Private credit is an asset class that involves lending money to middle-sized companies at relatively high rates of interest and has become increasingly popular with public pension funds seeking higher investment returns and trying to reduce unfunded liabilities.
Although this new asset class is understandably attractive to investment managers stretching to achieve high assumed rates of return, public pension systems should also consider the risk of credit defaults, high fees levied by intermediaries, and lack of liquidity before jumping in too deep.
The definition of a middle-sized, or in industry parlance, a “middle market” borrower varies. Investopedia defines the middle market in revenue terms, placing any company that earns between $10 million and $1 billion in annual revenue in this category. But since unprofitable companies are not good lending candidates, others use ranges of EBITDA (earnings before taxes, interest, depreciation, and amortization) when defining the categorization of middle-market.
Writing a sponsored post in Private Debt Investor, Tim Healy of Twin Brook Capital Partners suggests that companies producing EBITDA in the range of $5 million to $50 million annually qualify as middle market.
Firms in this category are too small to issue bonds, tap the syndicated loan market, or carry a credit rating. So, compared to large corporations, it is harder for middle-market firms to borrow. Traditionally, they have obtained debt financing from banks, but in recent decades banks have shied away from carrying corporate loans on their balance sheets. Banks are required to hold capital against their assets (to absorb defaults), and management generally regards holding loans as an inefficient use of capital.
Consequently, middle-market companies need non-traditional sources of financing, and public pension funds are a logical fit. Pension systems have the capital to invest and need to generate high investment returns, ideally in the form of regular income that can cover promised pension benefit payments. High periodic interest payments meet these needs.
These attributes have caught the attention of several public pension funds, with some investing heavily in private credit (also called private debt). For example, the Arizona State Retirement System (ASRS) has allocated 15% of its portfolio to private credit. Another 7% is devoted to related asset categories such as distressed debt and collateralized loan obligations.
The California Public Employees’ Retirement System, CalPERS, the nation’s largest pension fund, is targeting a 5% commitment to private credit in 2022, up from zero last year.
Overall, citing data from industry research firm Preqin, The Wall Street Journal reports, “Across the U.S., state and local retirement funds with private-credit portfolios are expanding them faster than any other alternative investment, from an average allocation of 3% to an average target of 5.7%, according to analytics company Preqin.”
Another attractive feature of private credit assets relative to traditional bonds is that they usually carry floating interest rates. Rather than having a fixed coupon like a corporate bond, middle market loans are normally priced in terms of spread above a benchmark interest rate, such as the London Interbank Offered Rate (LIBOR) or Secured Overnight Financing Rate (SOFR). When market interest rates rise, so do interest payments on the middle-market loan. As a result, these loans are insulated from market risk in contrast to fixed-rate bonds whose market value rises or falls inversely with interest rates.
But floating interest rates are a double-edged sword. As interest rates rise, the borrower faces higher debt service costs and becomes more vulnerable to default. Lending to borrowers with low-profit margins or relatively high amounts of debt subjects public pension funds to heightened credit risks under these circumstances. High default rates in a credit portfolio can sharply lower overall investment returns or even result in a complete loss of value.
The Wall Street Journal noted:
But while private credit offers interest rates that have largely disappeared from the public market, it is less well-suited for another role bonds have historically played in pension portfolios: providing a hedge against stock-market downturns.
That is because market turmoil raises the likelihood of default among riskier lenders, and there is no significant secondary market for private credit where pension funds in need of money to pay benefits could cash out in a pinch. In the fourth quarter of 2008, when the Bloomberg investment-grade index returned 3.98%, the Cliffwater index returned minus 6.68% and the Burgiss index returned minus 15.17%.
“When the market turns downward, private debt will not make money or protect capital,” said Stephen Nesbitt, chief executive of Cliffwater LLC, an alternative-asset manager and adviser.
The impact that the Federal Reserve’s tightening will have on private credit in 2022 is still a developing story. According to the law firm Proskauer, which maintains a Private Credit Default Index, the default rate for companies with EBITDA between $25 million and $50 million rose from 0.8% in the last quarter of 2021 to 1.8% in the second quarter of 2022, but the default rate for firms with EBITDA below $25 million actually fell from 1.6% to 1.3% over the same period. Since the Federal Reserve raised interest rates 75 basis points in both June and July, the second quarter data do not reflect the full impact of the latest Fed action.
Another concern with private credit involves fees. Pension funds do not typically lend to companies directly. Instead, they gain exposure to middle-market loans through third parties such as fund managers or private equity firms. These intermediaries expect to be remunerated for their efforts, and their charges can be high relative to traditional fixed-income investments.
For example, the South Carolina Retirement System recently reported that the fees on its private credit portfolio amounted to 2.58% of assets annually compared to just 0.10% for its investment-grade bonds.
Finally, middle-market loans are illiquid due to the lack of a secondary market. Pension funds acquiring private credit assets should expect to hold these loans to maturity. As long as private credit holdings are balanced by highly liquid assets in a pension fund’s portfolio, the inability to sell loans prior to maturity should be a manageable issue.
In summary, private credit appears to be a good fit for some pension fund portfolios. Still, given the heightened default risk in a rising interest rate environment, high fees, and low liquidity, public pension fund managers should be careful and avoid over-committing to this asset class.
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