Pensions make beeline for private debt

“People love cash,” to quote a grey-haired pension trustee talking about a new policy in the UK which allows pension scheme members over the age of 55 to cash-in on their overall pension pot. It will mean a lump sum for those who avail of the offer, as well as a tax bonus for the government in certain cases, but less money in the pot for those who subscribe in the long-run, he says.

Managers in a healthy funding position will be a little less nervous about a possible run on the coffers. But those already running deficits will have another factor to consider in their quest to balance the books. As part of that quest, UK pension fund managers are increasing their allocations to private debt. 

Three patterns are emerging in the way they are allocating. The first being the set-up of a specific allocation, the second through a separately managed account and the third directly, reflecting a general trend for disintermediation seen throughout global markets since the financial crisis.

Gregg Disdale, a senior advisor at Towers Watson, is seeing more pension fund managers set aside allocations specifically for private debt, but not to the same extent as private equity. “There is an increased desire for yield and it’s no surprise that fixed income allocations are increasingly looking [at] other levers to pull to increase returns, one of those is going up the risk curve, and the other is taking on greater illiquidity, and we are seeing both.”

Debt provides a natural hedge against interest rate rises as well as enhanced yields, whereas bonds and their equivalent lose value as the yield is fixed and the underlying spread is eroded. This is particularly true for the unitranche product at present, explains Callum Bell, from the corporate and acquisition finance team at Investec. That said, the asset class carries its own idiosyncratic risks due to the opaque nature of the market, he and others note.
Bell says: “Private debt is attractive as it offers floating-rate exposure and therefore carries an embedded hedge to inflation and rising interest rates.”

The data points to managers moving up the risk curve but also shows that they are seeking more return for that risk in recent months. According to S&P Capital IQ LCD, new-issue institutional spreads for new leveraged loans (spreads over the base rate for Term B and C loans) per unit of leverage hit a high post-crisis in the US in the third quarter of 2011 and steadily decreased until the second quarter of 2014 (see table). In tandem, leverage approached pre-crisis levels and technical conditions worsened, with retail funds experiencing heavy outflows and volatility in the oil and gas sector. Since then, investors have been getting higher spreads in response to the increased risk.

ROLE MODELS

As was first seen with sovereign wealth fund managers and pension fund managers in the US, separately managed accounts are also growing in popularity with UK pension fund managers.

“Outsourcing of the entire illiquid credit mandate to a single manager is to some extent being driven by a desire for a low governance solution, allowing an investor to access numerous asset classes through a single manager,” Disdale says.

The allocation method can also achieve lower fees in return for what typically is a very large mandate and big credit managers are the likely beneficiaries of this strategy. However, Disdale highlights some challenges with the separate account mandate: “The key questions in diligence for us would be whether a single manager can genuinely rotate the portfolio across different illiquid asset classes over-time, [in that] will it be spread out in pre-set allocations across different funds, and whether the manager is best in class in all the underlying components.”

In the US, the strategy was evidenced again in April with the Texas Teachers Retirement System creating two new $1 billion separately managed accounts for credit opportunities with existing mandate managers Apollo Global Management and KKR. The $129.9 billion public pension fund already has two managed accounts with the firms, established in 2011, now standing at $4 billion each and taking total allocations with the two up to $10 billion.

In the UK, the £4.9 billion London Pensions Fund Authority shortlisted the services of four managers – Apollo, Ares Management, Babson Capital and GSO Capital Partners – to manage a £100 to £150 million private debt mandate, based on their ability to invest in multiple strategies, and was assessing which manager or managers to work with at time of writing.

GOING DIRECT

A third approach has been apparent in the sovereign wealth fund and insurance company universe for some time: direct investment.

The £5.7 billion Lancashire County Pension Fund, which has a 30 percent allocation to credit, is one UK pension manager that has re-evaluated its credit investment strategy as a result of high bond prices and low yields, completely moving out and selling them all within the last two years. It has allocated to a variety of non-bond credit strategies, including private debt and direct lending, Trevor Castledine, deputy chief investment officer, tells PDI.

The allocation is split into four equally sized strategies: emerging markets, leveraged finance, real estate and credit opportunities. In real estate, it has provided £180 million of debt secured on social housing, in an off-market private deal. “We’ve joint ventured to create a housing association, who we have lent the money to ourselves,” Castledine explains.

In general, Castledine says he likes private lending secured on assets, including senior loans and senior and mezzanine loans or whole loans secured on prime real estate, which is “underbanked at the moment”, he says. “If you have the right origination capability I think you can get good value. We have invested in that globally,” he adds. 

Lancashire has also allocated to SME lending products. It committed €100 million in 2014 and another £150 million in 2015 and will happily commit more. Though he warns repeatedly that he believes private debt is a strategy that only those who really understand should invest in.

Half the allocation is liquid while the other half is illiquid. Having said that, Castledine would have no qualms about it all being illiquid as the fund has a separate bucket for holding liquid assets.

“Our investment decisions are not made by a judgement as to whether they are liquid or not. They are made by reference to what we think the risk-rewards characteristics are and how they fit our portfolio as a whole,” he says.
The switch to alternative credit strategies means that it made returns of more than 10 percent year-on-year last year, which will pay off in the long-term when compared to lower yielding bond investments, he says.

“I think we probably just about outperformed what we would have done had we been holding bonds. The bond index in theory did very well last year because of the drop in rates across the whole curve but not many bond managers actually managed to match that index because they positioned themselves with short duration. If you are holding bonds today, the expected yield on them for the rest of their lives is very, very low. The expected yield in our portfolio hasn’t dropped at all,” he says.

FEE TALKS HEIGHTEN

However, Castledine, a former structured finance banker who worked at Royal Bank of Scotland and Nomura, says he would be very sceptical about endorsing the private debt market as a whole. “You have to be extremely careful in selecting the strategy and the manager and negotiating very hard on the fees otherwise don’t get into something you don’t understand; there’s a lot of money to be lost in this space,” he says.

One area that poses particular consternation for him is shipping finance managed by private debt funds. As with other private debt strategies, he questions whether some people overseeing the funds have the correct grounding in the respective discipline. “I would be quite cautious generally that there is a lot of money being raised because its flavour of the month, and that a lot of that money is being raised by people whose interests, in my opinion, are not necessarily aligned with their investors and who are trying to charge fees that are simply not justified by the work they do or expertise that they are bringing to bear,” Castledine says.

Management fees range from around 75 basis points at the lower end of the risk spectrum to about 150 basis points at the higher end. Performance fees are typically lower than those seen in the private equity market, at around 10 to 15 percent. But as returns compress across the market, attention is also turning to performance fee catch-ups, where fund managers typically take all the outperformance after a preferred return, or soft hurdle. One source said that he believes that a hard hurdle should be in place so that investors are not paying fees on returns that could have been generated in public credit markets.

Questions around fee structures are just one reason why pension fund managers are keen to fully understand the asset class, as was recently highlighted by the move by LPFA to appoint Chris Rule as chief investment officer last year, formerly head of alternatives at SEB Investment Management, as well as its direct selection of a credit manager.

“The provision for both in-house and external management is essential,” a spokesman for LPFA tells PDI. “The understanding gleaned from in-house management; including understanding what it costs to deliver services, means much more effective negotiations can be had with external managers. The most effective funds seem to have scale to use in-house resources, but supplement this with intelligent partnerships and co-investments with genuinely good external managers,” he says.

Seeing more institutional investors get on board with the opportunities offered by private debt is great for the market. Equally heartening are the signs that investors are not all just piling in, they have an appreciation of the risks as well as the returns. In the long-run, building up in-house expertise is a far more sustainable approach for both investors and managers.