BlueBay see covenant protection as “vital in preserving capital” in a situation where companies underperform due to company specific or economic downturns, he said.
But going forward it will be important to pinpoint sectors of private credit that can maintain high barriers to entry for traditional banks.
Nick Warmingham, a senior investment director at Cambridge Associates, an investment consultant, echoes Blue Bay’s Fobel on the quality of the team and details around the underwriting process, pointed out that when underwriting a manager ideally “one would look for a team that has worked together on restructuring situations”.
However, noting a paucity of data on how funds have performed during a credit crunch, this makes it difficult for pension funds to examine track record and performance.
Hence recognising managers that standout can prove problematic.
RETURN TARGET
Given that yields in the direct lending market have declined of late, the demand and supply dynamics are pushing managers to raise leverage in funds in order to meet expected return targets. That poses challenges for pension funds considering them. As such they need choose investments that match their return targets as well as managers who are likely to succeed by navigating through tricky times.
But as asset managers are competing to offer lending, they may sometimes alter the covenant lever or leverage lever. In so doing this changes the risk profile of funds. The upshot of this is that it can prove quite difficult to decipher and understand where managers are taking on added risk.
For investors considering alternative credit it does help to keep an open mind, especially since there are several other asset classes within the sector apart from private debt. Some like Trey Parker, head of credit at Highland Capital, has contended that there is a “liquidity advantage” to being invested in a tradable asset class versus a non-tradeable one. And, this was despite the higher markto-market volatility.
Others like Ranbir Lakhpuri, a portfolio manager at Insight Investment for secured finance, see advantages in investing in syndicated loans compared to direct lending since there is lower leverage in the market. That said, the former can exhibit covenant-light transaction and weaker documentation.
For others, the structured credit market is seen as offering opportunities, provided managers take on sensible levels of risk. With a rise in the number of unitranche structures – complex structures that enable higher leverage and a promise of heightened returns from the loans – their risk and complexity aspects could make them a potentially unsuitable investing avenue for pension funds.
CASE FOR THE DEFENCE
Alternative credit and private asset products are certainly appealing given that they provide stable investment return, increase the diversification of the portfolio and can be regarded as a defensive asset class.
As pension funds acknowledging that a static 60/40 portfolio allocation to equities and bonds will not be sufficient to meet their long-term target returns, the risk and return profile of alternatives will keep them in the spotlight. However, as Kindert at NNIP noted: “Due to their illiquid and complex nature, investors should develop the ability to assess the different products, create alignment of interests among stakeholders, and put stronger emphasis on the governance framework to ensure that companies have sufficient guidance to navigate a vastly changing financial world.”
Whatever the sub-sector, funds should monitor managers and investments carefully. With alternative credit having grown substantially during a prolonged period of low interest rates, it raises the possibility that risky loans have been extended to less than robust borrowers. As such investors should focus on due diligence and evaluate opportunities across the entire sector.
