Oliver Hamilton, principal consultant at Townsend Group, an Aon company, considers the merits of private debt investing and how pension schemes can mitigate the risks.
Private debt is a catch-all term for non-publicly traded debt. It covers a large spectrum of opportunities and asset classes, from low-risk loans secured against long-term government concessions to those provided to private equity-owned companies, direct lending and real estate.
UK pension schemes have been allocating to private debt for around a decade. The development of private debt markets in the UK and Europe accelerated in the wake of the global financial crisis when increased regulation reduced bank participation. The popularity of private debt investing has also increased as more funds have come to market and track records have been established. It is no longer considered a niche opportunity by many institutional investors.
Private debt is attractive to pension scheme investors as it offers potentially higher returns and income than can be achieved in equivalent public markets, while increasing diversification within their portfolios. The wide opportunity set means that there are assets available for pension schemes with different investment requirements.
Net returns typically range from between 3% to 12%, although they will be strategy dependent and vary over time. In the case of direct lending, while measuring premiums to liquid markets is difficult and is subject to much debate on its meaning, investors could expect premiums above more liquid bank loans, in the range of 1% to 3%.
That said, the search for yield and increasing commitments have meant that some private debt returns have fallen, while fees have stayed high and borrower protection (loan covenants) has, in general, reduced. It is important to note that many of the strategies that pension schemes invest in are subinvestment grade and we expect a weaker credit outlook as the end of the economic cycle approaches. Of course, these headwinds are faced by public markets too, but it is important that investors should not be lured into a false sense of security from the recent benign credit environment. Nor should investors expect the same protection relative to public credits. Private debt, for example, is still exposed to company bankruptcies. The universe has also expanded greatly with several new players that may not have the requisite expertise to mitigate credit difficulties in a riskier environment.
That is not to say that healthy premiums over publicly-traded debt can no longer be found. Private debt continues to have its advantages over public debt. For starters, the typically higher coupon and other ancillary income received by investors create a cushion against any losses. In addition, private debt fund managers have more control over the terms of the loans and insight into troubled investments compared to their public market peers.
To help manage risks, investors should build a diversified private debt portfolio with a range of managers, durations and styles. Additionally, investment and operational due diligence is particularly crucial since private debt is most often accessed via closed-ended funds and cannot be easily divested. It is important not only to assess a manager’s underwriting ability, but also their expertise in working out difficult or defaulting loans successfully, especially given where we are in the credit cycle.
Private debt will continue to play an important role in pension scheme portfolios. However, seeking out the best opportunities is complex and, when coupled with the greater governance associated with investing in these strategies, it is essential to work closely with consultants and managers with a proven track record in this area.
For more information, contact Oliver Hamilton via oliver.hamilton@aon.com.
