It wasn’t long ago a direct lending fund could happily justify charging investors fees in the senior debt space. Making high single-digit returns took skill and expertise, after all. Today, however, the fees remain largely the same, but the returns are falling as more firms crowd into the market.
This contradiction has prompted some larger institutional investors to look at insourcing investment strategies. Among the latest is the Pension Protection Fund, a UK vehicle set up to protect members if their pension fund becomes insolvent.
In June, the £28 billion PPF said it would bring some of its private and public debt strategies in-house as it attempted to cut fees across the board from 0.54 percent to 0.43 percent. This is despite alternative credit achieving an 11.75 percent return, according to its latest accounts, making it the second-best performing strategy.
The move is more than just about savings. The fund says it sees “insourcing as a way of increasing our ability to meet the specific nuances of the PPF portfolio, rather than solely a cost-saving measure. As such, we will continue to look for opportunities but will only insource where we believe we can improve our performance compared to external fund managers”.
PPF is not alone in its strategy. A number of the larger Canadian pension funds have entered the infrastructure and real estate space as direct investors in recent years. Similar moves are now taking place in private debt. For example, the UK’s Universities Superannuation Scheme acquired a portfolio of €3 billion of loans made to private debt funds to kick-start its own lending platform in January.
Managed successfully, an institutional investor can keep more of the returns – but with any investment strategy there is no guarantee of success. The cost of building the necessary internal infrastructure is a large upfront burden and there is the more difficult proposition of establishing a reputation as a credible lender. Hiring talent may speed that up, but wage requests can quickly grow if staff are aware they are in high demand.
Beyond the benefits of better returns, there is the issue of control over what loans investors are being exposed to and greater transparency in due diligence procedures and servicing.
Fees are showing a general trend of coming down in the private debt space as managers acknowledge increased competition. But while returns are not looking so handsome, there is the expectation that this will change once we move past the latest stage of the credit cycle. The push to insource may be seen as a vote of confidence in the long-term future of an asset class that is still beset by questions about its longevity.