Arizona State Retirement System’s credit portfolio has added almost $1 billion of excess value to the pension plan’s total fund over the past decade by outperforming its benchmark: the Standard & Poor’s/Loan Syndications and Trading Association’s Leveraged Loan Index, plus 2.5 percent. That $1 billion is more than a fifth of the $4.78 billion of value the retirement plan has added from outperforming its total portfolio benchmark over the same period.

With a 20 percent allocation to private credit – including direct lending, distressed debt and other speciality strategies such as litigation finance – the retirement plan stands apart, even from many of the asset class’s most enthusiastic backers. Early adopters of private debt may have big credit books, but the magnitude of Arizona’s target for the asset class puts it in a different league from most investors.

“If you look at state pension systems, right now about one-third have private debt allocations,” says Steve Nesbitt, chief executive of LP advisory firm Cliffwater. “Of the third that do have it, the average target allocation is 6 percent.”

So, how did a south-western US pension quietly become a dominant force in private credit?

The more than $41 billion fund is the 83rd largest public pension plan in the world. It might not dominate financial news headlines in the manner of California’s two largest pension plans – the California Public Employees’ Retirement System and the California State Teachers’ Retirement System – but ASRS planned the scaling of its private debt allocation in a short timeframe.

The secret? Large fund of one partnerships. This approach allowed credit to take a central role in ASRS’s portfolio and helped it embrace more arcane strategies, such as aircraft leasing.

“It goes back to the genesis of when we got into private debt,” says ASRS’s senior fixed-income portfolio manager, Al Alaimo of the programme, which started in fiscal year 2012 with a 3 percent allocation. “[Chief investment officer] Karl [Polen] and I worked on it jointly together. As we delved into the asset class, we felt the risk-adjusted return in private debt was much more attractive than most other asset classes out there.

“So, we wanted to have the ability to scale up and go well above and beyond the 3 percent target, and we partnered with top managers to do that. That really allowed us to go overweight in the asset class.  Over the next several years, we increased the target to 10 percent and then 12 percent of the total fund.  We now have about 13 percent invested in private debt.”

Big cheques

Consider the $1.2 billion direct lending account with Cerberus Capital Management, which focuses on US private equity-backed mid-market transactions. Initially a $400 million commitment in 2012, ASRS has tripled it in size to a level larger than many commingled private credit vehicles. Furthermore, Cerberus has the ability to lever the fund up to approximately 1.5x the fund’s equity. ASRS also put $500 million with the credit manager to invest in European non-performing loans.

In addition to Cerberus, other large allocations have gone to Ares Management, HPS Investment Partners and Monroe Capital.

Such accounts allow ASRS to not just scale its credit programme but also give the pension much more bargaining power on fees. “Commingled funds cost just below 3 percent of net assets – about 3 percent, maybe a little less,” Nesbitt says. “If you do a separately managed account, you can do significantly better than that, but it depends on the strategy and the manager.”

The pension looks for three separate capabilities in the managers it works with: a dedicated deal-sourcing network, rigorous credit underwriting, and in-house portfolio management and workout capabilities.

“All of that seems fairly obvious,” Polen says. “You’d want all those capabilities. But then as soon as you say, ‘you have to have all three of these and you’re not outsourcing stuff’, it thins out pretty fast in terms of who can meet all those requirements.”

Among the three necessities runs a common theme: a manager’s ability to independently assess and tackle transactions and difficult situations.

Polen emphasises the importance of firms chasing their own transactions: “If they weren’t sourcing their own deals, if they were taking pieces of other people’s deals, [the deals the managers were looking at] were going to be picked over and not be as good.”

Touching on underwriting and having a “well-developed credit discipline”, he says ASRS’s GPs have had to do their own legwork: “Depending on the context, they had to have people that covered industries or regions or whatever, so that they were not relying on other people to do underwriting or not just reading packages but they were doing independent research in credit.”

ASRS’s philosophy has been echoed in multiple in-house surveys of limited partners, including PDI Perspectives 2019 and 2020. Last year, 92 percent of respondents said the size of a GP’s team and its investment capacity formed “a major part” of the due diligence process. This year, the proportion was 88 percent.

Also critical is a manager’s track record. In the 2019 survey, 98 percent of respondents said it formed a major part of the process, while in 2020 the figure was 93 percent. And with that comes the importance of operating through cycles.

“We looked at their performance through the cycle and how well their portfolios held up and what their loss ratios were [as] a pretty key test, in terms of how we thought about it,” Polen says.

Monroe Capital chief executive Ted Koenig says the pension has been a trailblazer in private credit.

“They were one of the early adopters of the product and they have been increasing their allocation to the asset class over the last five years,” he says. “Many of the other state pensions have followed the Arizona plan in how they are creating portfolios, picking managers and building out asset classes.”

Returns get real

The firm’s large allocation to real estate, also a 20 percent target, has produced similarly positive results. This asset class has added almost $940 million in value beyond its benchmark over a 10-year period. Although results across real estate and credit have both added substantial value, ASRS’s approaches to the two asset classes are distinct.

“From a credit standpoint, we’re diversified in the portfolio,” Polen says. “Once we find a manager that we have confidence in, [and know] they can do a good job, we’re not checking the underwriting on any individual assets that we end up invested in.

“It’s completely the opposite in real estate. We’re the only owner of that property. While we have thousands of positions in credit, we own between 100 and 150 properties that make up our real estate portfolio. So, we are doing our own underwriting on each and every asset that we buy. We do annual property reviews, we re-underwrite everything every year, and we’re very hands-on with the operations of our real estate assets. So, it’s a completely different approach in real estate.”

In September, ASRS and Tricon Capital Group set up a joint venture, with the former committing $400 million and the latter allocating $50 million. The partnership will invest in single-family build-to-rent communities in the US Sun Belt region, of which Arizona is a part.

Some LPs have taken this tack within their credit portfolios. The South Carolina Retirement System and Barings BDC entered into a $550 million JV for corporate and real estate debt, with $500 million coming from the pension and $50 million from the Charlotte-based firm.

The University of California Board of Regents took a similar approach. It partnered with Owl Rock Capital Partners to invest in senior secured loans in mid-market companies or the broadly syndicated market. Previously, it had a similar partnership with Goldman Sachs BDC.

In 2011, the pension had a 5 percent allocation to real estate, totalling $1.4 billion, of which just $9 million went to direct investments, sister publication PERE reported. Since then, real estate has made up a larger portion of its portfolio almost every year.

When alternatives go mainstream

The plan considers credit and real estate to be “foundation” asset classes rather than alternative asset allocations. The two are core categories for ASRS’s portfolio and each has a target allocation of 20 percent.

However, many of the investments in those two categories are currently to alternative strategies, such as mid-market lending, or are direct investments. ASRS maintains an effective target limit of 10 percent for private equity, which is the allocation’s current level. In addition, ASRS had 17.8 percent of its portfolio in credit and 14.6 percent in real estate.

Many LPs have upped the ante in private equity, leaving alternative credit a rather small part of their books comparably. ASRS has taken a different track. “The private equity programme, that’s probably where we are most passive,” Polen says. “We don’t have the scale to implement a direct [programme]. What I described in real estate essentially is a direct investing programme.

“[Private equity] is the one category where we do invest in commingled funds. Essentially everything in credit – 80 to 90 percent of it – is separate accounts where we have special rights, including liquidity rights, and really everything in real estate is the same – all set up through separate accounts to implement a direct investing programme.”

Nesbitt says there are two approaches institutional investors can adopt when it comes to including private credit in a portfolio: “One is opportunistic: they view it as an alternative to private equity. The second approach is as a less liquid but higher-yielding fixed income. If it can earn 6-10 percent with yield [in this low interest rate environment], that sounds like a pretty good trade.”

ASRS’s credit portfolio can, in theory, be public or private. However, the pension fund’s benchmark pushes it into higher-returning mid-market lending and other niche debt strategies.

“Our benchmark for the credit asset class is the S&P/LSTA Leveraged Loan Index, which is the broad leveraged loan market, plus 2.5 percent,” Alaimo says. “So that rules out investing in the tradeable leveraged loan market. Based on our benchmark, it pretty much precludes public market credit strategies.”

The pension reduced its public market exposure – to high-yield bonds – in fiscal years 2018 and 2019, according to ASRS’s credit-implementation plan for fiscal year 2020. ASRS plans to up its credit allocation and be overweight in the asset class. It anticipates holding 21.1 percent of its book in credit in fiscal year 2020, 23.1 percent in fiscal 2021 and 24.5 percent in fiscal 2022.

The documents say that the fund hopes to achieve a 9-10 percent net return, including leverage – higher than the 7.5 percent target return. For the one- and three-year periods, the credit asset class generated returns of 9.1 percent and 10.2 percent respectively as of 31 March.

On a benchmark basis, the credit asset class outperformed the one-, three- and five-year periods by 3.5 percent, 2.1 percent and 3.1 percent respectively, also as of the first quarter’s end.

ASRS is among a minority of LPs whose credit portfolios have outperformed, according to the Perspectives 2020 investor survey. Only 20 percent of respondents said their debt investments had outperformed their benchmarks, 68 percent said their holdings had met the benchmark and 11 percent said they had fallen short.

Finding the niches

In addition to making a bet on credit, ASRS has embraced speciality finance strategies, particularly in recent months – a build-out that has come after the pension fund filled its corporate lending bucket.

“We thought [mid-market lending] was more the centre-of-the-fairway opportunity,” Alaimo says, “and over time we expanded it to include European lending and then we also filled out our US middle-market lending to take advantage of the lower middle market with a partnership with Monroe. We also added an asset-backed lending strategy that’s similar to asset-backed securities but done in the private market – that’s with Ares.”

With $1.8 billion in commitments, the bulk of the commitments in fiscal year 2019 have gone towards ‘other credit’, a sub-category that serves as a catch-all for things not absorbed in the private debt category. It includes US and European corporate credit, real estate- and asset-backed lending, distressed debt and high yield investments (when the pension fund holds such positions).

“So basically, we tried to replicate what we could do in the public markets but in the private world, with much higher returns,” Alaimo says. “And that’s how we’ve approached it: replicate public market credit risk but do it in the private market with superior due diligence, superior covenants and superior returns.”

In the eyes of its managers, ASRS’s approach has paid off. “Arizona is probably one of the most knowledgeable and forward-thinking credit investors I’ve ever met,” says LCM Partners chief executive Paul Burdell. The pension committed $350 million in 2016 for the London-based GP to invest in pools of small European performing and non-performing loans sold by the continent’s banks and other financial firms.

“The width of their knowledge isn’t limited to just sponsored loans,” he continues. “Because they know the broader subject backwards and forwards, it provides them with the capability to look at a new credit strategy in a relatively short period and understand it almost as much as the GP. That gives them an edge in managing assets for their pensioners and in how they develop their relationships with GPs.”

When it came to expanding into new strategies, ASRS looked at several factors, Alaimo explains.

“We wanted to see, one, if there was a real investment opportunity that could generate double-digit returns,” he says, “and that the manager we would be partnering with had some competitive advantage that would allow them to pursue that strategy. So then, based on that, we would assess the robustness of the opportunity. Could we deploy capital in the size we want and generate these types of returns? Could we build a diversified portfolio within that asset class?”

That said, it’s tough luck for up-and-coming credit managers that are not already part of the ASRS programme and are hoping to win a commitment.

The credit implementation plan for fiscal year 2020 notes that the pension does not plan on adding any new strategies; rather, it plans to scale its accounts with existing managers.

They will have to hope that other pensions take a leaf out of ASRS’s book in its enthusiastic embrace of private debt.

On the lookout for something different

Backing DWS’s infrastructure strategy was one example of Arizona’s willingness to diversify. “It’s another situation where they knew we were active in private credit, came to us early on and we moved on it quickly,” says Alaimo. “We had been looking at the infrastructure space off and on for the past couple of years but had not seen a compelling opportunity until DWS came along.”

The litigation finance commitment to Melody Capital Partners, which closed in August and is expected to return 15 percent, came as that strategy was gaining steam.

“It’s a very high-return asset class and not correlated at all to the economy,” he says. “We were one of the first investors they came to. It fitted exactly into what we were looking for, which was: high return, low correlation [to US financial markets], and so we quickly moved on investing in that strategy in size, and we became the majority-control investor of that company through a fund structure.”