Friday letter: Pendulum swings

Fears of rising interest rates are sending US institutional investors away from traditional fixed income to other areas of credit, namely private funds. Even more significantly, they're shifting their focus from the US to Europe and Asia.

No one knows when exactly the Federal Reserve is going to raise rates, but it will of course happen eventually and many investors have already been positioning their portfolios to hedge accordingly.

At a presentation before Congress this week, Fed chairwoman Janet Yellen said she’s inclined to still keep rates near zero for now, but expects to raise them if the economy and jobless rate keep improving. The unemployment rate dropped to 6.1 percent in June from 7.5 percent at this time last year, according to reports from the US Labor Department, when expert estimates had predicted the rate wouldn’t hit 6 percent until late 2015.

Good news for US jobs seekers, but potentially bad news for bond returns. This is why many investors have been putting more money into other strategies for some time now. Some are notably raising allocations to private credit to boost returns.

The New Jersey Division of Investment recently boosted its targets to global opportunistic credit and credit hedge funds at the expense of traditional fixed income. The $77 billion pension fund already has some investments in private debt with major players like GSO, TPG and others.

The Alaska Permanent Fund also ploughed $750 million of its $52 billion into a separately managed account with Leon Black’s Apollo Global Management earlier this year. The money is to be invested across a range of Apollo’s private debt vehicles.

The $11.6 billion Orange County Employees Retirement System, meanwhile, has raised its target to what it calls diversified credit to 10 percent from 7 percent. The California pension also established a first-time $450 million direct lending program, for which it hired several investment managers targeting the US, Europe and Asia.

Several institutional investors and their consultants tell PDI that the time to invest in American private debt funds has come and gone, though, and that most US pensions are now looking to European and Asian credit funds to get more bang for their buck. To be sure, there are many managers out there raising money for European funds, including big names like Allianz, Apollo and Ares, but it remains to be seen which can garner the most investor interest.

There are no shortage of European or Asian managers looking to raise capital, but the challenge for LPs – even highly sophisticated ones like the larger US pension funds – will be identifying managers with the ability to deliver alpha in potentially less familiar (to the investor) markets. The success of some first time managers complicates matters further, for it's not simply a matter of backing the established heavyweights.

The savviest LPs will have the courage and judgment to allocate capital to the emerging European and Asian opportunities before their peers. It's often said that investors have long memories, but managers do too. Emerging managers, or established ones expanding into new geographies, will remember the support offered by investors should they successfully deploy capital and look to raise successor funds in the years to come. So to our investor readership: be bold, and grasp the opportunity before the moment passes!