Private debt can help schemes reach endgame goals

As a result, schemes are facing the prospect of disinvesting assets to meet those payments, at a time when the outlook for future investment returns and sponsoring employers’ business conditions appears uncertain, and many remain underfunded.

The endgame for trustees and sponsors can be defined with varying degrees of complexity. The key objective of all endgame strategies, regardless of definition, is to improve the position of the member by minimising the risk of failing to deliver future benefits.

As such, trustees are grappling with the increasing need to hold low-risk assets to cover short-term benefits with a high degree of certainty, while continuing to generate returns to achieve buyout over the longer term. In this scenario, the one asset class many investors turn to is private debt.

Trustees are grappling with the increasing need to hold low-risk assets to cover short-term benefits with a high degree of certainty, while continuing to generate returns to achieve buyout over the longer term

The attractions of private debt

Private debt continues to be popular with institutional pension schemes. The key attractions to trustees of maturing schemes lie both in contractual income, and the associated yield premium that it provides compared with similarly rated public debt.

Indeed, provided trustees have the time horizon to deal with the illiquidity of the asset class, the addition of private debt to a traditional, liquid-markets portfolio can, in fact, improve expected returns.

One of the big attractions of private debt also resides in the freedom to exchange liquidity for additional yield.

While public debt has lost discipline, with yields still bouncing around historic lows despite the potential for tightening of policy to combat the threat of inflation, private debt offers investors an attractive reward with target returns of 5 to 7 per cent for a B credit risk.

This is an appealing trade for those investors that will not become forced sellers within a known timeframe.

Investors that can hold a private debt fund until the full return of capital can also expect to be rewarded with a significant illiquidity premium over public holdings.

Meanwhile, those with short time horizons or uncertain liquidity requirements would benefit from looking elsewhere, as there is often almost no liquidity in the secondary market if the pension scheme suddenly needs to sell to fund buyout or other benefit payments.

Additionally, private debt might offer more for pension schemes than just harvesting additional yield when backing long-term liabilities.

There has been increased focus on environmental, social and governance transparency and targets in recent years, and it has now become doubly important to get ESG due diligence right, especially considering that debt holders do not influence company behaviour by share ownership or by sitting on company boards.

One solution to that is to simply select debt opportunities that have clear ESG benefits from the outset. Financing infrastructure that has clear environmental benefits such as renewable energy sources is a good example.

However, the current environment demands a better approach than just greenwashing a portfolio to advance the sustainability agenda. Once again, here private debt offers investors the benefit of introducing more scrutiny and control on ESG issues, over and above public markets, through the ability for investors to set their own bespoke lending terms.

The accompanying risks

While we expect private debt to continue to generate attractive risk-adjusted returns over the medium term, there are a number of additional risks to manage and due diligence costs impacting net returns that investors need to take into account.

Generally speaking, returns will depend on default rates and security offered. However, defaults have been at historic lows for many years and there is anecdotal evidence of a lowering of lending standards as the market matures. This will be an issue if defaults increase in tandem with recovery rates worsening.

When looking at inflation risks, it can be attractive that private debt typically provides income linked to floating rates.

If base rates increase in line with inflation, then the impact of inflation on returns may be less of a concern, although this has not been seen yet in the post-Covid-19 era. There is also an increasing opportunity to access inflation-linked income related to infrastructure projects to further hedge against inflation risk.

As a result, it is key to select a top tier asset manager that can diversify issuer-specific risk and manage the impact of unexpected inflation on investors’ returns.

Private debt is seeing a lot of interesting developments in credit, and this continues to attract talent to the sector. It is then as important as ever to select an asset manager with the relationships and size to compete for the best opportunities, as well as the expertise and resource to lift the bonnet on lending terms and security.

Finally, investors should also keep an eye on the costs of management and their impact on returns, as annual charges often include a share of returns and a base fee that is typically around 1 per cent a year higher than for asset managers in public fund space.

Regardless of the additional costs and due diligence required, if institutional pension scheme investors have a sufficient timeframe to avoid being a forced seller of assets, and the need for contractual income, at what we believe to be an attractive yield, then private debt continues to be an interesting asset class to hold as part of an endgame strategy.

Ian Burns is principal and actuary at Buck