UK's RPMI Railpen Aims to Boost Private Debt

Marianna Duarte de Aragao of Bloomberg reports that one of the UK’s largest pension funds, which oversees the retirement assets of 350,000 British railworkers, is betting on private credit to help preserve returns during the next downturn:
RPMI Railpen aims to boost its exposure to private debt to as much as 40% within a private investment strategy totaling 4.5 billion pounds ($5.5 billion) across two funds. While still a fraction of the scheme’s 30 billion pound asset total, the value of one of the funds dedicated to private markets doubled to almost 1 billion pounds in 2018 from a year earlier.

“When the cycle turns, debt will be affected, but likely to a lesser degree than the equity piece, hence including the strategy in a wider private markets portfolio,” Andrea Ash, investment director at RPMI Railpen, said in an interview.

Institutional investors such as RPMI Railpen are pivoting toward private credit as they search for returns amid ultra-low interest rates and negative yields. A July survey of more than 550 European buy-side firms revealed that private debt would be among the most favored investment asset classes in the next three years, alongside private equity and infrastructure.

Return Kicker

The railworker pension scheme’s private debt push goes beyond direct lending by also targeting distressed and niche strategies such as credit risk transfers. The fund, which hired two investment directors for its in-house private markets team last November, is currently “below target” when it comes to private debt, according to Ash.

“In the distressed space, we’re at the end of the cycle so you have to be careful as it’s like trying to catch a falling knife on the way down, but you can generate a real return kicker on the way up,” Ash said.

The renewed hunt for yield among investors is helping drive a boom in fundraising, with global dry powder reaching an all-time high, according to law firm Akin Gump Strauss Hauer & Feld LLP. In the direct lending space, the flood of capital has intensified competition and led to higher leverage and weaker underwriting standards.

While quantity and quality of covenants and use of leverage are natural concerns for investors given the end of the cycle, “there remains a good case for having private credit in the portfolio,” Ash said.
UK's RPMI Railpen is one of the more sophisticated investors around the world and it is certainly among the best UK pension funds.

Last September, Railpen snagged a BCI executive, Michelle Ostermann, for the new role of chief fiduciary officer for investments.

Andrea Ash sounds like a very smart lady. She understands the credit cycle and is very careful and measured in what she is saying in regards to private debt.

RPMI Railpen isn't the only UK fund interested in boosting private debt. A 500-year old Christian institution in England is also seeking to boost returns by shifting money into firms that extend private loans to small and medium-sized companies:
The Church of England Pension Board plans to increase its allocations to private credit to 8% percent over the next 10 years, from 3% at the end of 2017, according to its chief investment officer Pierre Jameson. The pension fund manages 2.6 billion ($3.3 billion) pounds of assets.

This is part of a broader change of tack by the 38,000-people member fund toward private investments and away from equity, Jameson said in an interview.

The strategy is another example of how pension funds are being drawn to private assets as they seek to lift returns and meet payout commitments amid ultra-low interest rates. The asset class is also less sensitive to market volatility, according to Jameson.

“Escaping from price swings is key for U.K. pension schemes given we’re required to mark to market,” he said. “Private assets’ values are based on realistic expectations and cash flows for the underlying businesses so we feel our actuarial assumptions are solid and not vulnerable to market sentiment.”

The church’s pension scheme aims to slash its public equity allocation to 35% from 66% currently within its “return-seeking assets,” which account for 85% of the fund. It will reallocate the proceeds into infrastructure, private debt and private equity. The scheme expects returns of 6% to 8% on its private credit investments, Jameson said.

Asset Growth

The number of Europe-based public pension funds investing in private debt has jumped from 60 in 2015 to 136 last year, with their median allocation to the strategy increasing from 1.28% to 2% in the period, according to Preqin, a London-based research firm.

“The return profile from private credit looks interesting given how low yields are in the public fixed income market. Many are also moving away from equity due to high valuations,” said Samuel Gervaise-Jones, a senior director at bfinance, a consultancy firm that advises pension funds and other end-investors.

“There remains room for growth as there are plenty of pension funds with no exposure to the asset class,” Gervaise-Jones said.

Investors’ appetite for higher-yielding assets, together with banks pulling back from riskier lending, is helping drive a boom in private debt fundraising. Preqin noted that assets under management had soared to $770 billion in June 2018 from $275 billion in 2009.

But as capital floods into private credit and competition intensifies, more leverage has crept into deals and underwriting standards have loosened. This has prompted regulators to look at the sector more closely.

End-investors “acknowledge that the market has changed and are putting much more focus on managers’ origination and underwriting processes,” bfinance’s Gervaise-Jones said.
What is the attraction of private debt as an asset class? Simple. Jim Bianco of Bianco Research posted this on LinkedIn: "Negative debt expanded by a record $650 billion on Friday (Aug 2). Total negative debt is a new record at $14.52 trillion. Negative debt is now 26.3% of all sovereign bonds, also a new record."

HOOPP's CEO Jim Keohane once told me there's is NO way they will ever buy negative yielding debt under any circumstance, and they're not alone. As negative yields spread throughout the world and threaten to hit the US, investing in alternative investments like real estate, private equity, infrastructure and private debt becomes increasingly popular.

Why? Look at the wild gyrations in public markets this week. Not just stocks but even US Treasuries long bonds are swinging like crazy.

Pension plans want steady returns that meet their liabilities without all the volatility of public markets. As rates tumble to record lows and go negative, investors are increasingly attracted to private debt.

What is private debt? I'd invite you to read this BNY comment to understand private debt as an asset class but in a nutshell, following the great financial crisis, banks retrenched from lending to small and medium-sized businesses, creating a vacuum that is filled by pensions who invest in private equity funds or do direct lending internally.

When public corporations borrow, they emit corporate bonds, typically to buy back their shares to boost earnings-per-share and boost their executive compensation. I'm being very cynical but it's by and large the truth. Investors love it because they get rewarded even if they publicly scorn companies for not investing enough into the real economy.

Private companies, especially smaller ones, don't have access to corporate debt markets so they either go to banks who typically lend them on 5-year term loans and charge hefty rates or they go to alternative lenders who can lend for longer, offer better rates and more flexible terms.

I'm over-simplifying it as there is more to private debt than direct lending but that is the gist of it. It's about the spread alternative lenders make from borrowing at ultra low rates and lending to small to large private companies looking to grow their business.

Are there risks? You bet, this late in the economic cycle, an exogenous shock can hit the high yield credit market, clobbering public and private markets, and as money pours into private debt, covenants are getting way too loose and pose risks if there is a significant downturn and borrowers aren't able to pay back their loans.

Of course there are ways to mitigate these risks but in a really bad economic crisis, there is no way private debt won't get hit too. Also, as more and more money pours into the asset class, returns have come down from mid-teens five years ago to 6 to 8% (on average) now.

Still, it's risk-return profile is a lot more attractive than volatile equities and that's why investors are flocking to private debt.

And it's not just UK investors boosting their exposure to private debt. Martha Porado of the Canadian Investment Review recently discussed how Canadian institutional investors are boosting their allocation to private debt:
Canadian institutional investors are taking on more private credit, both as a replacement for equity, as well as a tool to enhance their fixed income allocations, said Janet Rabovsky, partner at Ellement Consulting Group in a webinar presented by the Canadian Investment Review on Tuesday.

For pension plans in particular, the equity-like return that private credit can yield, accompanied by significantly lower volatility than equities, has major appeal, she said.

But what is private credit?

“Private credit is exactly as the word states, credit that’s not publicly traded,” said Rabovsky.

There’s no strict definition for the asset class, she added, noting it’s a catch-all term that encompasses a range of solutions, the most popular of which is direct lending. Debt tied to infrastructure and real estate also fall into this category.

As with any asset class, there are pros and cons to investing, and the choice to take on private credit should be determined by both financial and non-financial factors, said Rabovsky.

Liquidity is one factor to consider. “As with other private asset classes, one hopes to access an illiquidity premium. Some might argue that this is diminishing given the popularity of this asset class. But it still remains, especially outside of core holdings.”

Private credit’s lower volatility and tendency to be floating rate, meaning returns will go up as interest rates do, are also attractive aspects of the asset class, added Rabovsky.

Picking the right manager when first entering the asset class is extremely important, she noted. “Disciplined and skilled managers who have experience in negotiating covenants and asset security have an advantage, as do those who have invested through the global financial crisis.”

It’s also important for investors to understand what they’re getting into. The asset class is more complicated than traditional fixed income, using vehicles investors may not be familiar with, while higher fees and different tax considerations are also in play, said Rabovsky.

“As with any asset class, investors should not invest in something they don’t understand and don’t have the time to monitor.”

As with all debt-based investment, default risk goes hand-in-hand with private credit, she said. “It’s fair to say there will be defaults. These are higher risk loans, but many don’t experience any permanent capital loss or very little capital loss ratios, with ratios which are well below those of high-yield debt.”

When specifically considering direct lending, the most popular form of private credit, there are several sub-categories and distinctions, noted Rabovsky.

“Loans can be sponsored or non-sponsored,” she said. “A sponsored deal is where money is lent to a private equity sponsor who will usually purchase the company with 50 per cent equity and 50 per cent debt. This means that when there are issues with the company, there are equities backing the company which can be drawn on and the sponsor may be asked to provide more capital.”

Non-sponsored lending, on the other hand, is lending directly to the business owner. This method is less popular because it often requires more hand-holding from the lender, though returns are generally higher, congruent with the added effort, said Rabovsky.

Within real estate debt, a borrower is leveraging a real asset — in this case, physical property. “It includes both commercial mortgage and senior-secured and mezzanine debt. Real estate debt funds have become popular as they can close on a deal much more quickly than a bank and offer the borrower more flexibility.”

One increasingly popular form of real estate debt is commercial mortgages, especially in the current low interest rate environment, noted Rabovsky.

Infrastructure debt is also secured against physical assets. As with real estate debt, infrastructure tends to be purchased through a combination of debt and equity, she said, noting a social infrastructure asset, like a hospital, is likely to be closer to 90 per cent debt, since it probably includes a guaranteed government payment to the investor.

A port, on the other hand, is an example of economic infrastructure, and would be with about 50 per cent debt and 50 per cent equity, said Rabovsky.

When investors are considering a private credit investment, they should ask themselves two key questions, she added. “What are you hoping to achieve? And where in the portfolio are you going to be placing this? Is this an equity replacement or is this a fixed income enhancer? And that may determine whether you’re looking at the more public or private forms of credit.”
I hope this comment helped many of you get a better understanding of private debt and why investors are embracing it and what the risks are.

Below, one of the biggest trends increasing in investments in the private markets (in alternative investments) is private debt. In this video, Steve Balaban explains four types of private debt, as well as a recent private debt fund call KKR Private Credit Opportunities II.

Also, an interesting panel discussion with some of Canada's leading experts on private debt.

Third, Kewsong Lee, co-chief executive officer at Carlyle Group, discusses the state of the deals market, the growth of private credit, and the future of private equity. He speaks with Bloomberg's Jason Kelly on "Bloomberg Daybreak: Americas" (September, 2018).

Fourth,  Howard Marks, co-founder and co-chairman at Oaktree Capital, discusses a $1.8 billion loan made by Apollo Global Management LLC, opportunities in distressed investing, and his take on Federal Reserve policy. He speaks with Bloomberg's Erik Schatzker on "Bloomberg Daybreak.

Lastly, a great panel discussion on credit markets which took place at this year's Milken Institute conference featuring top institutional investors. Fast forward to minute 18 to listen to Justin Slatky's take on private debt.