Will private credit become a mainstay of DC portfolios?

Last week, Nest, the mastertrust set up to bolster the auto-enrolment market, issued a request for proposals covering mid-market corporate loans, real estate debt and infrastructure debt.

However, the scheme has demanded that managers innovate away from the traditional model of small, closed-end funds charging high fees.

If you believe that there is an illiquidity premium, which personally I do, why don’t you take advantage of it?

Andy Cheseldine, Capital Cranfield Trustees

Instead, chief investment officer Mark Fawcett has asked for proposals for scalable evergeen funds, which would charge lower fees with the prospect of attracting considerable inflows as the scheme’s assets grow.

Fees 'more proportionate' to expected returns

“When you talk to managers the range of fees is absolutely enormous, from just straight high double-digit AMCs [annual management charges], to triple digits with a performance fee of some sort,” said Fawcett.

One fund Fawcett and his Nest team came across charged 1.25 per cent, with a 20 per cent incentive fee at an 8 per cent hurdle.

“These asset classes do obviously require a bit more work than maybe some of the listed asset classes, but what we’ve seen is that the fees tend to be more proportionate to the expected returns rather than the amount of work put in,” he added.

The scheme may grant mandates for individual managers across the three credit classes, but it will also consider solutions that combine the three in a bespoke multi-asset approach. Managing environmental, social and governance risk will be required of winning pitches.

The logic for DC schemes crossing the public-private divide is clear. Yields have compressed in corporate bond markets, and advisers to DB funds such as the Enfield Pension Fund are telling clients that these spreads are an insufficient reward for the risks involved.

“We would expect to get a return premium from investing in private credit over public credit, and that return premium will be partly illiquidity and partly complexity. Sourcing bank loans, for example, in the US is more complex than just investing in high-yield bonds,” Fawcett said.

Regulatory tweaks could heal daily pricing headache

However, with fees significantly over the level of the charge cap and complexity adding a governance headache, can the average DC scheme ever expect to access these premiums?

“There’s absolutely no reason why not,” said Richard Butcher, managing director at professional trustee company PTL, before explaining that he doubts private credit will become a mainstay of DC portfolios.

Butcher said that while greater returns over public credit markets could make the asset class a good engine for the growth phase, these are accompanied by increased risks.

There are also complications with illiquidity, the very feature that contributes to the return uplift in private markets. Despite the potential for young DC savers to stay invested for 50 years, many schemes and administration systems are built around providing daily pricing and daily dealing to members.

Butcher said the Pensions Regulator may be able to ease this headache for schemes, by tweaking guidance requiring schemes to invest contributions promptly to allow for investment in assets that are not available for purchase every day.

“It’s well-intentioned and by and large it’s absolutely fine, but they need to just refine it a little bit,” he said.

Schemes need scale

Andy Cheseldine, client director at Capital Cranfield Trustees, argued for a distinction between daily pricing, allowing members to see up-to-date balances, and daily dealing, where members who are likely to remain inert for many years are given the option to withdraw in a day.

“If you believe that there is an illiquidity premium, which personally I do, why don’t you take advantage of it?” he asked. “You need to have daily pricing because that’s what administration systems require now… I don’t think that requires daily dealing.”

However, Cheseldine said that scale will remain an important factor for assessing the suitability of private credit and other illiquid assets. Negotiating on fees in the way Nest has requires large potential investments, and schemes need educated buyers on their trustee boards and good communications to convey their decision to members.

“It’s not just about the current size of assets, it’s also about the cashflow, what the future contributions look like,” he said.

While Cheseldine estimated that schemes may need £250m in assets and decent growth potential to consider investing, he said that schemes may be successful in lowering fees if they use their long time horizons to offer managers some reassurance.

“Perhaps unlike defined benefit schemes, you know that this is going to be quite sticky money,” he said.