BCI's Daniel Garant on Doubling Private Debt and Other Portfolio Shifts
BCI began building the allocation to private credit after the GFC when new regulatory burdens on banks requiring they hold more capital opened a gap for investors to lend more to private companies. Today, one reason opportunities in the asset class have spiked is because of its competitive advantage over the syndicated loan market, explains Daniel Garant, executive vice president and global head of public markets at BCI where he oversees a $137.8 billion allocation to fixed income and public equity, the bulk of which (79.5 per cent) is managed internally.
“Private debt competes with syndicated loans in the upper-mid market, but syndicated loans are more subject to market volatility. For instance, private debt transactions saw a higher certainty of execution than syndicated loans when Russia invaded Ukraine – private debt brings certainty of execution.”
According to BCI’s 2021 annual report, private debt accounted for 9.1 per cent of the $71.2 billion fixed income portfolio.
Another reason he favours the asset class is because private debt is tied to a floating rate, meaning returns will adjust to inflation.
“There will be a lag, but a floating rate will adjust with rising rates and this is a good protection against inflation.”
In a third seam, the allocation also supports BCI’s clients’ liability profiles. “In this sense, private debt fits with assets like infrastructure and real estate,” he says.
BCI invests in private debt via partnership with external managers either in separately managed accounts or co-investments. In a hybrid approach, the internal team carry out the screening and research on each individual credit.
“It is not a passive model where we allocate to external managers; we get to select the credits we like and the pricing we are comfortable with,” says Garant.
Bias for Active
It’s an active approach that is reflected across the portfolio. In another strategy born from today’s investment landscape (where Garant says volatility will bring plenty of opportunities despite the challenges) he is increasingly prioritising active equity over owning the entire market to strike when opportunities are mispriced, add value, and better manage risk as lockdowns in China and war in Ukraine cause a prolonged supply chain crisis for many corporations.
Active allocations in the public equities program include two active funds with a strong ESG focus (global thematic and global quant ESG where ESG scores drive the stock selection). The global thematic fund’s investment process focuses on long term trends based on internal research.
“Allocations are really based on our expectations of where trends are going in the next three to five years,” he says.
The Global Quantitative ESG Equity Fund has outperformed its benchmark since its inception in 2019.
“In addition to risk management, our ESG screens are a source of value creation.”
Emerging markets
BCI’s belief in active management over indexing is also apparent in emerging market equities. BCI has started to integrate ESG analysis into emerging market equities (23.1 per cent of the $66.6 billion public equity allocation) for some client funds.
“The effort on the ESG side in emerging markets is significant,” he says, describing how emerging market assets have a wide dispersion that requires a bottom-up and top-down analysis. “We can’t just do stock selection; country selection also matters,” he says.
BCI decided to shift more from indexing to active in emerging markets over a year ago, a prescient decision given today’s darkening economic picture of rising rates and slower economic growth in emerging economies.
“We are now seeing clear signs that geopolitical developments in emerging economies are going to be a factor in the future in a way we haven’t seen for the last 15 years,” he says.
Leverage
He is also mindful of the impact of rising rates on other investment seams in the portfolio. Like leverage, where ensuring financing costs are adequately compensated with expected returns is a growing theme for investors.
For example, he believes private equity will increasingly feel the pinch given its dependency on the availability of cheap leverage, particularly if the selloff in public equity proves a warning shot of tougher times in private equity too.
“Things are getting pricey,” he says.
BCI increasingly filters opportunities in the portfolio, steering clear of investments where bidders are getting on top of each other; happy to be outbid and only allocating to the best transactions.
In an approach that differs from Canadian peers, BCI’s member funds decide their own level of leverage in line with their own liabilities and funding ratios. They make the decision when they select their asset allocation in an approach that Garant argues offers more transparency than other approaches where investors struggle to gauge how much leverage they have because it is already embedded in products.
“Instead of embedding leverage in asset classes at the corporate level, we have structured an application of leverage at a client level. Some clients will want to increase leverage because of where they are in their asset mix, others won’t, and we don’t make a decision on their behalf – it is client specific.”
Economic landscape
Looking out on the macro landscape, Garant is most concerned about wage increases, already starting to come through, fuelling inflation further. “Wage inflation worries us most because it is more persistent,” he says.
Moreover, investors are in the hands of central bank policymakers who have been slow off the mark in anticipating and taming inflation: rates will continue to rise more than what is already priced in, he predicts.
Although he is confident central bankers have the tools they need to fight inflation, he is worried about whether they will chart a soft or hard landing for the global economy.
“The Fed will be able to tame inflation, this is not the issue. The question is whether they do it in a way that will cause a short-term recession. There is a risk of an economic slowdown.”
He concludes, however: “Nothing lasts forever; I don’t believe in strong inflation for the next 10 years. Central banks have the tools to bring it under control.”
This is an excellent interview with Daniel Garant, EVP & Global Head of Public Markets at BCI.
It's also a rare interview because Mr. Garant and the rest of BCI's senior leaders are typically tight-lipped about their investment approach.
But I welcome it and hope to see more interviews like this in the future.
Some thoughts on the interview above.
Let me begin with private debt. I downloaded BCI's 2020-2021 Corporate Annual Report here and looked into details on strategy and asset allocation in its Fixed Income portfolio (pages 33-34):
Here is the key passage:
BCI’s fixed income program invests in public and private market debt. We offer clients a diverse range of products, including government and corporate bonds, and private debt. Our strategies include yield curve and credit spread positioning, duration timing, sector and security selection, and leverage. The private debt program provides exposure to opportunities in Canada, the United States, and Europe through our partnerships with top-tier private debt managers.
Issuers within our pools are assessed and reviewed regularly for default and credit risk. We use internally and externally produced credit ratings to assess credit risk. Additionally, we actively integrate ESG factors into our investment analysis and decision-making.
We continue to strengthen our internal fixed income capabilities for managing credit strategies and increase allocations to strategies that offer higher risk-adjusted returns.
In the past few years, BCI has significantly expanded access to fixed income credit products and capabilities, notably through the Corporate Bond Fund and the Principal Credit Fund. We also facilitated the use of leverage by some of our clients in their long-term strategic asset allocation through the launch of the Leveraged Bond Fund
Now, as at March 31st, 2021, BCI had 9.1% of its $71.2 billion fixed income portfolio allocated in Private Debt.
According to the article above, it plans to double this allocation.
Can this be done? Consider this, right now, CPP Investments, the largest pension fund in Canada, has the highest allocation to private debt (16% of CPP Investments' total assets are in Credit, a huge chunk of that is Private Credit) as well as Private Equity (32% of total assets) but it also owns Antares Capital, a preeminent player in middle market private debt space with more than $50+ billion of capital under management.
If BCI is to double its allocation to 18% of its fixed income portfolio assets, it will need to allocate more to its strategic partners in this space.
At 18%, that represents roughly $13 billion of fixed income assets or 6.5% of total assets (using figures from March 31st, 2021).
At 6.5% of total assets, private debt is going to make a difference in the total portfolio and add nice risk-adjusted returns to the fixed income portfolio.
Daniel Garant is right, syndicated loans are more volatile than private debt which are private debt arrangements between parties where there is more certainty of execution.
Moreover, private debt loans are tied to floating rates which are tied to inflation, so there is an inflation-adjusted component embedded in these loans (with a lag).
And just like Real Estate and Infrastructure, there's a better match between private debt and the liabilities of their clients which are long-dated.
Also, note this part of the interview:
BCI invests in private debt via partnership with external managers either in separately managed accounts or co-investments. In a hybrid approach, the internal team carry out the screening and research on each individual credit.
“It is not a passive model where we allocate to external managers; we get to select the credits we like and the pricing we are comfortable with,” says Garant.
They are actively engaged with external managers on selecting the credits and pricing they are comfortable with.
Now, returns have been coming down in the private debt space as competition intensifies but it remains a very important asset class and one where if the approach is right, it can add significant risk-adjusted returns.
Again, even if BCI doubles its allocation to private debt in its fixed income portfolio (to 18%), it will still remain 6-7% of the total portfolio, which is fine and within the median allocation at other large pensions.
There are plenty of opportunities out there.
Today I read KKR has raised $1.1 billion in its inaugural Asia credit fund that provides debt financing to companies, marking what the US. private equity firm said was one of the largest such first-time fundraisings in Asia Pacific.
I'm just giving you an example of how private credit is taking off everywhere, including in Asia where companies are tapping into alternative sources of funding though banks still account for the bulk of financing.
Investors are drawn to private credit because of higher risk-adjusted returns.
Alright, let me close out my comment with some other thoughts on the interview:
- Active allocations in the public equities program include two active funds with a strong ESG focus (global thematic and global quant ESG where ESG scores drive the stock selection). The global thematic fund’s investment process focuses on long term trends (3-5 years) based on internal research. Interestingly, the Global Quantitative ESG Equity Fund has outperformed its benchmark since its inception in 2019, which underscores the point that in addition to risk management, their ESG screens are “a source of value creation."
- In emerging markets, rising rates mean active management is critical and ESG also factors into their investments there. Moreover, he rightly notes this: “We are now seeing clear signs that geopolitical developments in emerging economies are going to be a factor in the future in a way we haven’t seen for the last 15 years.” I couldn't agree more, following the invasion of Ukraine, geopolitical risks are more important than ever and he's right: “We can’t just do stock selection; country selection also matters.”
- On leverage, I found it interesting that BCI uses an approach that differs from Canadian peers, as its members decide their own level of leverage in line with their own liabilities and funding ratios. “Instead of embedding leverage in asset classes at the corporate level, we have structured an application of leverage at a client level. Some clients will want to increase leverage because of where they are in their asset mix, others won’t, and we don’t make a decision on their behalf – it is client specific.”
- He thinks Private Equity will feel the pinch given its dependency on the availability of cheap leverage,
particularly if the selloff in public equity proves a warning shot of
tougher times in private equity too. No doubt, if public markets get hit, it will reduce the exit window for private equity and impact returns but it will remain the most important asset class at pensions with along horizon.
- Lastly, on the macro front he is confident central bankers have the tools they need to fight
inflation, but he is worried about whether they will chart a soft or hard
landing for the global economy. They are also worried about wage inflation.
The macro challenges are plenty but the real estate buying frenzy is over and as Francois Trahan points out, when housing activity starts declining, a recession is on its way (citing Ed Leamer's paper "Housing is the Business Cycle"). Other experts also think it's time to prepare for a recession.
Right now, the risks of a policy error are high because the Fed dragged its feet and started raising rates way too late, but this can change as economic data changes.
Some are even talking about the Fed pausing in September before mid-term elections (highly likely) but it remains to be seen whether it can avoid a hard landing.
Inflation is already wreaking havoc on demand and you see it in the earnings reports of Walmart, Target (got hit hard) as opposed to Dollar General (benefiting from shift in consumer spending).
Some think stagflation is what lies ahead, I'm highly skeptical and think secular deflationary headwinds will come back with a vengeance (high debt, aging demographics, rising inequality, technological innovation, etc).
All this to say the macro front isn't easy so read up as much as possible from experts to get an informed opinion and stay humble and alert.
Below, for some investors, recent asset allocation decisions have been heavily influenced by volatile geopolitical developments and levels of inflation that many predicted would be transitory. Managers of pension funds and endowments, and other institutional investors are required to make strategic decisions to ensure that obligations can be met decades ahead. In an environment where short-term investing can be rewarded generously, how do long-term investors keep their capital patient? What asset classes and geographies are the most attractive? What roles do ESG concerns such as sustainability, diversity, and inclusion play in their organizations and investment processes?
BCI's CEO/ CIO Gordon Fyfe took part in a panel discussion on long-term strategic thinkers at the recent Milken Institute event. Take the time to watch this discussion and listen to Gordon's views on many issues including why engagement works better than divestment.
Also, Bob Prince, co-chief investment officer at Bridgewater Associates, discusses the impact of Federal Reserve policy and inflation on bond markets, outlook for the US economy, and the firm's investment strategy He speaks at the World Economic Forum’s annual meeting in Davos, Switzerland on "Bloomberg Surveillance."
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