PPF’s Bhudia on managing the up and downside of private credit

The UK’s Pension Protection Fund was set up in April 2005 to provide defined benefit pension holders with a last line of defence in the event of a pension fund not being able to meet its obligations

The PPF is a statutory body, independently funded through levies on eligible pension schemes, returns on the investments it manages, assets that have been transferred to it, and assets recovered from failed schemes and companies. The organisation has more than £32 billion ($41 billion, €37 billion) of assets under management and a membership of more than 250,000. It protects close to 11 million people belonging to defined benefit pension schemes in the UK.

The PPF takes on mature and less mature schemes and its investment book has therefore been built with two aims: to meet the requirements of existing cash pension holders, including the hedging of interest risk exposure; and to generate total returns for current and future schemes and assessments. The PPF views private debt differently within the context of these objectives.

PDI spoke to Purna Bhudia, head of credit at the PPF, whose team invests primarily in longer dated, fixed interest rate-like assets to support the interest rate hedging of liabilities.

What’s the story of the PPF’s engagement with private debt so far?

The PPF has long invested in private debt to support our total return objectives, but in 2014, a project was instigated to consider private investment-grade debt assets
to assist the hedging of our pension liabilities against interest rate movements. We initiated contact with managers in 2015 and built an externally managed portfolio.

In 2017, the PPF initiated a plan to have an insourced credit function to sit alongside a manager-directed portfolio. In September 2018, we insourced our public credit investment capacity, building out the team. A small portfolio of public bonds externally held with our managers was brought in-house. We now have over £1 billion of public bonds that run alongside circa £3 billion of private debt assets within the hedging credit portfolio.

Given market conditions, how is the current strategy being shaped?

At the PPF, we are agnostic in terms of private or public debt exposures in our investment approach. Both public and private assets support our long-term liability hedge objectives and, as such, are run side by side in a seamless process.

This approach allows us to optimise net risk-adjusted returns, particularly in sectors such as housing associations, universities and utilities that span both public and private markets. In these sectors we look to invest in the best risk-adjusted post-fee opportunities. By spanning both markets, but operating seamlessly, we have expanded our investment universe such that we can diversify our holdings across a broader range of sectors while better managing total sector and rating risk exposures.

Because of our unique set-up, when we asset allocate to public versus private debt, we look at risk-adjusted return such that at any point in time we can assess whether the private or public market asset offers value.

There are areas of the private markets that have become stretched as investment appetite for private assets has outgrown supply. At the PPF, we remain value conscious. Indeed, we may still invest in areas that may feel tight if it optimises the risk returns of the book as a whole. Maintaining appropriate sector diversity and rating breadth is as important as single asset values in generating the long-term returns.

The strategy also allows us to quickly deploy funds in the public markets where market volatility presents opportunities. Similarly, we can deploy funds in private markets if we identify a particularly attractive asset. In either case we are not hamstrung by asset allocation decisions made under differing market conditions. We have a responsive iterative process where we can constantly assess where we are best placed to invest in assets to meet long-term returns.

What are the biggest challenges today?

One of the biggest challenges is generating appropriate value and maintaining investment discipline in a low interest rate environment where there is an ever-increasing appetite for fixed-income securities. We look to keep true to a long-term perspective and having the discipline to step back if the risk-adjusted returns are insufficient. We stand by a solid governance ethos. The objective of the HAIL portfolio (illiquid assets with hedging properties) is to support the payments to pensions and, as such, it remains focused on a sound and solid investment rationale.

We also look to be nimble. Market dynamics can rapidly change. For example, recent changes at the Public Works Loan Board will fundamentally change council appetite for debt. Our structure allows us to be dynamic while maintaining a strong governance framework. We are able to move fast and we can either deploy directly or utilise the expertise of our external managers.

How we deploy money is quite different from models commonly found in the market. We see our managers as strategic partners and work closely with them. From March 2020 we’re building out our own internal capacity to selectively invest in private debt where we have the skillset. However, we will continue to invest with managers that have greater depth of skills and resources.

There has to be a humble honesty in recognising our capabilities. Our managers are better resourced to understand more complex debt structures. And while insourcing can save fees, this comes as a fixed-cost resourcing expense. We fully appreciate that the upside in credit returns is capped while the downside on default can be substantial. It is important to invest correctly. Getting it wrong is costly and can offset any fee savings.

What kinds of strategies do your objectives steer you towards?

Anything that you can think of in an investment-grade sterling book. We have everything from housing associations, infrastructure, wind, solar, ports, the full range of public debt, universities and student accommodation. We invest in hybrid lease structures and swap repacks. It is a broad spectrum. We don’t have a crystal ball to see how the world is going to be in 20 years’ time, and this investing in a wide range of assets to maintain diversity is paramount.

What makes the PPF distinctive within the LP universe?

I cannot speak for other LPs and what they’re thinking but I can share thoughts on how I see the PPF. A standard defined benefit corporate pension scheme has the backstop of the parent company behind it. In the end, if the pension scheme loses money, there is the capacity to call on the parent entity to meet any shortfalls with additional contributions. At the PPF we are the last line of defence without that additional support. This remains in the back and the front of our minds when we invest. We have a clear objective with a risk and return target setting for our different asset classes. Within the HAIL portfolio, the objective is to provide long-term stable investment returns from fixed-income assets.

ESG is a focus across all assets but particularly the HAIL book, given its long-term holding structure. While many people look at ESG in certain social respects, I also see it as a fundamental investment proposition. Environmental and social preferences are already shaping consumer appetite and behaviours. The ‘G’ in ESG, which stands for governance, is also fundamentally important. Good governance is core to our investment philosophy and to us that means good governance within the PPF, at our managers, and within the entities we invest in.

We have illiquid private debt instruments that span decades. The world is changing rapidly. We have to retain a long-term outlook beyond immediate returns and profit targets. Within our long-dated private debt structures we are always cognisant of the protections in place should things evolve unexpectedly, whether it is amortising structure, security, covenant structures that ensure loss protection or other defences and support mechanisms available to the industry.

We consider future visibility as well as backward understanding of a credit. For example, when we have assessed the impact of potential changes to the retail price index on our assets, we have to not only consider the return implications but also the impact it may have on the credit risk investment in terms of revenue streams and matching of income to debt payments. When we invest, we aim to objectively and honestly assess the actual exposures we face so that we can deal with them. It is a balancing act. We recognise that being over-cautious or over-zealous both result in sub-optimal returns.

Does internalisation help as you have more control over ESG?

I would say we have a very strong collaborative dialogue with our managers and we choose them because they have the same mindset as us and are very focused on the ESG aspect. Our head of ESG over the last year has been working on enhancing our ESG framework. We work very closely with her on all aspects.

When people look at ESG they often forget the ‘G’ aspect. We have declined to participate in investment opportunities where the governance structure has not looked appropriate, been defined well or where incentives haven’t been aligned. It’s not just about the environment or social ethics. There are sound fundamental reasons why, from a governance perspective, you wouldn’t want to take things forward. An entity is only as strong as the management and governance structures behind it.

From March 2020 onwards, with the move towards internalisation, what happens to the external relationships?

It’s not a new model, but an enhanced model. We do not invest externally where the post-fee returns do not justify externally managed investment. By insourcing we are expanding our opportunity set to include these assets. It’s not a detracting strategy, but an enhancing strategy. Whatever we do is to expand the investment universe to maximise post-fee returns.

We have invested time in our manager relationships and have a lot of respect for what our managers do. They recognise our end duty to maximise net risk-adjusted returns after fees for our long-term stakeholders. We believe our managers have a lot of skill and depth, not only originating assets but managing them on a forward-going basis. The model with our managers works. However, we do want to expand the universe of opportunities that we have.

How do you factor in unpredictable aspects such as regulation or politics?

We cannot foresee or mitigate for every negative event. However, we can ensure that appropriate protections are in place for the assets that we invest in. For public assets there is always the opportunity to mitigate loss by trading the asset. For private assets we look for additional protections with the structure. We can invest in shorter maturity profiles where there is limited visibility or structural protections. Even in deteriorating sectors there can be opportunities, for example by investing in the best-in-class or well-funded entities or debt structures that can weather change. Diversity is also key.

I cannot ensure that every asset I buy today will perform as expected. Downgrades are inevitable. Moody’s transition rates indicate that circa 4 percent of single A entities will fall to sub-investment grade over a five-year period. In private debt structures we are often investing for 20 years. However, in a diversified, well-managed portfolio these risks are balanced to protect total long-term returns.

Our goal is to build a holistic book involving layering risks, whether it is the ratings, maturity, sector or geography. It is also knowing what risk exposures we have and what protection mechanisms are or can be put in place. It is assessing a single asset and its contribution to the strength of the portfolio as a whole.

We have a strong team at the PPF that undertakes continuous forward-looking risk assessment. It’s a long-term outlook which every asset manager should have when they’re buying into this asset class. Given the nature of the PPF and how we have evolved as an organisation, we’re very conscious of believing in and holding true to the needs of our stakeholders.