Allocations to private debt, private equity and venture capital are growing among pension schemes and insurers as they seek premium returns and diversification.
During portfolio institutional’s Private Markets Club Conference, private credit proved to be a popular discussion point given how the asset class is maturing.
The emergence of asset-backed finance in direct lending portfolios is a sign of how the market is growing. “It adds more corporate exposure and there are some great dynamics in terms of banks offloading their loans and looking for partners,” said Andrea Ash, Railpen’s investment director of private markets.
This has also evident in London CIV’s alternative loan book.
The local government pension pool launched its first mid-market, senior direct lending vintage around four years ago. Scalability, diversification and strong contractual cashflows were attractions for Vanessa Shia, the head of private markets at London CIV who oversees £3.7bn worth of assets.
The pool’s second private credit vintage arrived last year, which included non-core asset-based lending. “It is a complementary strategy and a diversifier to what we have been doing in senior and direct lending,” Shia said.
Nick Smith, managing director of private credit at the Alternative Credit Council (ACC), a private credit trade association representing 250 members collectively managing $2trn (£1.5trn) of assets, expects to see further growth. “The story of bank retrenchment feels like it has a long way to play in these areas where we see banks stepping back and partnerships emerging.
“In terms of where the story is going, I don’t know what chapter we are in but it feels like it is more in the middle than the end,” Smith said.
The ACC estimated that the industry deployed £333bn of capital globally last year, which is not far off the size of the entire market 12 years ago.
“We have had real growth and trends around consolidation with large managers getting larger,” Smith said.
And it appears hawkish central banks will not halt this growth. “Higher rates have been a double-edge sword for the sector,” he added.
“Most loans are floating rate, which improves returns but puts greater pressure on borrowers. We are seeing that story playout, but it appears to be at manageable levels.”
Alongside such impressive growth and the emergence of new asset classes in private credit portfolios, another positive development has emerged: transparency is improving. “Lenders are getting quarterly information from borrowers which is comparable to, or better than, what you get in the public markets.
“Investors are increasingly sophisticated and are demanding the information they want,” Smith added. “So we are seeing a maturation of that part of the market alongside the growth. For someone in my position, this is quite encouraging.”
Value creation
These are uncertain times punctuated with bouts of market volatility, so how are pension schemes extracting value from these alternative asset classes?
London CIV is a long-term investor; therefore it is positioning its asset allocation towards structural secular trends, such as decarbonisation, digitalisation, demographics and decentralisation. “For us, it is aligning our investments to those long-term trends,” Shia said.
“Gone are the days when you generate returns off the back of strong growth and low inflation,” she added. “We want to create a diversified portfolio with value creation and some downside protection through inflation linkage.”
Ash also looks at the bigger picture. “Having been through 2022-23, when valuations in the innovation space fell off a cliff, it is easy to get caught up in a short-term view,” she said. “It is about maintaining the discipline to look at the long term.
“We are in a new normal environment,” Ash added. “The easy money has gone. We need to work harder to identify the GPs who are focused on value creation, buying into the complexity now that the easy drivers of performance have gone.”
No second chances
Another factor for asset owners to consider is liquidity, or the lack of it.
Ash sits within the illiquid growth fund, so she and her team are mandated to take liquidity risk. The fund looks at liquidity from the duration of the investment and the cashflow it generates.
“2022-23 focused our mind on what we mean by liquidity,” she said. “Are we being paid for it? Do we understand it? How is it changing over time?”
Ash and her team drew a surprising conclusion from these questions. “Illiquidity can be our friend,” she said. “As long as you can handle it, it allows for value creation.”
Smith added that there are constituents in the market who are comfortable with illiquidity, but they need to decide how much of it they can tolerate. “I would argue that institutional DC schemes could bear a lot more illiquidity than they have,” he added.
“They haven’t got a problem with it. Their problem is generating returns. So from an institutional perspective, it’s important to understand what are their real liquidity needs?”
Then there are the assets. From a risk management perspective, there is not a huge secondary market for private credit. “Can you deal with the assets if things are going wrong?” Smith said.
“There is not the safety valve that you have in public markets where you can sell out of a position,” Smith said.
A sustainable view
Environmental, social and governance (ESG) factors have become increasingly influential over institutional investor portfolios. The success of integrating such aspects into equities is well documented, but it is harder to achieve with debt given that lenders do not vote on corporate policy.
Yet this is not deterring Ash and her team at Railpen from trying to generate positive environmental and social outcomes from their private lending portfolios.
“We cannot effect change at the asset level, but we can work with managers around best practice and expectations,” Ash said.
Implementing ESG is difficult for smaller managers, with data proving to be a particular challenge. Smaller companies do not have the capacity or capability to meet all of the many data disclosure requirements.
Another issue is that ESG standards vary between managers in the US and Europe. London CIV tackles any issue here by engaging with their managers to implement best practice. “We use our position as a large allocator to effect change,” Shia said.
“All of our managers work with us to develop their ESG capability,” she added. “It is understood that you need to achieve a certain standard with ESG to attract institutional capital.”
But the conversation soon returned to data being the big problem.
“We have ESG reporting obligations and expectations but no consistent ESG reporting at the corporate level,” Smith said.
To help address this, the ACC has created a due diligence questionnaire to help investors understand managers’ approach to ESG integration to improve their chances of partnering with the right people.
The organisation has also worked at the industry level on setting some baseline ESG disclosure standards to help the market function better.
So it appears that sustainability and social issues are becoming more influential over private credit portfolios.
“ESG is now very much a topic of conversation in credit,” Ash said. “Go back five to 10 years, it was very much the domain of equity investing but is now a live topic on the debt side.”
Outlook
Looking forward, investment sentiment for these alternative asset classes appears to be strong. In particular, the interest rate environment bodes well for private credit and private equity, Shia said. “When the IPO and M&A markets come back online we should see a lot more deal volume,” she added.
The focus on digitalisation and decarbonisation will also continue to provide opportunities across different capital structures. “So I’m bullish in the year to come,” Shia said.
But while Ash also looks to the future with optimism, she warns it will not be an easy ride. “Going forward there will be more volatility baked in,” she said. “We are all going to have to work harder.”
One the debt side, she remains positive on the core cashflow opportunities. “The beauty of the asset class is there are so many different underlying sub-strategies which complement each other.”
Within venture capital, Ash points to there being a shift from software to science. “Going forward, the opportunities will look different,” she said. “There is a heap of requirements to go with that – changes in capex, liquidity and ecosystems. This is incredibly exciting.”
In private equity there will also be plenty to do. “Again, the drivers of value are going to be different in the absence of low-cost leverage,” Ash said. “It is going to be about the operational value add. So we will have to work harder.”
Smith expects to see further institutionalisation of private credit. “We are called the Alternative Credit Council but private credit isn’t that alternative anymore.
“The scale and breadth of the sector is now that these conferences are happening more frequently,” he added.
Then there is the attention on reporting. The FCA’s review on valuation practices, for example, said that while they saw lots of good practices there are a few areas where the sector can “pull its socks up”.
“These efforts reinforce that this is an institutional-grade asset class, which it always has been,” Smith said.
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