Pensions Go ‘Exploring’ In Exciting World Of Opaque, Illiquid Private Credit

It’s time pension funds pile into direct lending!

Because absolutely nothing could go wrong with funneling billions of dollars of other people’s retirement money into private credit.

As regular readers know, we are not predisposed to rolling out tired, old “what could go wrong?” cliches. “What could go wrong?” is a joke you use when your creative writing skills have failed you.

And yet, sometimes, that joke is appropriate. This is probably one of those times. Consider this, from a Bloomberg article out Monday:

Arizona’s $41 billion State Retirement System is looking to dedicate one out of every six dollars it manages to direct lending — more than five times the industry average — in a move some see as a harbinger of what’s to come for the booming asset class.


In a recent survey of firms managing nearly $400 billion in private-credit strategies, nearly 90% said they expect pension funds to up their allocations over the next three years. The Ohio Police & Fire Pension Fund said this month that it was cutting its high-yield exposure as it moves toward a 5% target for private debt. And in its most recent financial statement, the Teachers’ Retirement System of the State of Illinois said it “continues increasing exposures to private debt opportunities,” even as it retreats from fixed income broadly.    

We get it. We really do. Fixed income yields are paltry. Consider that even after the universe of negative-yielding debt shrunk by roughly $6 trillion (with a “t”) since August, the pile of debt sporting sub-zero yields is still above $10 trillion.

Direct lending returns since 2010 have totaled more than 160%. By comparison, returns on high yield bonds and leveraged loans look relatively meager. The Bloomberg piece mentioned above cites a recent Goldman note which is actually just an update on the bank’s previous work on private lending.

Goldman emphasizes investors’ “strong ‘search for yield’ motives as a key driver of the growth in the direct lending market”. The chart below shows why investors would be inclined to take the risk associated with private credit:


The yield on the Cliffwater Direct Lending Index offers more than 5% of yield pick-up over high yield bonds and leveraged loans.

There’s a lot of nuance to this discussion, and we’ve been over it at length in these pages, most notably in “‘Private’ Parts: Explosion In Private Debt Market Cements ‘Liquidity As The New Leverage’“. But the bottom line is that peculiarities and myriad idiosyncratic factors aside, the dynamics here are similar to what you’d expect in a burgeoning, high-growth market. Money coming in equals demand, and where there’s voracious demand, there will be a rush to create supply, which in turn raises the risk that underwriting standards will deteriorate.

“All that money pouring in is making the asset class more competitive, and thus less attractive”, Bloomberg goes on to say, noting that “the influx of cash may fuel weakening lending standards”.

Clearly, that risk is magnified when you throw in concerns about the length of the cycle and the prospect that, central banks’ best efforts aside, we’re approaching a turn.

Bloomberg uses a chart based on Preqin data that shows AUM in the private debt market more than doubling since 2012. What’s interesting is that according to Preqin, the “dry powder” portion of the total $812 billion in AUM sat at $269 billion as of June – that’s just off last year’s record.

“So much capital has been raised that not all of it has found an opportunity to be deployed”, Goldman says.

While the bank notes that late-cycle concerns could prompt caution when it comes to locking up money for the long-term in private credit, “the large amount of capital still available for deployment” should foster “competition among direct lenders”. The bank sees continued growth.

At the end of the day, this is just investors looking to lean into the illiquidity premium in order to capture more attractive yield.

Which is fine, as long as everyone is ok with pension funds investing in direct lending. And also other things.

The Arizona retirement system, Bloomberg goes on to say, is also going “exploring” (maybe “spelunking” is better) in other fun places, like litigation finance and aircraft leasing ABS.

The fund looks after the benefits of some 250,000 people.


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