Public Pensions Gorge on Private Debt in Quest for Big ReturnsBy
Direct lending returns can exceed 10 percent with leverage
As money pours in, some managers warn of overheated market
Public pensions from Arizona to Ohio are seeking to boost their returns by shifting money into firms that extend loans to companies, plowing into an opaque, illiquid market that’s boomed as investors seek out higher-yielding assets.
The Arizona State Retirement System has invested $4.2 billion, more than 10 percent of its assets, with managers such as Cerberus Capital Management, Highbridge Capital Management and Ares Management. The nearly 600,000-member fund has garnered 10.8 percent returns and may invest as much as 15 percent of its assets in the sector, said chief investment officer Karl Polen.
The $15.7 billion Ohio Police and Fire Pension Fund has invested 1.5 percent of assets to funds that lend to middle market companies -- and plans to ramp up to as much as 5 percent. The loans have generated 11.5 percent returns, said executive director John Gallagher.
“All in all, we would prefer to pick up a good old U.S. Treasury bond and invest in that, but the returns aren’t there," said Gallagher, executive director of the Ohio Police and Fire Pension Fund. “The big thing is trying to invest higher in the overall capital structure to get as much protection as we can without sacrificing too much of the return."
Public pensions have latched onto private debt because it has so far yielded outsized returns with less risk than stocks. The median internal rate of return for private debt funds formed between 2005 and 2015 ranged from 7.4 percent to 11.9 percent, according to researcher Preqin Ltd. That’s more than the median, 6.8 percent annual return that U.S. pensions earned on their entire portfolios in the 10 years ending in March, according to the Wilshire Trust Universe Comparison Service.
Almost 250 U.S. retirement systems invest in private debt -- which includes direct lending to companies -- a 30 percent increase since 2015, according to the London-based firm.
Private debt firms raised a record $107 billion last year, according to Preqin.
“We’ve got an asset class that we think has attractive risk characteristics and helps achieve our target returns," said Polen, the investment chief for the Arizona fund. “If it got overheated, we would potentially cut back. We believe the managers we have are disciplined and wouldn’t make loans if they didn’t make sense."
Direct lending to small and mid-size companies isn’t new, but it has exploded after the financial crisis. Stiffer regulations, including limits on leverage and higher reserve requirements, led banks to retreat from commercial lending. Private investment funds stepped in to fill the void.
Direct loans, which often have terms of three to five years, are predominantly floating rate, making them attractive to investors if interest rates rise. Many funds use leverage to boost returns.
As the private credit industry has grown, so have warnings that lending standards are falling and that competition will erode returns. Almost half of private debt managers surveyed by Preqin in November 2017 said lofty valuations would be the key challenge facing the industry in 2018.
“The way the direct lending business is developing is somewhat scary right now,” Bob Kricheff, portfolio manager and global strategist at Shenkman Capital Management Inc., said at last month’s Milken conference in Beverly Hills, California. “If you have a moldy piece of meat and close the fridge door it’s still going to be bad -- you just don’t see it.”
Arizona’s pension doesn’t invest in loans without financial covenants, protections that restrict borrowers from loading themselves up with debt or meeting periodic performance goals, said Polen. Managers it hires must have a long track record, a “big commitment” to credit analysis and their own monitoring and servicing operations. Arizona’s loan portfolio has "minimal" writedowns, he said.
Eighty percent of the Ohio Police and Pension fund’s loans are first lien, meaning the pension would be the first in line to get paid if a loan defaulted, Gallagher said.
“We’re not too big on covenant lite investments," he said.
— With assistance by Sally Bakewell