensions Infrastructure Platform (PIP), which will invest £1 billion in UK infrastructure assets including debt, is another good example of this.

Many pension fund managers are familiar with private debt in the original sense – mezzanine and distressed strategies. But direct lending, particularly to corporates not backed by private equity sponsors, is a new idea. Direct lending falls somewhere in the middle of the private debt returns scale, between infrastructure on the lower end and more opportunistic investments at the higher, Gregg Disdale, senior investment consultant at pension advisor Towers Watson, explained to PDI.

How pension funds allocate depends on their specific circumstances. Some corporate pension schemes running large deficits are allocating to private debt, as they seek better returns on a risk-adjusted basis, PDI understands. The opportunity to gain exposure to lending in a region where banks are restricted is very compelling, as are the returns.

But far from reducing exposure to the low yielding public markets completely, at most a UK pension fund manager might make a new allocation of around 5 percent to the asset class, coming from both their credit and private equity allocations.

As always, illiquidity is an important factor for pension fund managers to get to grips with. It’s all about relative value. As Disdale puts it: “The critical question for us when assessing these ideas is are we being sufficiently compensated for locking up our capital. You need to believe you are being better paid per unit of risk versus other alternative credit investments.”

Surfacing data that will help UK pension fund trustees answer this question will ultimately decide how meaningful a role private debt will come to play in their portfolios.