Pension funds on the record: In-house due diligence of private debt managers pays off | Interviews

We have an allocation to private debt, or alternative credit, within our broader credit, to complement our investment grade and high yield. The programme started around eight years ago. We have built the programme around direct lending through LP stakes. We invest only through managers and through funds and we do not do any direct lending ourselves. 

We started with ‘plain vanilla’ direct lending, investing in cashflow-generating companies. That still constitutes the majority of our programme. Over the years, we have added special situations and distressed credit strategies, so those three types of strategies account for the majority of our assets invested in private debt. 

We allocate about a third to a half of our higher-risk alternative credit portfolio to direct lending focused on cashflow-generating, healthy companies, typically owned by a private equity sponsor. 

We then invest between 30% and 35% in special situations direct lending, which consists of new loans to companies that are not currently generating stable cashflows. These can be companies that have recently been spun off or that have just concluded a process of restructuring. 

The remainder of the alternative credit portfolio, about 25%, is invested in distressed credit. This consist of buying high-yield bonds and syndicated bank loans in distressed companies and holding such investments through a restructuring phase, until we eventually become equity owners and act as private equity investors. 

To a lesser extent, we invest in opportunistic funds. For instance, we invest in non-performing loans. 

Within our broader credit portfolio, we also have low-risk direct lending investments, such as real-estate-backed loans and other high-credit quality corporate lending. These are intended as substitutes for investment grade credit. 

The portfolio consists of multiple funds, managed by more than 20 private equity firms. Our direct lending investments focus on Europe and North America, but some of our distressed debt managers can invest in emerging markets as well. 

All the investment and operational due diligence for our credit investments is conducted internally, while the legal and tax due diligence are carried out by external service providers.

Making time for analysis

Whenever there is a new strategy that we considering investing in, we spend some time getting to know the segment and key players, trying to understand the supply and demand dynamics for that particular type of credit, and why we think the segment would offer an attractive risk-return premium. 

We then spend a lot of time talking to our various contacts that we have developed over the years, trying to find out who are the key players, and especially who are the best managers. We then try to get in front of the best private equity managers [known as general partners, GPs] and to get to know them better. Over time, we have tried to diversify the exposure in terms of GPs as well as strategies. 

This is a labour-intensive activity, which we carry out internally rather than employing consultants, because we want to fully understand the drivers of risk and return. We also aim to understand where each manager fits within the market, in terms of the flow of credit. It is crucial to do the investment due diligence in-house.  

The vast majority of the funds in this sector are closed-end vehicles, which means that in a sense, investors need to get all their money back before they can assess whether the return targets have been met. There is always a risk that the loans that are underperforming stay in the fund for a long time, which could lead to some impairments towards the end of the life of the fund, affecting returns. 

“We allocate about a third to a half of our higher-risk alternative credit portfolio to direct lending focused on cashflow-generating, healthy companies”

That said, overall, if we look at the managers’ expectations and based on our own analysis, return expectations have been met to an acceptable degree and clearly outperformed both the fixed and floating alternative.

Floating rate is one component

For the funds that were fundraising in 2017, obviously we did not expect the floating rate to go to zero, which of course meant lower returns compared with previous vintages. Again, three years ago, we did not expect rates to rise to 5%. In other words, the floating rate is a key element in determining returns, but it is important to look at the performance of the underlying loans. In that sense, the asset class has met our expectations and the risk-adjusted returns at the moment are very good. 

In direct lending, there is no real duration risk, so the increase in rates has not hurt private credit in the same way that it has hurt high yield bonds. I believe that overall, the risk-adjusted returns are better compared with the liquid market.

Given the large number of managers and strategies, there are criteria that we apply each time we select managers. We look at historical track record and we set a higher bar for first-time funds. We want to make sure that the manager has skin in the game and is more focused on the quality of credits rather than the overall volume of lending. 

We want managers that not only have a strong origination framework, but also a proven restructuring team and that are able to get proper loan documentation, so they can use the covenants within the documentation to force the issuer’s owner to cover any shortfalls, for instance by adding more equity.

As the market has grown and lending standards have declined, we have tried to stay away from the upper part of the mid-market, where the covenants have become especially weaker. In the lower mid-market, covenants have generally been stronger. 

We would rather employ a manager that deploys capital at a slower pace but gets the appropriate loan documentation, rather than one that deploys quickly but with weak documentation.

Our direct lending programme does not have a dedicated allocation to sustainable credit. However, in a sense, sustainability and ESG questions have always been top of mind for credit investors, because creditors often end up paying if there are issues related to the environment, society or governance. If we come across a manager that does not understand these risks, we probably will not invest with them.