Private credit remains growing part of pension plan portfolios

Private credit assets of the 200 largest retirement plans grew 12.5% to $98 billion in the year ended Sept. 30 despite some asset owners’ portfolios falling during the period.

The good news and the bad news for the asset class are rising interest rates, industry insiders said. Rising rates are expected to benefit private credit managers with floating-rate debt, said Adam Bragar, New York-based head of the U.S. private equity practice of Willis Towers Watson PLC.

“But at the same time, there’s a good number of LPs that are less happy about returns of current funds because of interest rates,” Mr. Bragar said.

Rising interest rates hurt companies’ cash flow and ability to make loan payments. What’s more, credit managers with fixed-rate loan portfolios that do not adjust when interest rates go up — opposed to those including floating-rate debt — are seeing a drop in returns, he said.

The Cliffwater Direct Lending index, which represents $260 billion in private credit assets, unlevered, returned 6.6% for the 12 months ended Sept. 30, compared to 14.25% for the prior 12-month period.

While some plans with the largest portfolios reported asset declines during the year ended Sept. 30, most plans reported private credit asset increases.

Among Pensions & Investments’ top five private credit investors ranked by portfolio asset size, the portfolios of two defined benefit plans rose — the $48.7 billion Arizona State Retirement System, Phoenix, (up 10.6% to $11.5 billion) and $60.7 billion Illinois Teachers Retirement System, Springfield, (up 41.3% to $6 billion) while the private credit assets fell at the other three plans — $233.2 billion New York State Common, Albany, (down 6.5% to $8.5 billion); $430.4 billion California Public Employees’ Retirement System, Sacramento (down 28.9% to $7.7 billion) and $105.7 billion North Carolina Retirement Systems, Raleigh (down 2% to $6.9 billion).

“Investor appetite for private credit has gone through fairly wild swings over the 12 months ending in September,” said John Delaney, Philadelphia-based senior investments director and portfolio manager at Willis Towers Watson PLC.

Toward the end of 2021 and early 2022 investors were attracted to private credit for higher yields, he said.

“As interest rates rose and the more liquid parts of the credit universe repriced and became more attractive in the middle of 2022, the hurdle for investing in privates and tying up capital in less liquid structures increased, and investors focused capital allocations on more liquid markets,” Mr. Delaney said in an email response to questions.

Arizona State Retirement has the largest private credit portfolio on this year’s list, with $11.5 billion, up 11.2% over the year. Part of the reason is that pension fund officials have been increasing their exposure to private credit, boosting its target allocation by 1 percentage point to 23% in August as part of a new strategic asset allocation. As of Sept. 30, the pension fund was overweight private credit with 23.8% of its portfolio invested in the asset class, according to information on its website.

Investment staff believe that private credit presents a “compelling opportunity to exceed our 7% target over an expected extended period of time,” said Al Alaimo, deputy CIO, at the pension plan’s Nov. 28 board meeting. Historically, private credit has produced a 9% internal rate of return, he said.

Mr. Alaimo added that the recent drop in the equity, fixed income and tradable credit markets “created the best investment environment for credit we’ve seen in a few years and the potential return opportunities are higher than in the start of the year (2022).”

Pension fund officials expect that private loans for middle-market buyouts and mergers and acquisitions in the U.S. and Europe present the “most attractive market” they anticipate will achieve double-digit returns and be an area in which they can invest a large amount of capital, Mr. Alaimo said.

“It’s a huge opportunity we’ve been exploiting for the last decade,” he said. And the majority of the plan’s private debt is in senior secured loans, which are mostly in floating rate and benefit from rising interest rates, Mr. Alaimo said.

Arizona is also invested in distressed debt situations as well as niche credit investments that include equipment leasing, infrastructure collateralized loan obligations, litigation financing, life insurance policy investments, litigation finance and risk sharing transfers from banks, mainly with European banks, he said.

“Private credit held up very well in 2022,” mainly due to floating-rate senior secured assets that outperformed other loans that were flat for the year, said Thomas Majewski, Greenwich, Conn.-based managing partner and founder of Eagle Point Credit Management, which manages $7.5 billion in credit assets under management.

“While middle-market credit is great, it’s not perfect and some companies will face some challenges no matter how good (the credit managers’) underwriting,” he said.

Most companies are facing headwinds today, it’s just a question of the severity of the headwind and the impact of rising interest rates on the company, Mr. Majewski said.

Rising rates are good for lenders of floating-rate debt; however, the companies have to pay the higher rates and some may face challenges paying the debt service, he said.