Pension funds chase returns in private-market debt
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4 min read . Updated: 15 Feb 2022, 06:22 PM IST Private loans offer retirement funds the income that once came from bonds, but at higher risk
Retirement funds are clamoring to invest in private-market loans, hungry for an asset that can beat public markets while at the same time throwing off cash to help pay benefits.
Two of the nation’s three biggest pension funds—those serving public workers in New York and California—have added private-credit allocation targets in the past two years. Across the U.S., state and local retirement funds with private-credit portfolios are expanding them faster than any other alternative investment, from an average allocation of 3% to an average target of 5.7%, according to analytics company Preqin.
For decades, U.S. pension funds have been scaling back on bonds, bank loans and other types of publicly traded debt as yields dropped. Now the retirement savings of firefighters and school bus drivers are helping fuel an investing boom in private loans to borrowers ranging from private-equity managers overhauling companies to consumers buying on layaway.
Michael Lombardi, director of credit at the $280 billion New York State Common Retirement Fund, which serves police, firefighters and other public workers, said that he expects to hit the 4% allocation target set in 2020 by the end of this year.
“The team has spent all of 2020 and 2021 focusing on private credit," Mr. Lombardi said. To fund the new investments, the pension plan is moving money out of high-yield bonds and bank loans.
U.S. pension funds’ private-credit holdings now amount to tens of billions of dollars, though the exact total is hard to track because many funds don’t report those investments separately from other alternative assets. Canadian pensions, earlier adopters of private credit, also have tens of billions in the asset class.
The loans are considerably riskier than the investment-grade bonds public retirement systems once relied on for income.
Alongside sovereign-wealth funds, endowments and insurers across the world, pension funds have helped bring total private-debt assets under management to $1.5 trillion in 2021, nearly twice as much as five years ago, according to Preqin. The figures include money that investors have committed to private debt funds but that managers have yet to collect.
Rules stemming from the 2007-09 financial crisis made banks more reluctant to issue and hold loans to middle-market companies. Money managers filled the void by pooling private loans and offering them to large investors. The higher interest rates proved appealing to many of those investors after decades of falling yields. One pension fund’s investment staff joked that it added private credit after the fixed-income department became the “no-income department."
Many pension funds are turning to the same group of managers who invest their private-equity portfolios, firms such as Ares Management Corp., Blackstone Inc., and Oaktree Capital Management LP, that have received massive inflows in recent years from retirement systems’ steady march into alternative investments. Federal regulators last Wednesday proposed landmark new rules for those private markets.
Returns on private-credit investments tend to be lower than private equity, but so is the risk; creditors get paid before equity investors in a bankruptcy. Private credit typically locks up money for less time, about five to seven years, managers said. During that time the investment throws off interest, generally at floating rates, an advantage at a time when benchmark interest rates are rising.
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Those regular income payments are a key draw for state and local pensions trying to invest their way out of shortfalls and still collect cash to help pay benefits. As America’s workforce ages, many retirement funds are taking in less in contributions from current workers than they are distributing in pension checks.
Directors of the $480 billion California Public Employees’ Retirement System in November approved a 5% allocation to private credit, part of a portfolio overhaul aimed at keeping annual investment return projections at 6.8%. Without changes, the pension fund, which has about 80%of the expected amount needed to pay promised benefits, was projecting annual returns of 6.2%.
At the $50 billion Arizona State Retirement System, which first created a 3% target for private debt in 2012, more than 21% of the portfolio is now invested in the asset class. Private credit “has proved to be a better source of returns" than publicly traded debt investments, said Deputy Chief Investment Officer Al Alaimo.
Annualized five-year returns are 8.84% for the Cliffwater Direct Lending Index and 9.04% for a group of private-credit funds, not including distressed debt, tracked by the data-analytics firm Burgiss. That compares with 4.27% for U.S. corporate bonds and 5.24% for U.S. junk bonds, according to Bloomberg indexes.
But while private credit offers interest rates that have largely disappeared from the public market, it is less well-suited for another role bonds have historically played in pension portfolios: providing a hedge against stock-market downturns.
That is because market turmoil raises the likelihood of default among riskier lenders, andthere is no significant secondary market for private credit where pension funds in need of money to pay benefits could cash out in a pinch. In the fourth quarter of 2008, when the Bloomberg investment-grade index returned 3.98%, the Cliffwater index returned minus 6.68% and the Burgiss index returned minus 15.17%.
“When the market turns downward, private debt will not make money or protect capital," said Stephen Nesbitt, chief executive of Cliffwater LLC, an alternative-asset manager and adviser.
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