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February 08, 2021 12:00 AM

Asset owners turn to private credit in quest for returns

Top funds nearly double their allocations to asset class despite high risk potential

Arleen Jacobius
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    Nimisha Srivastava
    Nimisha Srivastava said manager selection will be very important to earning the desperately needed yield.

    U.S. institutional investors are betting big that private credit will provide much-needed yield and an illiquidity premium to public debt, with assets nearly doubling in the year ended Sept. 30.

    Private credit assets of the largest 200 U.S. retirement plans nearly doubled, up 93.1% to $50.2 billion in the year ended Sept. 30. It is also a 212% increase from 2018, when Pensions & Investments first included private credit in its annual survey of the largest retirement plans.

    During the survey period, several defined benefit plans added or increased their private credit allocations, including:

    • $226.4 billion New York State Common Retirement Fund, Albany, with a new 4% allocation added in April.
    • $58.7 billion Pennsylvania Public School Employees' Retirement System, Harrisburg, increased credit-related fixed income to 12% from 10%.
    • $25.3 billion Los Angeles Fire & Police Pensions, which added a 2% allocation in August.
    • $15.2 billion Ohio School Employees Retirement System, Columbus, which added a 5% allocation in February 2020.

    The New York State Common Fund's new 4% private credit allocation is not without risk. "An elevated default cycle may certainly dampen return expectations, though it will also increase opportunities for some of our investment partners with dry powder," Matthew Sweeney, spokesman, said in an email.

    There's also a risk from so much capital moving into private credit. "While overcrowding in an investment strategy is always a concern, the growth in the private credit space is largely due to the pullback from commercial banks and other lending providers since the (global financial crisis)," Mr. Sweeney added. To mitigate against the risks, New York State Common officials are continuing to be mindful in their due diligence, promising new investment ideas while monitoring existing partnerships, he said.

    "In general, we want to understand the risks we are taking, while attempting to eliminate the surprises," Mr. Sweeney said.

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    As asset owners ramp up their exposure to private credit, they also need to be careful because if defaults climb or demand for loans decline, their portfolios could be negatively affected, industry insiders say.

    "Manager selection will be key in making sure investors achieve good private credit outcomes, particularly given the fund horizon means locking up capital for five to seven years," said Nimisha Srivastava, Chicago-based global head of credit, Willis Towers Watson PLC. "We believe manager dispersion (difference in outcomes) is likely to be greater going forward given the growth in strategies."

    Key attributes to consider are manager credit underwriting skills (an experienced and large enough team to properly analyze companies) and expertise in distress should company stress rise, she said. Investors should also ensure that the fund size corresponds to the opportunity set the manager is focused on (not being too aggressive with fund size to focus on attractive return on capital for investors), Ms. Srivastava added.

    Driving investors into private credit is not only the search for yield in a low-interest-rate environment but also returns in the form of a liquidity premium over bonds that exist right now, she said. "This is not always the case, but it is as wide as we have seen it."

    Compared to October 2019, when the illiquidity risk premium for U.S. direct lending was under 50 basis points, which is below its fair value range and therefore unattractive relative to its holding period and public market comparisons, WTW's current illiquidity risk premium for private credit is closer to 200 basis points, above the fair value range.

    There is a significant need for capital by middle-market companies undergoing economic stress as a result of the pandemic, she said.

    The pandemic accelerated "the ongoing secular rotation of debt capital to private capital providers away from banks," said Christopher G. Wright, managing director and head of private markets at credit manager Crescent Capital Group LP, which has about $29 billion in assets under management.

    "The growth in invested private credit dollars was also driven by low redemptions as well as increased borrowing (by companies) to meet liquidity needs, add-on acquisitions, and/or to fund growth initiatives," he said.

    What's more, prior to the beginning of the pandemic, "there had been a strong M&A market that had pushed leverage toward record levels," resulting in a need for private credit, said Christopher Taylor, head of New York Life Investments Alternatives and CEO of New York Life's $11.8 billion credit manager subsidiary, Madison Capital Funding LLC.

    Willis Towers Watson estimates the total size of all private debt including real assets, specialty finance, distress debt and longer lockup credit at about $1 trillion, which is comparable to the U.S. high-yield bond market that is about $1.2 trillion, Ms. Srivastava said.

    As more money is flooding into private credit, funds are getting bigger, she said.

    Private credit funds worldwide have been raising at least $100 billion per year since 2015, according to Preqin data. In 2020, 200 private credit funds raised $117.7 billion, 11% less than the record amount of capital raised in 2019, $132.1 billion by 223 private credit funds.

    "Big funds are tending to get bigger. We're seeing fund sizes increase and what that means for returns and how selective they (the managers) will be are questions we ask," Ms. Srivastava said.

    If a manager raises a larger fund, such as $3.5 billion instead of the $3 billion the manager raised for its last fund, the question is whether that credit manager will achieve the same risk-return profile, she said.

    "The bigger you get, the less selective you can be," she said.

    U.S. institutional investor interest in the asset class is undeterred, while being cognizant of the risks.

    CalPERS does not have a private credit allocation but officials are interested in investing more in the asset class along with other alternative investments. CalPERS is embarking on a new asset-liability review in 2021 that is expected to be completed in November. Pension fund officials are aiming to invest more capital into private credit along with other alternative investment asset classes to boost returns, Dan Bienvenue, interim CIO of the $426.2 billion California Public Employees' Retirement System, Sacramento, said at a stakeholders meeting on Jan. 21.

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    Higher return potential

    Private debt has higher expected returns than its publicly traded counterpart, Mr. Bienvenue said. But it is relatively illiquid and "requires expertise and it takes time to deploy" capital into the asset class, he said.

    While it doesn't have a dedicated private credit allocation, CalPERS made several investments — including a $2 billion commitment to West Street Strategic Solutions Fund I, a distressed debt fund managed by Goldman Sachs Group, and a $350 million commitment to Sixth Street Fundamental Strategies Partners (A), an opportunistic credit fund managed by Sixth Street Partners LLC — last year from its private equity portfolio. CalPERS had $604 million invested in private credit as of Sept. 30, this year's survey shows.

    The five asset owners on this year's list of the U.S. retirement plans with the largest private credit portfolios are $42.2 billion Arizona State Retirement System, with its portfolio up 7.3% to $8.7 billion in the top position; New York State Common, with $7 billion in private credit; $120.7 billion North Carolina Retirement Systems is No. 3, with credit assets up 8.2% to $6.2 billion; Pennsylvania Public School Employees is in the fourth spot with $5.2 billion; and the $180.2 billion Florida State Board of Administration is fifth with private credit assets up 7.1% to $3.6 billion.

    New York State Common officials expect private credit returns to be the result of a combination of income and capital appreciation, spokesman Mr. Sweeney said.

    The Ohio School Employees Retirement System's board added a private credit allocation "to increase yield-oriented returns compared to public fixed income," CIO Farouki Majeed said in an email. Private credit also provides returns in the form of quarterly cash distributions, he said.

    Ohio School Employees officials are not rushing into investments because they have more than three years to achieve the 5% target.

    "Capital deployment will depend on opportunities and risk," Mr. Majeed said.

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