Cornwall agrees new private credit allocation

Investing in private credit allows pension funds to lend to businesses that find it difficult to borrow from increasingly risk-averse banks, and it can be an attractive option for schemes looking for returns.

During a pensions committee meeting in December 2016, as part of an investment strategy review, the Cornwall Pension Fund decided to include private credit in its investment strategy.

Pension schemes have the ability to tie up capital for a period of time, and that illiquidity premium is well rewarded

Andrew Stephens, BlackRock

The £1.5bn local authority scheme has decided to appoint bfinance to search for a manager, or managers, for the asset class.

Schemes can tolerate illiquidity

According to Andrew Stephens, head of UK intermediated business at BlackRock, the regulation of banks and the requirements for capital adequacy have led to a supply/demand imbalance with regard to lending to certain middle market companies.

“While that demand for capital is still there, someone needs to provide it,” he said, and this is where pension schemes can step in.

They are able to do so because they tend to have long-dated liabilities and “have the ability to tie up capital for a period of time, and that illiquidity premium is well rewarded”, said Stephens.

In terms of credit quality, he explained that investors can opt to lend to companies that have credit ratings comparable with investment-grade ratings in public markets. But “then of course you can go down the credit spectrum” towards higher-yield investments, he added.

Private credit can act as an equity replacement

Pension schemes might also want to use higher-yielding credit assets to diversify away from equities. Ajith Nair, head of fixed income research at consultancy KPMG, said that “a significant portion of pension funds still depend on equities to generate returns”.

He added that, for example, a scheme could replace part of its equity allocation with something like private credit, resulting in a “more efficient portfolio” with similar returns to equities, but lower risk.

When investing in private credit, Nair pointed out that it is important to avoid concentration risk. “What you don’t want is extreme… or concentrated exposure to one geography,” he said.

He noted that it all depends on the client, so a UK council pension fund might look for exposure solely in the UK, but schemes might want to have exposure to a broad range of geographical regions, because opportunity sets can move around depending on regulation or political events, such as Brexit.

“Purely from a risk mitigation point of view and from an opportunity set point of view,” Nair said managers with the broadest exposure in terms of geography are usually preferable.

Banking regulation will shape the market

David Rae, head of client strategy and research at Russell Investments, agreed that diversifying regionally means investors are exposed to a range of business cycles, but added that the credit quality and sector type very much depends on the overall objectives of the scheme.

On one hand, there are many schemes “looking across the private markets for ways to really help to complement and supplement their liability hedging-type assets, so they’re looking to increase the yield, but looking for assets with a very long duration,” Rae explained.

On the other hand, some investors view private credit as “an opportunity to harvest what is possibly one of the few remaining risk premia” and are choosing investments to help generate an attractive return, “albeit doing that over a reasonably long time frame”, explained Rae.

Rae also noted that potential tax reforms in the US could have a significant impact for different types of lenders and would affect leveraged and higher interest rate loans, while further changes or regulation affecting banks’ ability to lend “could certainly alter the profile of the market”.