Pension Funds Invest More in Private Credit Than Ever Before

Pension-fund investment in private-market loans in North America reached an eight-year high in 2022, despite banks pulling back on lending and default rates increasing.

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According to analytics company Preqin, the average share of retirement funds parked in illiquid, unrated debt has steadily increased to 3.8%, the highest on record. Although this is only a small portion of the overall portfolio, it amounts to more than $100 billion in the retirement savings of U.S. and Canadian teachers, police and other public workers, according to a Wall Street Journal estimate. And the pensions are planning to add more, with an average target allocation of 5.9%.

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The California State Teachers' Retirement System (Calstrs) is the latest pension fund to show interest in increasing private-credit investment. The Calstrs board has directed staff to include private credit in proposals for the pension's new asset allocation, which board members will vote on later this year. This move could signal a shift in how pension funds view private credit as an asset class, and could lead to more pension funds allocating a portion of their assets to private credit.
Calstrs investment chief Christopher Ailman believes that the current economic conditions are here to stay for the foreseeable future. "We all think it's going to be around for a long time," he said.

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The Ohio Public Employees Retirement System added a 1% allocation to private credit in January, following in the footsteps of the California Public Employees’ Retirement System and the New York State Common Retirement Fund, which are building out private-credit portfolios of 5% and 4%, respectively. In Canada, some pension funds took advantage of early-Covid market dislocation to expand their already-robust private-debt portfolios.

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Pension funds are increasingly turning to private-market assets and other alternatives to stocks and bonds in search of higher returns. However, this shift has left many pension funds short of the funds needed to cover benefits and market losses. In 2022, these losses are expected to largely wipe out the pension funds' gains from 2021. This means that pension funds will have to rely on taxpayer funds or worker contributions to make up the difference.

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When investing in private credit, a pension fund typically gives money to a manager who also collects money from other institutional investors. U.S. pension funds often turn to the same big managers handling their other private-market assets, including Ares Management Corp., Blackstone Inc. and Oaktree Capital Management LP.
The manager pools the money in a fund that makes loans to companies or other enterprises for a period of around five to seven years. The loans often go to private-equity-held firms in areas such as software or healthcare, to pay for an overhaul or restructuring ahead of an eventual sale. But the debt can finance anything from airline leases to credit for online shoppers.

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A slowdown in bank lending in 2022 made room for the growth of private-market debt. According to data from PitchBook LCD, investors lent out an estimated $200 billion in private credit last year, up from $156 billion in 2021. The firm found that institutional leveraged-loan issuance fell by 63% and high-yield bond issuance by 78% from 2021 to 2022.

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A year ago, the banking sector was competitive. However, now that banks are not lending and public markets are shut, the sector is much less competitive, according to Craig Packer, co-founder of Blue Owl Capital, a private-market asset manager. Preqin reports that there is more than $1 trillion in total private debt outstanding. This asset class has seen significant growth over the past decade, due in part to stricter regulations on banks following the 2007-09 financial crisis. These regulations made it more difficult for banks to issue and hold loans to middle-market companies, leading many to seek out private debt as an alternative source of funding.

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Retirement officials said that private credit is appealing because interest payments adjust to match prevailing rates, and this gives cash-hungry pension funds a steadier income stream. Managers and consultants said that the rising rate environment creates opportunities because companies that are struggling to cover interest costs may be willing to take out relatively expensive private loans to keep cash flowing. They added that if a private loan is at risk of default, a small group of lenders can intervene earlier and negotiate more easily than is possible in public markets.

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The success of private lending depends on how loans are selected and managed. Investment consultant NEPC said in a presentation to the Ohio workers fund last year that many private-credit managers have had trouble liquidating funds by the promised maturity date. Also, a private loan portfolio that isn’t sufficiently diversified or that uses too much leverage can put investors at risk, since one default can potentially wipe out a year’s worth of interest, said Steve Nesbitt, chief executive of Cliffwater LLC, an alternative-asset manager and adviser.

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The default rate on private debt rose to 1.56% in the third quarter of 2022, the first significant bump in 18 months, according to the Proskauer Private Credit Default Index. This index is compiled by law firm Proskauer Rose LLP to track private loans issued mainly to private-equity-backed businesses. Other private-market assets have already run into trouble. For example, Breit, Blackstone's nontraded real-estate investment trust aimed at individual investors, limited how much investors could withdraw in December, causing a dip in Blackstone stock.

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Private debt has outperformed high-yield corporate bonds over the last 15 years, according to Bloomberg index data. The direct lending index from Cliffwater returned an annualized 8.84%, while funds tracked by Burgiss that don't include distressed debt returned 7.54%. This period includes the 2007-09 financial crisis.
It is difficult to ascertain how private credit would fare in the event of another crash, given the limited scope of this asset class in the late 2000s.

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"We try to stress caution with private debt because it's a relatively new asset class," said Oliver Fadly, head of private debt at NEPC. "It's not fully tested yet."