UK pension funds are at risk from a proliferation of new players entering the private credit space and “aggressively” bidding up asset prices, according to PGIM Fixed Income.
The US asset manager is concerned that UK institutional investors are ploughing money into loan products offered by a new breed of asset managers, lured by the floating rate nature of these products which are perceived to be less vulnerable to interest rate rises.
This trend, it added, has been driven in part by consultants who are advising pension funds to put money into these types of strategy which is bidding up these assets.
The availability of private credit, especially direct lending products, has escalated in recent years as tougher regulations on capital requirements have forced banks to pull back lending and institutional investors to fill the void.
Figures from Preqin show the private debt asset class saw record fundraising in Q4 2016, with $50bn secured among 47 funds. North America-focused private debt funds secured 85% ($43bn) of capital raised by funds closed in Q4, accounting for 64% (30) of the fund closures. Europe-focused funds meanwhile raised 12% ($6.2bn) of the total across 26% (12) of all funds closed.
Late last year the Church of England Pensions Board (CEPB) committed £80m to US corporate loans with Audax Senior Loans (ASL). CEPB chief investment officer Pierre Jameson told PI at the time the attraction was because it is “private markets, it’s illiquid and there’s no direct mark-to-market as such”.
However, PGIM Fixed Income senior investment officer Gregory Peters believes the sector has pushed too far for yield across the private credit spectrum, from corporate loans through to peer-to-peer lending.
“In private credit there has been a tremendous amount of money put in and it has been added aggressively to a lot of pension schemes,” he said. “It is really being driven by the advice that a lot of the UK pensions funds in particular are receiving that private credit is the way to go.”
Peters said because these assets are not mark-to-market they have “exceedingly high” Sharpe Ratios: a measure of risk-adjusted return.
PGIM chief strategy officer Taimur Hyat added the manager’s preferred activity in this space was to lend directly to corporates.
He observed a lot of growth had been in sponsor-driven lending where funds have been set out along with private equity sponsors.
“We generally find the pricing is more competitive when the sponsors are driving the leverage that is added on,” he added. “That is where we believe there is less good value for private debt investing than in the direct to corporates [space].”
A paper published by consultancy bfinance in March noted that leverage, and therefore risk, has increased in senior direct lending funds.
The consultant noted unitranche loans – those that combine senior and subordinated debt into one debt instrument – have gradually become more dominant in the senior portion as managers try to keep internal rate of return expectations on track despite spread compression.
Willis Towers Watson head of illiquid credit Gregg Disdale said there are some areas of the market, in particular US direct lending, that feel “better competed” than others and without a pick-up in M&A activity, there is a concern there might be too much capital floating around.
“There are an inordinate amount of new funds being raised all the time and that is a space where unless you have an edge, it is difficult to compete at the moment,” he said. “People are competing any way they can which at the moment is on price and what managers would call ‘flexibility’ which is weakening credit standards.
“The concern with new players is they might do silly things to steal market share.”
Disdale also noted seeing slightly higher levels of leverage as multiples of EBITDA.
“There is definitely more risk being taken in the system we think,” he added. “You are seeing slightly higher levels of leverage and you are seeing pressure on covenants.”
Cambridge Associates managing director in the credit investment group Tod Trabocco said he saw about $35bn of equity commitments in the US direct lending market last year, which potentially becomes around $60bn to $70bn once levered up .
However, he added that while debt levels have crept up since the financial crisis, there appears to be a ceiling on the level of company leverage – and private equity sponsors are writing as big, if not bigger, cheques than they have ever written before.
“While the leverage levels have moved up, private equity sponsors are paying their share of the bargain – and that is important,” he added.
Cambridge Associates head of UK pensions practice Alex Koriath added there are still opportunities in direct lending.
“But,” he added, “you have to be careful who you go to and whether the guys you invest with have the ability to turn things round and deal with a loan if it goes sour.”
