There continues to be potential for pension capital appearing where bank lending no longer wants to go. Commentators in the UK and continental Europe have heightened expectations that pension funds will step in to help fill the continent’s bank financing gap. Societe Generale, for instance, recently predicted further “disintermediation” by investors sidestepping banks and looking for greater seniority than bond holding. Over in the US, the news that average yields on high-yield debt have fallen below 5 per cent for the first time, according to the Barclays US High Yield Index, could also give added impetus to funds exploring the higher reaches of the capital structure.
The consultant call
David Bennett, head of investment consulting at Redington, says his consultancy is advocating moves into direct lending investments in the majority of its asset allocation reviews for institutional clients. He argues that the relative value appears quite strong: “The general trend in credit spreads has been considerable tightening, and there are not as many opportunities any more in high-yield or investment grade debt to make the returns that funds need.”
Bennett is confident that the area of direct lending will progress from its relatively exotic status to something more mainstream in time. “Provided a fund has capacity for investments in illiquid assets, there seems to be considerable interest as the asset class offers exceptionally attractive risk-adjusted returns,” he reckons.
Bennett says the European direct lending market is much less developed than that of the US despite the greater need for post-crisis refinancing. Relatively unattractive pricing is a major barrier in Bennett’s view. He expects the pricing to become more attractive though, as European borrowers seek out non-bank funding in response to the challenging environment they face when refinancing the so-called “maturity wall”.
The fund angle
Investors have also raised uncertainty over the structuring of direct lending investments as a stumbling block. Steven Daniels, chief investment officer of the $10-billion Tesco scheme’s inhouse investment arm, told this year’s UK NAPF Investment Conference that pension funds are “potentially good banks, but we are not mugs”, pointing out that it would scrutinise any investments in the area. In a similar vein, Niels Jensen, investment director of the $11.8-billion Lægernes Pensionskasse in Denmark, recently told top1000funds.com that checking that “the spreads are attractive enough” is a vital consideration to the interest his fund has gained in the credit opportunities space after seeing bank credit squeezed.
Brett Cornwell of Callan Associates adds that fees remain a sticking point for many US funds, with a “hedge-fund style” fee structure of 1.5 to 2 per cent in management fees, plus additional performance fees the norm. “Five-year-plus lock-ups are part and parcel of the illiquidity downside,” Cornwell adds.
Cornwell accepts the return advantages can outweigh these concerns in many cases. Andrew Bratt of the Pension Consulting Alliance in California, while also accepting the advantages of direct lending, believes some of the slow take-up among pension funds can be explained by difficulties in “finding the proper portfolio segment for this type of investment”.
Bratt argues that direct lending is “not liquid compared with traditional fixed income and it does not present the opportunity for private equity returns. I see this as a problem for many pension funds, save for those who specifically allocate to this type of product.”
Larger public pension funds are proving thus far to be the most common US direct lending investors, adds Cornwell. He characterises the typical fund exploring the asset class as “having healthy fixed income investments already, and liquidity in other parts of the portfolio, seeking yield, generally being more sophisticated with alternatives, active in private equity and having larger staffs to vet managers.”
The $9.9-billion Orange County Employees Retirement System and $8.4-billion San Diego County Employees Retirement Association are two US funds recently reported to be exploring the direct lending option.
Lending in all shapes and sizes
The most accessible way for funds to benefit from banks’ limits appears to be through direct lending funds. Plenty of skilled providers are competing in this area, Bennett says, despite significant challenges in checking credit worthiness, structuring loans and providing sufficient governance. The likes of M&G Investments’ UK corporate financing fund have been the most notable recent European offerings for their linking of pension funds with small and medium enterprises.
Some of Europe’s biggest investors have gone for something seemingly more ambitious though – making their own infrastructure loans or snapping up debt from banks’ hands. Dutch fund manager APG made an inflation-linked loan in a €80 million ($105 million) road-financing deal last October, a uniquely valuable investment in a country whose government does not issue inflation-linked bonds.
Bennett recognises that infrastructure loans are more of a specialist niche for large investors, saying, “You really need a manager with a specialist hat on”. A great attraction of infrastructure loans, argues Stefan Lundbergh, head of innovation at Cardano and board member of the $35-billion Swedish fund AP4, are their inflation-linking properties – especially if done in partnership with a government.
Lundbergh cautions that funds wanting to take the direct route on infrastructure loans must recognise the level of expertise needed – underwriting loans being far from a simple exercise. His reckons these complexities can limit the number of opportunities, saying “all the legal work, paperwork and negotiations to get the loan in place are worth it for big-ticket investments, but this becomes more difficult for smaller ones”. Liquidity and valuation difficulties will also be acquired when the loans enter the portfolio, but there is no reason why talented medium-sized funds should not be able to rise to this challenge though, he adds.
PensionDanmark also made waves last year by acquiring $350 million in infrastructure loans from the Bank of Ireland as part of a $750-million secondary loan mandate with JP Morgan. Secondary loans also require a “very different” skill set, says Bennett.
New equilibrium?
While Bennett believes “one day it’s possible that long-dated institutional investors can take a significant proportion of the corporate lending market”, Lundbergh reckons that competition issues will prevent pension funds from making too many inroads into traditional banking territory. Pension funds’ tax-free status in the Netherlands derives from their status as passive investors, which could be compromised by directly underwriting loans, he says. He adds that despite some expectation that pension funds could cover for retrenching investment banks,“I would expect more in the way of partnerships with underwriters”.
Cornwell argues that while externally managed direct lending remains an exotic option, “comfort levels” are definitely increasing. “Ten years ago, high yield was more exotic than nowadays. As you become more comfortable with the capital structure of these corporations and how the lending mechanism works, it opens up space in the marketplace for those able and willing to loan,” he says
As professional investors, any expectations that pension funds can fill in the worst gaps in European lending might be over-ambitious though. Projects in countries saddled with government debt worries might after all only find pension capital offered at rates as unappealing as those offered by the continent’s cautious banks, says Lundbergh.
Then there is the question of how long the window of opportunity will stay open for, as in healthy times banks generally have no trouble lending money. Longer dated infrastructure loans could prove to be the most durable of the current bout of lending from funds, Bennett says. While banks can be expected to eventually expand balance sheets again, instead of simply muscling pension funds out of the direct lending space, a “new equilibrium” could emerge, he argues. The edge institutional investors can gain over banks in long-maturity lending is one Bennett expects them to keep beyond then.
