ASRS began making select investments in opportunistic credit in 2008 in the shadow of the global financial crisis to take advantage of dislocations.
The crisis was caused by the securitization of subprime mortgages that had nothing to do with corporate lending, Alaimo said, adding that the reaction of regulators was to take risk out of the banking system.
ASRS also added private debt as a strategic asset allocation in 2012 with a 3% target.
“When we delved into it and met the managers in the space and recognized the opportunity, we thought the risk-adjusted returns were very attractive and we decided to build up a much more aggressive allocation to the asset class, to direct lending,” Alaimo said, pointing out that the underlying driver was “banks being squeezed out of very attractive lending and other credit opportunities by regulators in the U.S. and Europe under the Basel framework.”
Their target grew to 10% in 2015, 12% in 2017 and then in 2018 the pension fund created an all-encompassing credit asset class with a 20% target.
In 2022, ASRS approved a new strategic asset allocation with a credit target of 23% and a range of 17%-26%. The total return target for credit is 9%-10% net of fees, he said.
The credit asset class annual returns totaled 9.8% inception-to-date for the period ended June 30, 2023, 9% over the one-year and 10.9% over the three-year period, according to a credit asset class implementation plan 2024 document.
Direct lending represented approximately 72% of the system's credit partnership commitments as of June 30. Another approximately 16% is in other credit and about 11% is in distressed debt. An investment committee document shows the pension fund's wide range of credit investments including smaller allocations to life settlements, aircraft leasing, litigation finance and maritime finance.
A fund-of-one approach
Arizona has a total investment staff of 13. For credit, it's Alaimo and one other staff member.
The pension fund's remaining allocations include public equity, its largest with a 44% target, followed by credit with a 23% target, real estate at 17%, private equity at 10%, and interest rate sensitive investments at 6%.
Alaimo worked in banking and as a research analyst of high yield bonds and then as an investment manager for a portfolio of high yield bonds, and he helped the pension fund build up a “substantial allocation of credit” that is “one of the highest of any pension funds, possibly in the world.”
The system works with consultants, such as Aksia, but only to confirm the pension fund's own due diligence, and it does not have a consultant advising on credit, he said.
The small staff has impacted how the retirement system has approached private credit.
“We form strategic fund-of-one partnerships with them (managers), and that’s allowed us to grow our allocation with the same manager and the same partnership. And it’s allowed us to be lean as an organization too, because we’re not trying to have 50 to 100 private debt managers in commingled funds,” he said. “We wouldn’t be able to execute with such a lean staff. We’ve deliberately chosen fund of ones. I think we were a pioneer in true fund of one partnerships.”
Fund-of-one structures are popular among pension funds, and can offer more customization, liquidity and lower fee terms, and faster redemptions.
ASRS first started creating fund of ones around 2013 when it was relatively new to many money managers, Alaimo said, adding that today approximately 95% of the actively invested private credit portfolio is in strategic fund-of-one partnerships.
The pension fund has also negotiated early termination rights with partnerships. Alaimo said a situation must be “extreme” to exercise the right, but it helps balance the relationship.
“If we have an early termination right, I assure you, we are a very important client to that investment manager that it equalizes the relationship, because we can terminate and whereas if you invest in a commingled fund, you can pretend you have some say, but you don’t,” he said.
Today, the system has 30 partnerships spread across 20 different investment managers. Of the 30, 16 are active strategies while 14 are out of the investment period and in liquidation, Alaimo said.
The system’s five largest private credit managers are HPS Investment Partners, Cerberus Capital Management, Ares Management, Monroe Capital and Related Fund Management, according to a June 26 investment committee document.
From initial meeting to finalizing legal documents, a private credit allocation typically takes six to nine months, Alaimo said.
ASRS has an assumed rate of return of 7% and Alaimo said private credit has helped the pension fund meet that over the last decade.
“We’re meeting our return targets, exceeding our return target for total fund with lower volatility through this credit asset class,” Alaimo said.
Room to grow
The most meaningful new partnership this year has been with AXA Investment Managers for $400 million in its significant risk transfer strategy. It’s an area Alaimo believes “is a very attractive asset class from a risk/return perspective." Basel III risk and capital requirements are "forcing banks to to exit certain lines of business, to sell assets, to sell risk. And we think, from a risk adjusted return standpoint, it's a very attractive market."
Other additions over the last 18 months have come from the pension fund adding to “existing select fund-of-one partnerships where we think there’s additional opportunity,” he said.
ASRS is a bit below its 23% target for private credit and with the rally in equities and growth of the total fund, Alaimo said the rally is conducive to increasing the private credit allocation into 2025 to keep pace.
The private credit market has rapidly grown to $1.7 trillion, according to data from Preqin.
“I think the market is going to continue to grow. You know, simply because the banks continue to be squeezed out of it from risk-based capital requirements,” Alaimo said.
With the growth, concerns and warnings from regulators have grown louder that the space warrants more scrutiny.
Alaimo said he thinks the concerns about risk in private credit are “overblown” and points to some manager partners that were investing in the market prior to the global financial crisis.
“There is evidence that they can handle severe stress,” he said. “They also went through a difficult period with COVID… and we saw how private credit managers were able to negotiate additional capital being put in by private equity sponsors, better covenants, higher fees in reaction to the stress caused in the individual credits in their portfolio.”
Over a 40-year career, Alaimo said the issues he has seen in private credit have been company specific.
“The primary issue with leveraged lending, where companies get in trouble, is not caused by the broader economic environment,” he said. “It’s caused by idiosyncratic risk at the individual company level, meaning a company got into its own trouble.”
