Beneficial tail winds including a lack of liquidity and reduced bank lending are set to fan returns in private credit, allowing investors like pension fund manager $87.5 billion New Jersey Division of Investment with scale and flexibility to provide solutions for cash-strapped borrowers.
“Banks are sitting on the side-lines,” said Jessie Choi, private equity portfolio manager and head of hedge fund/risk mitigation strategies at the Trenton-based fund, speaking in a recent investment council meeting where discussions centred around investment ideas and new allocations to particular managers.
“A dynamic tail wind in private credit bodes well for this investment,” she said.
New Jersey is in the process of rebalancing its allocation to private credit, titling to stable direct lending strategies to anchor the portfolio.
Choi said analysis of the asset class shows that non-sponsor-backed deals (lending to companies that aren’t owned by a private equity sponsor) see less traffic and competition, giving managers the ability to negotiate directly with companies. This in turn makes the underlying loans more secure in a proactive value-add relationship with corporate borrowers.
Manager selection
New Jersey looks for managers with low loss rates and strong track records in an asset class where corporate default is a key risk. Other important manager characteristics include cradle to grave deal teams that not only structure and negotiate the transaction, but stay with the investment throughout so that senior team members that were originators and underwriters, remain on side for the duration.
In a conservative approach, New Jersey channels investment into the senior part of the capital structure, targeting returns of 6-7 per cent. However, the rise in interest rates means returns are now higher and committee members heard that demand for credit over the next two to three years should bring above average returns. It will also drive a safe set of structures for institutional investors that include stronger covenants, not seen for some time.
“It’s good to hear managers are getting stronger covenants,” said Division of Investment director and CIO Shoaib Khan. Khan added that the return of covenants and spreads offers a window into a more challenging business cycle ahead.
This most likely means that default rates pick up, but investors sitting at the high part of the capital structure (unlike high yield which has a different risk return profile) will see less turbulence. Secure, protected investments with equity-like returns promise an attractive outlook for private credit, said Choi.
Asset allocators v asset gatherers
Investing with the best managers is vital to portfolio success but the committee voiced concerns at the ever-growing size of external manager private credit (and private equity) funds. The trend towards larger capital raises, frequently amounting to billions of dollars, could start to impact managers ability to execute and deploy capital. New Jersey is increasingly mindful of the risk of allocating to asset gatherers where managers harvest lucrative management fees but are slow to allocate and invest.
One way to navigate this risk is to ensure asset managers increase their resources. New Jersey’s investment team’s due diligence includes ensuring the opportunity and strategies exist for managers with large sums to deploy.
restructure of risk mitigation strategies
New Jersey is also in the process of restructuring its portfolio of Risk Mitigation Strategies, targeting increased diversification, and a reduction in volatility and fees – alongside improving liquidity via strategies with shorter redemption windows. Choi said that the current environment of elevated volatility because of higher interest rates offers an opportunity for hedge fund strategies.
In 2019, New Jersey dropped the hedge fund share of the portfolio to 3 per cent from 6 per cent following a spate of enduring high fees and mediocre returns.
The reshaped portfolio will involve allocating to around 12-13 funds of which around six are already in portfolio. Hedge fund returns are likely to spike with increased macro and geopolitical volatility, added Daniel Stern, senior managing director in the hedge fund research team at investment advisor and asset manager Cliffwater, also speaking to the committee,
The restructured portfolio will seek investments in macro, trend following, currency and commodity strategies and will be able to invest in assets that are not available in other parts of the portfolio. It will also benefit from the ability to go long or short. The new look RMS portfolio will remove strategies that have a higher beta component and the committee heard that it is possible to reduce fees by moving away from traditional long-short strategies within equities and event driven allocations towards systematic strategies that charge less.
Committee members honed-in on manager selection, and the extent to which New Jersey ensures access to the best managers with strong pedigrees in its top-down approach. Other concerns focused on the need for third party managers to invest assets, rather than hold the allocation in cash/bank accounts, given the current returns available on cash.
Market outlook
Although markets have rebounded, Khan warned of continued volatility, and said small caps and emerging markets trail other market segments. Interest rate hikes, regional bank concerns and fears of a recession merit continued investor caution ahead.
In a few noteworthy strategies in response to market uncertainty, New Jersey is overweight cash in an allocation that is benefiting from higher interest rates.
Elsewhere, the fund has maintained its exposure to equity and fixed income, positioned to capture returns as the market rebounds, and avoiding the need to chase markets if they edge higher. In private markets, New Jersey remains below its target allocations across the board, positioned to take advantage of opportunities undergoing a reset that could include reups and new opportunities where the fund doesn’t have exposure.
