Private credit – potential benefits

Private credit offers a range of potential benefits that make the asset class particularly well-suited to DB schemes as they approach their endgame.

• Additional yield - an ‘illiquidity premium’ compensates investors for the long-term, illiquid nature of the investments, with a pickup in spread relative to public corporate bonds.
• Contractual income – reliable cashflows can be matched to schemes’ future liabilities.
• Security – private credit offers higher recovery values than public market credit
• Diversification – private credit has low correlation with traditional asset classes, adding diversification via access to unique economic drivers.
• Inflation protection - areas such as infrastructure debt are increasingly providing opportunities to access inflation-linked contractual income.
• Environmental benefit - many private credit opportunities have clear environmental benefits, for example, infrastructure loans for wind farms and other renewable energy sources.

The extent to which a scheme can take advantage of these benefits by investing in private credit will depend on its specific liabilities and long-term target. Below, we discuss the role that private credit can play in DB endgame portfolios.

Background

The UK DB pension scheme landscape is changing. The vast majority of schemes are now closed to new entrants, and an increasing number are also closing to future accrual. As a result, DB pension schemes are maturing. As they do so, and their average funding position gradually improves, trustees and sponsoring employers are increasingly focusing on the ‘endgame’.

The endgame may be to buy out the scheme with an insurer, or to continue running the scheme with a self-sufficiency approach. Either way, as schemes approach their endgame, there is a shift in the investment strategy towards assets which provide contractual income. For example, this might involve a shift towards corporate bonds to match a scheme’s cashflow requirement, coupled with an LDI strategy to hedge residual interest rate and inflation risk.

There is a wide range of contractual income assets that can be used, each with different yields, liquidity and levels of risk. The assets selected within an endgame strategy will depend on the return requirement. A scheme that is better-funded will require a lower investment return, allowing it to invest in lower-risk assets such as government bonds and investment-grade corporate bonds. However, if additional returns are required, less liquid assets such as private credit can be incorporated. This would allow the scheme to take advantage of the illiquidity premium offered by this asset class, while still providing contractual cashflows to match future liability payments.

What do we mean by private credit?

Despite seeming relatively new, private credit is perhaps the longest-standing asset class as, at its core, it involves money being lent directly to a borrower. The table below provides some examples of private credit asset classes.

Why private credit for endgame portfolios?

Illiquidity premium

The illiquidity of private markets gives rise to the concept of an ‘illiquidity premium’. This means investors can expect a higher return from private market debt than public corporate bonds to compensate for being unable to readily exit a position. This differs from public bonds where a secondary market is available and therefore liquidity is better. Illiquidity premia tend to vary across the rating spectrum. The yield pick-up achievable on AAA credit is typically smaller than that on BBB rated debt instruments.

For DB endgame portfolios, the extent to which a scheme can take advantage of illiquidity premia will depend on its specific liabilities and long-term target.

If a scheme is targeting buyout with an insurance company within a fixed period, say 10 years, then it may not be appropriate to invest in illiquid assets maturing beyond this period. There is a risk the scheme will be unable to buyout if it cannot sell its illiquid assets (insurers are generally unwilling to take on private credit holdings from a pension scheme). However, these schemes can still invest in private credit assets with shorter maturities to take advantage of illiquidity premium in the period up to buyout.

Another consideration is the level of uncertainty in the liabilities. For schemes with a significant deferred population there may be material uncertainty due to transfer-value activity and other options on retirement. A scheme should ensure there is sufficient liquidity within the overall asset portfolio to meet unexpected future cashflow requirements.

Long-term contractual income

Private credit investments such as infrastructure debt can be very long-term in nature (beyond 30 years in some instances), providing relatively stable and predictable income over a long time horizon. This can be attractive for pension schemes seeking long-term income to meet longer-dated liability cashflows. It reduces reinvestment risk associated with shorter-dated investments that will need to be reinvested in future credit (public or private) at uncertain yields.

Security/recovery rates

Endgame portfolios are constructed to be held for a long time. As such, careful attention should be paid to minimising the probability of default. Should a default occur, the aim is that assets will have a high recovery rate.

Given this objective and the current stage of the credit cycle, the higher recovery values of private debt investments versus public debt can make the asset class additionally attractive. Since private lenders have the opportunity to directly negotiate and structure the terms of the credit with the borrower, robust covenants are typically included in order to mitigate against perceived risks. This results in high levels of protection in the event of default.

Moreover, while the majority of issuance in the public bond markets is unsecured, private credit issues are mostly secured. To illustrate, on the public side, the ICE BofAML 10+ year BBB Sterling Corporate Excluding Subordinated Financials index consists of around 95% unsecured bond issuances. Conversely, private debt markets are almost entirely secured, with the exception of some corporate debt private placements which can come to market on an unsecured basis. Therefore, the amount of risk being taken in private debt investing is often lower than with public bonds, as there is often physical security – real bricks and mortar – standing behind each private investment.

This combination of security and a structure designed to protect the interests of debtholders means that, in the event of a default, recovery values for private assets tend to be much higher than those on the public market.

Diversification

It is generally well-understood that diversification within asset portfolios reduces risk. Private credit is generally less correlated to traditional markets, and offers access to unique economic drivers. Additionally, private credit gives access to smaller issuers or those who choose not to issue publicly, opening up different sectors and drivers. When considering whether a private credit instrument looks attractive, an investor should ask to what extent it enhances portfolio diversification.

Inflation protection

The vast majority of public corporate bonds do not provide any inflation protection so that schemes have to achieve their inflation protection solely through an LDI portfolio. Increasingly, however, some private credit assets such as infrastructure debt are providing opportunities to access inflation-linked contractual income. This can be a very attractive characteristic for pension schemes with significant inflation-linked liabilities.

Environmental benefit

Increasingly, trustees are focusing on environmental, social and governance (ESG) issues within their investment strategy. Due to the size of UK DB pension assets (circa £1.5 trillion), the investment decisions of trustees can have a significant impact on society. Although security of members’ benefits is the trustees’ primary objective, a secondary objective of having a positive impact on society and the planet is become increasingly important.

Private credit can play a key role in achieving this objective. Many private credit opportunities have clear environmental benefit, for example, loans to finance wind farms and other renewable energy sources.

Other considerations and risks

The asset manager requires a specific skillset

Private credit investments are typically illiquid and competition for deals in some areas is rising with investor demand. Extensive resources are needed to find, structure and monitor private assets, and a robust risk management framework is vital. Private debt strategies also take time to deploy, so an early start could be crucial in meeting investment outcomes.

The lack of a readily tradeable market for these investments reduces an investor’s ability to shift positions quickly. There is also the risk of operating in a less regulated environment. A focus on selective investing in well-structured transactions with sound credit fundamentals is the key determinant of success for private credit investing. As with all investment decisions, risks and benefits should be carefully weighed.

Consider a holistic approach

Today, as pension scheme investors look to take advantage of an increasing range of opportunities in private credit, allocations to separate investment ‘sleeves’ requiring oversight is becoming unmanageable. It also precludes the application of basic principles of good portfolio management.

Investors need to break down these ‘silos’ in order to ensure their overall portfolio is properly integrated and positioned to take advantage of evolving market conditions in each sector. This will ensure the portfolio is capitalising on the best opportunities at any given time, and efficiently delivering the primary benefits of private credit.

The argument for a more integrated approach to investing across a range of related sectors is even stronger for private credit than it is for public credit. First, investing in private credit requires direct origination of new loans (rather than acquiring assets in the secondary market). Gaining exposure can be ‘lumpy’ as the investor needs to work with the opportunity set available at the time. An integrated approach to investing across multiple sectors allows the investor to focus flexibly on those areas that are providing the most attractive relative value and loan flow at the time, and to pivot elsewhere as the environment changes.

The second reason pertains to tactical reallocations among sectors. In the public bond markets, a tactical reallocation among, for example, government bonds and corporate bonds could be easily executed, thanks to relatively liquid secondary markets. However, most areas of private credit essentially have no secondary market. Shifts in tactical allocation entail thoughtful reinvestment of maturing assets as they are repaid, into the sector that presents the best value. This requires common oversight across the various sectors in a single portfolio.

There are good reasons why some investors might choose to maintain a degree of separation between different areas of private credit. The investor might wish to more closely control asset allocation among sectors, or to more tightly define the permissible investment attributes in each sector (which may be particularly important for certain insurance mandates). Or the investor might want the opportunity to select specialist investment managers in each sector.

However, the internal resourcing and governance requirements for such an approach are typically available only to the largest investors. The benefits of a more disaggregated approach need to be weighed up against the many advantages that accrue to investing on an integrated and holistic basis.

Summary

The characteristics of private credit – including security, long-term contractual income, illiquidity premium, diversification and the potential for inflation-protection and environmental good – make this asset class well-suited to incorporate into DB endgame portfolios.

Trustees should ensure that any allocation to private credit is aligned with the long-term objective of the scheme. Particular consideration is required if a scheme is targeting buyout in the short term.

The growth in private credit opportunities over the last 10 years means an integrated approach is likely to be required to realise the most benefit. Low-governance ‘one-stop-shop’ products that provide a range of exposures to private credit assets are generally most suitable for all but the largest schemes.