PPF to coinvest in private debt to diversify credit portfolio

Private debt has been increasing in popularity with investors since the financial crisis as banks have provided fewer loans to businesses – giving schemes the ability to fill the void.

The PPF is exploring direct lending as part of its fixed income asset allocation. The appointed managers will be expected to originate direct loans to companies, primarily those based in the UK.

Barry Kenneth, chief investment officer at the pensions lifeboat, said¹ the allocation diversifies the fund's source of credit exposure and interest rate protection.

He added: "At the moment, we are heavy users of derivatives for interest rate protection so physical assets will help us reduce our reliance on derivatives."

The scheme will start out with a small mandate in direct lending but plans to grow its allocation to between £300m and £400m in two years. Kenneth said a large allocation to direct lending can ensure the portfolio is diversified.

It is common for schemes to invest in pan-European direct lending funds. These typically have a bias towards investing in UK businesses due to the high number of suitable mid-market companies, said Sanjay Mistry, director of private debt at consultancy Mercer.

In the past, returns of 15 per cent or higher attracted mostly opportunistic or private equity investors. But now returns of 8-10 per cent are more common, making it increasingly attractive to investors looking for fixed income, said Mistry.

Mistry said that the rebounding economy was making businesses seeking direct loans more robust and shortening the maturity of loans.

“As businesses grow they can often afford to refinance or close their five-to-seven-year loans after three or four years. As they become less risky they don’t need to pay the same interest rates on the loans,” he said.

Direct lending has also seen a rise in popularity in recent years, particularly with European investors, said Jon Exley, a partner in investment advisory pensions at consultancy KPMG.

Pension schemes can be well placed to invest in direct lending, due to their ability to tolerate the illiquidity of the assets.

Most investors looking to access direct lending will do so through a fund, said Exley. The other main ways are privately originated loans or asset-backed collateralised loan obligations.

“[CLOs] have a bad reputation since the financial crisis,” said Exley. “But it was the leverage rather than the underlying credit that was the problem. They can offer good rates of return.”

The manager chosen by the PPF will coinvest alongside it as a way of ensuring more closely aligned interests, said Kenneth. It is also hoped this approach will lead to better risk control and protection against risk.

“It’s always good if the asset manager has skin in the game,” said Kenneth.

Coinvesting can mean schemes carry additional risk as they are less diversified, but it also gives schemes the ability to move quickly to install triggers and protection into their plans.

¹In the original version of this article, Pension Protection Fund chief investment officer Barry Kenneth was misquoted as follows: "We have a big derivative book in our UK cash flows, so we’re looking to diversify that." We have allowed the PPF to clarify his statement.