The promise of higher investment returns and risk reduction are the primary drivers behind the determined institutional push into alternative credit strategies.
“Private debt offers good recovery and very attractive risk-reward characteristics with low correlation,” said David J. Scudellari, senior vice president and head of principal debt and credit, PSP Investments, the brand name of the C$125.8 billion ($93.7 billion) Public Sector Pension Investment Board, Montreal.
Growing familiarity with alternative credit strategies enhances their appeal and has led to the gradual adoption of dedicated alternative credit allocations within institutional portfolios, especially by public pension plans, noted James M. O'Brien, senior managing partner, Napier Park Global Capital Ltd., New York.
Before the most recent financial crisis, institutional investors “didn't allocate to credit strategies; they just invested in fixed income and took on a lot of credit risk,” Mr. O'Brien said. “It was only when credit blew up (in 2008) that institutions began to take notice” as non-investment-grade securities became comparatively cheap.
Texas County & District Retirement System, Austin, committed $450 million to a direct lending strategy, part of an expansion of the $25.6 billion fund's allocation to the asset class.
The separately managed account will be run by Benefit Street Partners LLC in a “straightforward middle market direct lending strategy,” said Paul J. Williams, chief investment officer, in an email.
TCDRS trustees approved an increase in the allocation to direct lending to 10% from 5% with funding coming from the reduction of the hedge fund allocation to 20% from 25% at an April 6 meeting. Investment staff began consolidating managers and reducing the hedge fund portfolio late last year, a process that will continue, Mr. Williams said.
Mr. Williams said the fund likely will add one or two more direct lending managers for allocations of similar size. “We have been spending time getting to know the space and like the return profile. Attractive current income generation (is available) with minimal principal risk when you hire managers with demonstrated credit skills. That's why you see larger allocations to (a) small number of managers. It's also a good time to be in floating rate instruments,” he said.
As of Dec. 31, TCDRS had $462 million committed to or invested in eight direct lending strategies, a transaction report showed.
Institutional interest in alternative credit strategies perked up again during periods of credit market weakness in 2011, 2015 and early 2016 — and interest is high now, Napier Park's Mr. O'Brien said. “Many more investors have specific allocations to credit-spread and cash-flow strategies now and the demand you're seeing in 2017 is the result,” he said.
Napier Park managed $7.6 billion as of Feb. 28 in alternative credit.
The search for higher returns has been rewarding for asset owners: 27% of institutional investors surveyed in December said their private debt investments exceeded expectations last year, and 66% said their expectations were met, according to analysis from London-based market researcher Preqin.
Institutional investors accounted for 61% of private debt investors, with endowments and foundations representing 22% of the total number, followed by private pension funds, 16%; public pension funds, 14%; and insurance companies, 9%, Preqin data showed.
Most institutions — 57% — told Preqin they intend to increase their private debt investment in 2017, while 32% said they will invest as much as they did in 2016. Over the long term, 62% of survey respondents said they will increase their allocation to alternative credit and 30% said they will maintain their current allocation.