Private credit assets remained at high boil last year as investor interest in the asset class continued to heat up despite recovering bond yields.
But concerns are rising over how the asset class will fare in a downturn and whether borrowers will be able to continue paying higher rates and expectations that loss rates will mount.
Read more stories from P&I's Top 1,000 retirement plans survey on Feb. 12.
Defined benefit funds of the 200 largest U.S. retirement plans reported $126.2 billion in private credit assets as of Sept. 30, up 29% from the year before and up from just $16.1 billion five years ago.
The growth in private credit assets is more than double the 12.5% growth rate in the prior year's survey. But investors shouldn't count on this growth surge to continue much longer as the spark that fired up the asset class' rapid advancement could fade if bond yields hold, industry insiders said.
"Investors have been focused on income generation, and for a long time they weren't getting that from public markets, which led to the boom in the private credit market," said Karin Anderson, director, North America credit manager research at Willis Towers Watson. "Now that high yield and loans have better yields than they've had for a long time, some investors may have a harder time adding to private credit allocations because of the liquidity trade off."
Many investors are turning to middle-market direct lending as a complement to high yield and loans, Anderson said.
"There's a lot of demand because the investment time horizon is shorter compared with more opportunistic private credit strategies" such as venture capital direct lending and infrastructure credit, she said.
"Still, investors need patience because middle-market direct lending has a five- to seven-year time horizon," Anderson said.
Venture capital direct lending or infrastructure lending can have a 10- to 30-year outlook, she said. "You're going to be clipping a nice coupon but it's a much longer horizon for the return of capital," Anderson said.
Investors in this year's survey said they are continuing to shift assets to private credit for its current income, diversification from equity risk and higher expected returns.
Arizona State Retirement System, Phoenix, again tops the list of retirement plans with the most assets in private credit, with $12.1 billion, up 5.3% from the prior year. ASRS was an early adopter of private credit. Its board has been steadily increasing its target allocation, which is now 23% from 3% in 2012, said Paul Matson, executive director of the $50.7 billion pension fund. Currently, the pension fund is tactically overweight to its strategic allocation, he said. Private credit accounted for 23.9% of ASRS assets at the end of the third quarter.
"Our initial foray into this asset class was expected to be temporary, lasting only while the capital markets were in post-2008 turmoil," Matson said.
When the market turmoil subsided and new banking regulations that required banks to shore up their balance sheets took hold, pension fund executives decided to not only to keep its private credit allocation but to increase it due to the high rates of expected return, the limited interest-rate duration because of the loans' floating rates and the modest term of the underlying loans, among other reasons, he said. ASRS officials also invested in a "series of separate account structures that embed a significantly higher degree of liquidity, alignment of interest, with often evergreen structures," Matson said.
ASRS' expected return for the asset class is 9% to 10% over multiyear periods with modest volatility, he added.
Ranked second on P&I's list of private credit investors, CalPERS' private credit portfolio increased 41% in the 12-month period ending Sept. 30 to $10.8 billion. Officials at the $450.3 billion California Public Employees' Retirement System, Sacramento, attribute the increase in what it calls private debt to its 5% target allocation that it adopted on Nov. 15, 2021.
"Although early in its development, the private debt asset class is performing as expected in the current market environment," said James Scullary, CalPERS spokesman. "The focus for the portfolio is to continue to look for deployment opportunities with high-quality managers and issuers to benefit from the rate increase while avoiding default and/or losses."
For CalPERS, the role of its private debt asset class, like its other private market asset classes, is to boost its entire portfolio's risk-adjusted returns, Scullary said.
"Our general view is that private assets, as a whole, offer a greater return opportunity per unit of risk relative to the public markets, lower realized volatility and diversification that is critical to our portfolio."
CalPERS officials acknowledge that there are risks inherent in the private credit asset class. These risks include that the assets are below investment grade, illiquid, opaque and in a relatively new asset class, said Jean Hsu, managing investment director and CalPERS global head of private debt at the most recent private debt review in March.
"If you think about private debt, we are doing things which are not investment grade," Hsu said. "So they are supposed to have risk. They are supposed to have defaults."
It is up to investors to invest in ways that mitigate the probability of default by selecting managers that offer investment opportunities with a lower default risk and that have the internal capabilities to increase recoveries when issues arise, Hsu said. Another risk inherent in private credit is its lack of liquidity, she said.
"You cannot sell it. You have to work it through,"Hsu said. Private credit also lacks transparency. There is less statistical data that investors could use to model potential outcomes, she said.
Moreover, the private credit asset class has a shorter performance history, Hsu said. The majority of the private credit funds were created after the financial crisis during a "very, very benign credit cycle and credit environment," Hsu said.
To counterbalance this risk, CalPERS is looking for managers with longer credit histories, preferably before the global financial crisis, she said. In a downturn, manager performance will vary significantly, Hsu said.
"If there is a lot of money chasing this area (then) you will see spread compression and then you will see loosening of ... underwriting standards," Hsu said.
Interest rates are also a factor because private credit produces higher returns and yields when interest rates are rising because most of the loans are floating rate, Hsu said.
New York State Common Retirement Fund, Albany, ranks third among private credit investors with its portfolio increasing 21% to $10.2 billion during the survey period.
The increase was due to returns as well as new investments, said spokesman Matthew Sweeney. The $246.3 billion pension fund has had a 4% allocation to credit since 2020 when the credit allocation was added, he said.
Pension fund officials expect private credit to outperform its 6.8% actuarial return target "while maintaining a relatively low correlation to other asset classes outside of the traditional fixed-income markets," Sweeney said.
In New York State Common Retirement Fund's fiscal year ended March 31, the private credit portion of the pension fund's credit allocation produced a return of 3.5%, largely because of the floating rate nature of those loans, according to the fund's annual report. By comparison, over the fiscal year, liquid credit funds generated -7.6% due to the steep rise in interest rates that mostly impacted fixed-rate securities, such as high yield, the report said. The pension fund with one of the largest increases in private credit during the survey period was the $72.2 billion Los Angeles County Employees Retirement Association, Pasadena, Calif., whose $5.3 billion portfolio increased 57%.
The increase reflects the implementation of a change in strategic asset allocation in 2021 that boosted the illiquid credit allocation to 7% from 3%, said Vache Mahseredjian, principal investment officer, whose team is responsible for LACERA's private credit portfolio. At the same time, LACERA's target allocation to liquid credit was reduced to 4% from 9%.
The increased private credit allocation resulted in increased commitments to existing managers and the addition of new managers, which subsequently made capital calls, he said. For example, two existing managers, Napier Park Global Capital and Magnetar Capital, saw their mandates increased to $1 billion each from $800 million each over the 12 months ended Sept. 30, Mahseredjian said.
At LACERA, its private credit portfolio is designed to provide moderate levels of current income and total returns as well as to diversify equity risk, the dominant risk in its total portfolio, Mahseredjian said.
"Our objective is to have credit be the primary source of risk as opposed to interest rate risk," he said.
