PGGM, the €228 billion asset manager for the Netherland’s second-largest pension fund PFZW, is working with US hedge fund manager Bridgewater to help restructure its portfolio to incorporate impact.

The research partnership will integrate a 3D approach incorporating risk, return and impact at PGGM that goes beyond its existing SDG alignment and particular focus on healthcare and climate themes. Still in the early throes of the partnership, the investors are collaborating on analytical detail and wrestling with the tough issues that go into building these new portfolios.

Arjen Pasma, chief fiduciary manager, PGGM, and Carsten Stendevad, CIO, sustainability at Bridgewater, took to the stage at Sustainability in Practice, the University of Oxford, to detail the strategy in action that will ultimately change the look of PGGM’s portfolio, most notably reducing the number of public market stocks.

“We will look very different in five years’ time,” said Pasma, who said the approach applies across public and private markets and the bar for claiming impact is high “There will be fewer names in the portfolio. Research involves a lot more than just buying a company.”

The importance of beliefs

In a catalyst to the new strategy, PGGM recently re-wrote its investment beliefs in a process that has shifted its focus away from exclusions, targets and risk and return optimization. Instead it has begun honing-in on the assets in the portfolio and conducted deep dive analysis on how to make the portfolio more sustainable.

The new approach is already addressing previous challenges – like the fact exclusions “don’t work” in the 30 per cent allocation to private markets. “For every single line in the portfolio, we want to know why it’s there and that we’ve evaluated the risk,” said Pasma.

Carving out beliefs sharpens strategy and helps navigate uncertainties. For example, investors need a strategy on whether or not to finance transition assets. Are they  prepared to invest in high emitting companies if they are reducing their emissions and are on a credible pathway? This type of analysis involves a long journey and comparing notes in a concrete and practical process. Elsewhere, beliefs help decide whether to focus on climate or social issues – or both.

“There is no right way of doing it, but you need to understand all downstream choices,” said Stendevad.

Beliefs also provide a framework to respond to difficult questions around performance. Investing for risk, return and impact requires a more rigorous investment process and frequent trade-offs in contrast to less complex ESG strategies shaped around exclusions.  It also involves having to defend strategies – like a decision to continue to invest in fossil fuels. “How do you measure that trade off? It’s a scary journey that might lose folks,” he continued.

Bridgewater conducts some its research in a top-down approach. This  seeks to analyse the impact of climate policy on markets and economies, for example the IRA and European climate regulation. Elsewhere, the team are looking at how China will balance growth and climate policies.  “Net zero won’t happen by itself. It will happen because policy makers make choices and our job is to try and understand how climate policies help the world and will change how economies work,” said Stendevad.

In a next step, Bridgewater is building out a detailed understanding of sustainability at an industry and company level, exploring how integrating sustainability interacts with impact, risk and return. “We want to take all this understanding and incorporate it into our fundamental investment processes. Any portfolio manager should be able to say this is my return, here is how it fits my risk dynamics, and this is how this company is aligned with sustainability. That is the north star but in practice it is difficult.”

The research partnership also seeks to understand which companies will impact the world most and aims to get under the hood of bank lending to fossil fuels – and to what extent banks are financing the transition.

“It’s not easy to to assess banks’ balance sheets and understand if they are aligned to net zero but only by breaking apart bank balance sheets, will we see if banks are putting money to sustainable outcomes,” said Stendevad.

In another strand, the research also seeks to assess to what extent sustainability endeavour is supported at CIO level. Strategy often flounders without leadership, and sustainability has to come from the top of the house.

Global investors have committed to net zero, but implementation around those commitments is slow with little action on the ground.

“We are seeing lots of commitments but not much implementation,” said Carola van Lamoen, head of sustainable investing at asset manager Robeco, opening Sustainability in Practice at the University of Oxford where attendees have collective assets under management of $8.5 trillion and include some 64 global asset owners.

“Around 50 per cent of our total assets under management are under net zero commitments. But that doesn’t mean these investors have introduced targets on a mandate level.”

Implementations and action on the ground include engagement and voting; working with partners and clients to identify companies with the biggest carbon emissions, and accelerating real world transition. Van Lameon added that joining forces with other asset owners through organizations like Climate Action 100+ as well as sovereign engagement is another way to act on net zero promises.

Sustainable strategy at £60 billion Border to Coast, the LGPS pool managing assets on behalf of 11 partner funds, has come under particular scrutiny because it manages money for public sector employees. Positively, being in the public eye has helped accelerate integration of sustainability – visible in new targets and the investor’s focus on investing in “well managed companies for better long-term outcomes.”

However, it has also bought the fund in contact with politics, including picket lines outside the investment office and press coverage of its investment process. “The emotion that comes with this is challenging and we have to remind ourselves why we do it,” said Rachel Elwell, chief executive of Border to Coast, reiterating: “We believe climate change will have a material financial impact on the portfolio so we must understand the risks.”

She added that integrating sustainability is challenging because it’s difficult for investors to gage what is within their control. “There is a risk that asset owners have oversold what they can deliver,” she warned. She said all progress depends on being in conjunction with policy makers. “We are seeing some splitting of strong coalitions in financial services because the government hasn’t kept up with leadership. There is a need for investors to engage with governments to help them understand their role.”

In a step change in its sustainability strategy, PSP Investments, which invests C$230.5 billion on behalf of Canadian public sector pension plans, has introduced a climate strategy set around short-term targets. This includes goals around investing in green and transition investments, and reducing carbon in the portfolio. The strategy involves mapping investments, data gathering, looking at the carbon intensity of investments and companies’ transition readiness. “Do portfolio companies have a plan and is it science-based?” asked Herman Bril, PSP’s managing director and head of sustainability.

Green asset mapping

Brill advised attendees to map their green assets to understand “where they are today, and where they will be in the future.” Moving forward, this should take into account regulation, changes in accounting methodologies, and the fact data will improve. “Every five years refresh and update strategy,” he advised. “Realise what you have learnt and how to move forward; move forward step-by-step.”

These moving pieces make hard targets difficult. Governments, companies, consumers and the accounting world need to align to long-term net zero targets, he said. “In reality we need all the levers to change,” he said.

Moveover, it is difficult for universal owners to effect change if the world is not decarbonizing. A short-term focus helps ensure delivering on actions rather than simply making false promises. In another approach, PSP Investments also changed its narrative around ESG, swapping talk of responsible investment to framing all discussions in the context of sustainability and climate innovation. This allowed the institution to move away from ESG and compliance. “The investment opportunity is massive. We are not an impact investor, but an investor with impact.”

Brill noted that it is easier to integrate sustainability in private investments because of the ability to steer corporate strategy via a board seat and direct engagement. PSP splits its portfolio 50:50 between public and private assets.

PSP prides itself on being strong and smart, staying on course and working with its board rather than try to influence the vicissitudes of short-term politics – something he said was unmanageable. “We invest 50-years forward,” he said.

Chris Mansi, global delegated CIO of Willis Towers Watson, a delegated asset manager for institutional funds, said that integrating sustainability is a multi-year process and progress will have challenges to be addressed on the way. WTW regularly reviews sustainability targets for client funds, breaking these goals down into short-term actions. He flagged that integrating sustainability requires a “financial underpinning” alongside assessment of impact and said that in most circumstances WTW did not support divestment as a means of achieving sustainability goals. “[Sustainable investment] requires ongoing review of where we are and how we make decisions.”

Indeed, many pension fund have set targets that they hope to achieve, but the reality is they may not. Panellists agreed that fiduciary duty in the context of net zero “needs consideration” particularly since the world “is off track,” the politicization of ESG is also slowing progress and integrating sustainability appears to be in decline. Some managers (particularly those based in the US) are reneging on commitments and trustees that used to commit to energy transition are now more reluctant because the political and social landscape has changed.

The conversation also focused on how divestment is no longer the right strategy – and that it is not possible to divest your way to net zero emissions. In fact, asset owners are finding themselves increasingly central to the debate on how to finance emission reductions.

Van Lamoen concluded that investors are allocating to transition assets, rewriting their strategic ambitions, beefing up stewardship and engagement. Despite the challenges, she stressed the important progress that has been made towards decarbonization, the introduction of more forward analytics and the role of engagement whilst signs of government inaction include the Inflation Reduction Act in the US and  Europe regulation that is also driving change.

The key question for pension investors today is whether risk premiums are the same as they were a few years ago when interest rates were much lower – or in the past when economic growth was much faster.

So says Timo Löyttyniemi, CEO at VER, the €21.6 State Pension Fund of Finland, established in 1990. In a recent research note, he writes how many investors expect returns to fall slightly in the coming years, but warns the economic backdrop can quickly change.

Interest rates were so low a couple of years ago that low return expectations had a real basis. Now that interest rates have risen by 2-3 percentage points, the key question is whether this rise in rates will be directly reflected in improved overall returns or whether risk premiums will be lower than before.

“The assumptions concerning these developments will be key questions to be pondered by many pension investors this autumn,” he writes.

“Risk premiums may vary depending on interest rates, the overall market sentiment and market prices. Even if the calculations were completely revised in response to these developments, the new assumptions could also prove wrong.”

Underlying return assumption are based on the yields of each asset class above the risk-free rate, he continues.

“The risk-free rate is the short-term interest rate, which in the euro area is currently around 4 percentage points.”

When investors make their return calculations they must determine how much equity investments, corporate bonds, high yield loans, private equity, real estate investments and other similar asset classes will yield above this said bond rate, he explains.

“When these are then weighted by asset class, we obtain the expected return for the entire portfolio. For pension investors today, it could be from 4 per cent to 6 per cent, or 2 per cent to 4 per cent in real terms over the long term (more than 10 years), depending on the pension fund, the composition of the portfolio and the assumptions used.”

Return expectations

The long-term return assumption (expectation or target) is probably the most important assumption made by a pension investor. It is determined, explains Löyttyniemi, by investors making a wide range of assumptions concerning returns, volatilities and correlations in respect of the various asset classes.

“While the return assumption seldom hits the bull’s-eye in the short term, it often proves more or less accurate over periods exceeding ten years. This means that while it is advisable to disregard it in the short term, it may well be used as a basis for the pension system in the long term. Reliability is not perfect but could be sufficient if other adjustment measures are available.”

As for pension liability calculations, he says they are complex and involve a huge number of assumptions relating to age, retirement and mortality rates. Perhaps one of the most important assumptions concerns the discount rate. “It may be a fixed rate or can be derived from market rates, in which case it varies in response to market rate fluctuations,” he says.

“In this respect, individual countries have made different choices. In Finland, the rate is fixed whereas in the Netherlands the discount rate is currently based on market rates.”

One challenge arises if interest rate assumptions prove wrong.

“If interest rates are sufficiently low, the risks of incorrect assumptions are probably lower as pension liabilities are higher in terms of current value and no false notions have arisen. Choosing a highly volatile market interest rate, on the other hand, forces you to invest at least partly in line with the corresponding interest rate behaviour.”

investment beliefs

Löyttyniemi explains that long-term investors base their decision on key assumptions and investment beliefs are a key part of the decision-making process. “Investment beliefs are important because they usually serve as a guideline for long-term policies and investment allocations,” he says.

Investment beliefs are used to draw up assumptions. Which in turn serve as a basis for various calculations, usually to optimise portfolio structures and the relative weightings of asset classes. “For example, one assumption could be the belief that a more sustainable company produces better returns or risks are lower,” he says.

“It can also be assumed that the carbon neutrality goals and schedules of governments and companies will be fulfilled. If these assumptions are not fulfilled, the investor can easily make wrong decisions and in that case investment returns may suffer. Of course, if there has been more talk than action in terms of responsibility, no damage has been caused by following the indices.”

Pension investors do not modify their portfolios overnight, concludes Löyttyniemi.

When changes to portfolio structures are made incrementally, the assumptions made or beliefs used in any given year do not result in undue risks or deviations. However, small changes accumulate to transform into big ones.

Many assumptions are confirmed over the long term rather than in the short term. But any correction to assumptions is also costly.

 

Sceptics cautious about the hype surrounding artificial intelligence underestimate the major scientific and civilisational advancements the technology will bring, says former Google Cloud chief scientist Fei Fei Li. She says investors should look beyond household tech names, and explains why Chat GPT-style large language models are just the beginning.

Asked whether artificial intelligence is just another fad, destined for bouts of market mania and malaise like cryptocurrency, Fei Fei Li takes issue with the premise.

“As a Stanford Professor, we are not in the business of hype – we are scholars and technologists,” she told the Fiduciary Investors Symposium, hosted by Top1000Funds.com on the grounds of the famed Californian university campus in September.

“I’ve seen hype cycles and misinformation, but I do genuinely believe this technology has arrived. This is a genuine inflection point in technology.”

Li, a professor of computer science and former Google executive described by Bloomberg as the “godmother of AI”, says the technology being developed in labs like the one she oversees at Stanford will not just trigger a productivity revolution that is advantageous to commerce, as predicted by bullish investors and analysts. Properly applied, it will “boost our civilisation in an accelerative way”, Li said.

While AI-enabled language models have captured global attention since the launch of the ChatGPT tool last year, the next frontier of innovation is the development of models that “understand the physical world” and can interact with it via robotics or other hardware applications, Li said. She gave the example of AI tools cooking an omelette, building flat pack furniture or changing an infant’s diaper.

But these physical world applications would also have vastly beneficial impacts for humanity, Li said, identifying the healthcare sector as being perhaps the example of use cases she is most excited by. AI-enabled medical technology and patient care could greatly alleviate the cost and labour burdens on hospital systems, she said.

Even the current iteration of large language models are assisting rapid advancements in health, she said, with some researchers using AI to comb through centuries’ worth of medical literature in search of new treatments and drugs in light of more contemporary knowledge.

“I am particularly gung ho about healthcare, it’s not easy, but there are so many human lives to be benefited — aged care, companionship, wellbeing, there are a lot of opportunities.”

‘Let’s not be lazy’

For investors, Li said the opportunity was almost unfathomably large given her thesis that AI will become as omnipresent as the internet. “Anything with a piece of software in it right now – your phone, your car, your fridge – tomorrow that will have AI in it,” she said. “It is the new compute. It manifests itself as a computational technology.”

And, as such, many of the largest Fortune 500 and Nasdaq-listed tech companies have understandably made forays into the emerging market, most notably Microsoft’s backing of ChatGPT issuer OpenAI.

However, amid the surging market demand and analyst and press attention, Li warned institutions not to confine their allocations to the promising technology to large-cap public equities.

“I want to invite everyone to rejuvenate this technology,” Li said. “I worry the oxygen is being sucked by a single-digital number of big companies. There’s nothing wrong with them, they’re amazing. But it would be better for many flowers to bloom.”

Professor Stephen Kotkin of Stanford’s Hoover Institution added: “So let’s not be lazy and just go to the big companies that own the cloud.”

But she also warned that funds willing to provide capital to start-ups operating in the AI space should ensure the firms and founders they are backing truly understand the computer science behind their operations, and not just the business use cases.

Asked about the downsides of AI, Li admitted that unregulated application of AI could be “dangerous” and identified misinformation as a key concern.

However, she concluded this was true of almost all groundbreaking technologies throughout history – and that the potential social and economic upsides greatly outweighed the risks.

“I am not a pure utopian,” she said. “To promise [only good would come from AI]  would be a little irresponsible, because along the way this technology, plus the pitfalls of human nature, creates landmines.

“[But] from the time we build axes with stones we knew those tools could be used positively and negatively.”

Over the last eight years the United Kingdom’s 86 local authority pension schemes (LGPS) have pooled their assets into eight mega pools, most going under the umbrella of newly created FCA-regulated asset managers, re-tendering their portfolios, moving staff to shared offices and nurturing new cultures into life. Some have taken a different approach, amongst which sits the £18 billion West Yorkshire Pension Fund for local government beneficiaries in the north of England.

West Yorkshire has pooled its private equity and infrastructure allocations into Northern LGPS, the pool for neighbouring funds £29.3 billion Great Manchester and £10.8 billion Merseyside Pension Fund, which together make up three of the largest pension funds in the country. Like other pools, the process has generated efficiencies by sharing resources, and according to annual CEM performance and cost benchmarking, Northern LGPS’ costs are materially below the global peer group average.

But when it comes to the rest of West Yorkshire’s portfolio, apart from two pool mandates in excess of £10 billion each, the pension fund continues to invest the bulk of its assets via its own 20-person in-house team based from its Bradford office. Two hundred miles north of policy makers in London, cranking up pressure on the pace and scale of pooling as it seeks to get the LGPS to invest at scale in the UK economy.

The government has just closed a consultation on pooling’s progress and processes that will shine a spotlight on Northern LGPS and West Yorkshire’s approach acknowledges Leandros Kalisperas, West Yorkshire’s CIO, charged with defending West Yorkshire’s reluctance to pool.

“There must be an element of people thinking, why should Northern be able to withstand the pressures that other pools have had to feel. But within Northern LGPS, we have a set of low cost listed mandates as well as direct and allocation expertise across private markets that is proving successful.”

Kalisperas argues that West Yorkshire’s proud heritage of internal investment management aligns with the government’s objectives to foster in house investment management within the pools, and a levelling up agenda designed to end disparity in wealth and opportunity in the UK by creating financial services jobs outside London.

“The government hasn’t created pooling just to be a middleman for trillion-dollar commercial asset managers,” he says. “If internal investment management is an important part of efficiency and levelling up and creating centres of excellence outside London, we are absolutely playing our part.”

Nor does he believe the current structure will impede West Yorkshire’s ability to access alternative opportunities, a portfolio he seeks to build out. West Yorkshire invests in private markets via GLIL Infrastructure which manages infrastructure assets both for another LGPS pool as well as for Nest’s DC assets, and via a private equity collective vehicle, NPEP.

“In private equity and infrastructure, we have a solid and practical pooling structure,” he says. “The biggest challenge in the UK going forward is simply the supply of opportunities.” Stable operational assets with income are hard to find for investors like West Yorkshire with a total return perspective, able to cope with long-term returns, he says.

Resourcing a bigger team could be easier with more assets under management, but West Yorkshire has a stable team and culture that shouldn’t be thrown away lightly and should be leveraged for the wider good. Pool success depends most on alignment of strategies and the underlying approach to investment rather than of total AUM, and size alone doesn’t necessarily equate to lower costs.

“If I had to choose, I would prefer to have a stable investment culture and team, rather than just be able to throw big numbers about,” he says. In short, West Yorkshire’s strategy is no different to other sophisticated asset owners that have in house expertise and strategic external partnerships, he says.

West Yorkshire is also committed to the government’s ambition that pooling support broad UK economic growth. Kalisperas wants to both fill and build out the alternatives bucket that is currently underweight its target 5 per cent allocation. “It will likely involve some reallocating of UK listed equity to UK private equity, UK private debt and venture.” He wants the boosted allocation to focus on local impact in the region with infrastructure, affordable housing, and climate investment at the top of the list. He is also interested in tech innovation spinning out of UK universities.

Unlike the other two funds in the Northern pool which represent large cities, West Yorkshire hasn’t been able to invest as much to boost the local economy because it has been harder to generate opportunities in its more diverse set of local economies. “I suspect that developers and commercial asset managers find it easier to supply local opportunities for Merseyside’s and Great Manchester’s pension funds, but we simply have to work harder to make sure that people know we are open for business,” he reflects.

That hard work includes creating an impact structure and strategic framework that will allow West Yorkshire to consider the types of investment that will generate a return but are unlikely to hit the return target at a total portfolio level. “There must be a place for investments that have a return below our total return target, but which have an impact. If there wasn’t, bonds would almost never be in anyone’s portfolio. Someone can say I want us to do more in West Yorkshire and someone else say we aren’t grant money – both views are correct, but they are not mutually exclusive.”

Alongside governance and benchmarking systems it has involved changes to direct reporting in the investment team, and making sure that investment opportunities aren’t just seen by one team, something Kalisperas worked on in his time at USS between 2010 and 2016. “We are creating more spheres of influence within the investment team and making sure it is not just one person looking at inbound opportunities from our partners.”

Still, despite the many benefits of West Yorkshire’s investment approach he notes the fund hasn’t kept up with the expansion in the investment universe and the global market opportunity. His plans for reallocation will also focus on fixed income and credit where he says West Yorkshire remains quite narrow in its current view of investment opportunities. Emerging market debt, asset backed securities or CLOs are corners of the market the fund simply doesn’t touch. “We should try and find ways to ensure we are allocated to a broader global market opportunity set.”

Around 70 per cent of the new benchmark is in allocations that are sensitive to economic growth that include public and private equities. Twenty per cent is in fixed income and credit instruments, 5 per cent in property and 5 per cent in alternatives.

Kalisperas has only recently got his feet under the table but he already knows what he wants as his legacy. “Much as I am proud of having been appointed, I want my successor to be local and that is harder to happen if people are only looking at one part of the puzzle. I want someone from the current team to apply for the job when I leave and if they are the best candidate, to get it.”

In the meantime West Yorkshire waits for the results of the consultation to provide clarity and on whether its hybrid approach to pooling is enough to assuage government masters in London.

 

 

Key Takeaways

  • The growth and maturation of private credit into a $1.9 trillion asset class has led more investors to consider a dedicated portfolio allocation to the asset class.
  • We believe portfolio construction in private credit should consider the underlying return components and ways to diversify types of risks, and not rely solely on mean-variance optimization.
  • The variability of alpha across funds represents idiosyncratic risk. This makes the decision of how many, and what kind, of managers to choose a critical part of risk management.

Growing, Robust Interest in Private Credit

From corporate borrowers to loans against streaming music royalties: private credit has evolved into a diversified asset class that offers the potential for return enhancement and diversification relative to public credit investments.  Having grown seven-fold since the global financial crisis (GFC), private credit now stands at $1.9 trillion in Assets Under Management.1 Encompassing a wide array of investment strategies across different risk and seniority levels, private credit can offer exposures ranging from pure credit to solutions structured as credit/equity hybrid vehicles, lending against a variety of underlying assets and borrowers. This growth and maturation, as well as greater recognition of the attractive features of private credit (including a 5% annualized outperformance over broadly syndicated loans in the past decade),2 has increasingly led investors to assign it a dedicated portfolio allocation. A recent survey of institutional investors representing $3 trillion of assets under management has found that they hold on average 5.7% of their assets in private credit, more than two percentage points below their target allocations of 7.8%.3 We expect a growing range of investors will examine the asset class more closely. Structurally higher base interest rates, compared with the past fifteen years, may make private credit yields attractive to investors with higher portfolio return targets than those of traditional private credit allocators–for example, endowments, foundations, and family offices. A dedicated allocation calls for a strategic approach to portfolio construction that considers investment exposures, sizing, and positioning.

Public-Private Parallels

Private credit strategies can play different roles in a portfolio, in alignment with the overall asset allocation. Investors can access varying positions on the credit quality spectrum, risk and return targets, yield versus growth profiles, and the degree of sensitivity to the economic cycle. We believe investors should look beyond a single, monolithic definition of private credit, employing a more granular and sophisticated approach to allocating across private credit strategies.  This approach can start with a framework for classifying available opportunities. One potential framework is to draw parallels between private credit investment strategies and their closest counterparts in public markets. This framework can help define portfolio characteristics, roles, and diversification approaches for a private credit portfolio.

Private credit strategies can be broadly classified into three categories, based on the underlying borrower and collateral type: corporate credit, real asset credit, and specialty and alternative finance. Corporate credit includes lending to companies for operations or business expansion, and to private equity managers to finance leveraged buyout transactions (LBOs). This is the largest segment of private credit ($1.5 trillion AUM) and is the core of most investors’ private credit portfolios.4 Real asset credit ($400 billion AUM) comprises lending to owners or developers of real estate or infrastructure assets for acquisition, improvement, maintenance (including refinancing), or development.5 The third segment, specialty finance, includes niche strategies that provide loans that are backed by equipment, future revenue streams like royalty payments, or financial asset pools such as consumer lending and investment fund financing. This segment forms a small part of assets under management, but we believe it is a growing segment of the market. Rapid innovation in data and financial technology has allowed lenders to evaluate, underwrite, and price often-complex instruments more robustly.

The key components of return, and their associated key risks, can be grouped across the spectrum of private credit strategies. These return components contain elements of both market beta (broad market exposure) and manager alpha (manager-specific return), with the balance differing by strategy as well.  Beta exposures generally form the core of an allocation to a particular asset class as they offer access to desired sources of return. Alpha is opportunistic and dependent on implementation and manager selection.

 

The base rate (typically the Secured Overnight Financing Rate) is pure beta, compensation for the time value of money. The credit spread over this base rate has elements of market-wide levels (beta) and manager-specific premium (alpha). This alpha may come from loan parameter customization associated with more complex businesses, assets that require meaningful skill to accurately underwrite, or the ability to offer one-stop solutions in size. Structuring likewise has both beta and alpha components.  Loan covenants and structural protections act as a source of potential credit alpha. Investment structures that offer potential equity upside, such as warrants and convertibles, represent equity beta exposure while also offering the potential for alpha (this is the case particularly in structured solutions). Finally, write-downs, or the avoidance thereof, represent the largest alpha-based opportunity. They reflect the investment manager’s skill in minimizing defaults and maximizing recoveries.

Private credit portfolio construction may not easily lend itself to relying exclusively on traditional mean/variance portfolio construction techniques. Loans are typically held to repayment and periodic marks are subject to manager discretion. This means periodic volatility may not ultimately reflect the main risk of the asset class, which is loss of capital. For some specialty finance strategies, the dearth of historical data means that a robust risk assessment may not be available. Returns in private credit are not normally distributed—especially in senior credit, where the upside is limited, and asymmetry is to the downside. Fund-level leverage, which is used frequently by private credit funds, magnifies the asymmetry. In addition, fund-level leverage enables an investor to achieve a similar level of return in various ways. For instance, a levered senior credit fund can achieve a similar yield as an unlevered mezzanine fund. However, the two funds would have different risk compositions, even if a selected risk metric like expected “Value at Risk” is similar. Therefore, these two investments are not interchangeable.

We believe diversifying across the underlying sources of risk is an important part of risk management in private credit portfolio construction. This includes evaluating the nature of risks in each strategy and the tradeoffs the investor wishes to make among them.

Investing across the capital structure can be an intuitive way of diversifying underlying beta exposures.  Performing credit tends to move with the economic cycle, with junior credit more sensitive to the cycle than senior credit. Distressed and opportunistic strategies may be counter-cyclical, finding a greater number of attractive investment opportunities when the economy is challenged. Hybrid capital opportunities may be less cyclical, with opportunities across market environments.

Diversifying across borrower type can be another risk management strategy. Different underlying collateral types may have different sensitivities in a particular economic environment. Real estate or infrastructure assets will not move perfectly with the corporate cycle. In infrastructure, for instance, many assets are engaged in providing essential services—transportation, energy, waste management—that are less sensitive to the overall economy. In real estate, demand for residential multi-family property is sensitive to the health of the economy, but sector-specific supply factors have offset some of this sensitivity in the current cycle. Sectors such as senior or student housing and specialized life sciences offices may be beneficiaries of demographic trends that transcend the cycle. In specialty finance, the idiosyncratic nature of many loans and underlying collateral assets make for lower sensitivity to the economic cycle and lower correlations to other investment strategies.

Diversifying across these three segments will not diversify away all risk. The various strategies are not uncorrelated; rather, they are imperfectly correlated to each other. Some systematic return drivers, such as overall credit availability and risk appetite, are related to the broader economy and therefore shared across investment strategies.

Implementation: How Concentrated Should Portfolios Be?

If asset allocation is largely about accessing desired beta exposures, manager selection focuses on the strategy for generating alpha. The ability of a private markets Limited Partner (LP) to influence investment results after the initial capital commitment is, as the term implies, limited. A well-honed implementation strategy can be a key risk management tool.

Most investors appreciate that careful investment manager selection is an important determinant in ultimate program outcomes.  Distinct skillsets are required from managers underwriting different credit strategies and at different parts of the credit spectrum. Experience through full market cycles is a potential differentiator in an asset class where the number of managers has grown significantly since the last recession. Experience can help private credit managers to navigate defaulted credits and renegotiate defaulted loans in workout agreements. Scale can improve the lender’s negotiating position in workout situations. It can also strengthen sourcing pipelines—a factor that should become more important for maintaining high underwriting standards, in our view.

How many managers should private credit investors choose? All private markets investment managers (general partners or GPs) generate excess returns, either positive or negative, relative to the investment universe. Some of this excess return comes from holding fewer or different positions than the benchmark. The rest is skill-based, systematic value-add (or value destroyed). The variability of alpha across funds represents idiosyncratic risk. The more managers an LP invests with, the more this idiosyncratic risk can be diversified away. But diversification means curtailing the potential positive alpha as well as mitigating potential negative alpha. Furthermore, there are limits to the benefits of incremental diversification. The costs of the additional program complexity will at some point outweigh the benefits. These costs can be direct (e.g., smaller commitments tend to garner fewer fee discounts) and indirect (e.g., a greater number of investments require more resources to manage and monitor).

To evaluate these costs and benefits, investors may want to consider the alpha and beta components of the underlying investments as well as managers’ typical approaches to diversification.  It is our view that LPs should remember that GPs are solving for the risk-return objectives of their own portfolios, not the portfolio of any particular LP. LPs must actively solve this for their own portfolio construction objectives.

In senior credit, a meaningful portion of return is beta-driven, with rate and spread betas dominating returns. Minimizing write-downs is the main source of alpha dispersion. Structuring upside is typically limited, and the potential for write-downs means there may be more downside risk than upside risk. A more-diversified portfolio can be a prudent approach from the perspective of the GP. It can mitigate losses from individual credit investment in return for relinquishing little upside. It is not uncommon for a senior credit fund to hold 50-100 positions over its life, which limits performance dispersion at the manager level. The chart below shows the dispersion of returns of simulated senior credit portfolios, randomly selected from the universe of funds in the Preqin direct lending universe. This dispersion is meaningfully lower than for other private asset classes. For instance, the intra-quartile dispersion across senior private credit managers in a given vintage year has been 0.1-0.3x over the past decade, compared to 0.7-1.1x for buyout managers. Dispersion in senior credit drops meaningfully as a portfolio diversifies to 5-7 funds; beyond that, diversification benefits trail off. Spreading out these fund commitments across multiple years can be a proxy for diversifying exposure across economic environments.  As such, the data implies that making 1-2 new fund commitments per year would have captured most of the diversification benefits. One caveat is that the benign credit environment of the past decade is likely to have depressed downside risk. In fact, upside dispersion has exceeded the downside in the more concentrated portfolios. This is potentially a function of the amount of fund-level leverage or more junior/second-lien exposure chosen by the funds that generated outlier returns, as well as inclusion of funds with a mandate across the capital structure in the direct lending universe. Given our expectations of greater downside dispersion in the next decade, increasing the number of commitments to 2-3 per year may be prudent for investors focused primarily on limiting downside risk in senior credit strategies.

In junior credit, an LP may wish to have greater diversification at the program level. In  these strategies, return drivers are more balanced between beta and alpha. Upside and downside risk are more symmetrical as well. The structuring component offering upside participation but a subordinate capital position meaning potentially larger losses.  Funds specializing in junior and opportunistic credit tend to be more concentrated and typically hold 30-60 positions. A number of factors may help explain this dynamic. The universe of junior credit opportunities is smaller than that of senior credit. In leveraged buyouts, for instance, the majority of debt financing is senior, first-lien. Senior tranches for larger issuances may involve two or three lenders participating in a single financing transaction. In contrast, mezzanine issuance most often involves one lender. The diligence and structuring burden may be higher as well in junior and opportunistic credit, given the higher risk and upside nature of the strategy. Furthermore, with more upside (alpha) possible in these strategies, fund managers—who are incentivized through performance fees—are mindful of not diluting away their alpha potential by over-indexing on loss avoidance. In our view, diversification should also extend to include a variety of borrower types. This is particularly important in junior and opportunistic strategies, where the probability of default is higher. A more diversified borrower base can mitigate the chance of significant losses from exogenous market or economic factors. This implies allocating across a greater number of private credit managers in this part of the risk spectrum.  An analysis of Preqin fund data shows that a portfolio of 12 junior credit funds has had a similar degree of dispersion as a portfolio of five senior credit funds.6 This suggests three to four new commitments per year in junior credit – more than in senior credit, but fewer than an analogous analysis would suggest for private equity strategies.

Because of the wider variety of strategies, approaches, and risk profiles in junior credit compared to senior credit, manager weights can vary by strategy. This can be a function of the risk profile of individual strategies as well as the LP’s conviction in the respective managers.

The amount of available data on non-corporate credit does not allow for a similarly robust statistical analysis. Investors in these strategies may need to consider additional parameters. For instance, the real estate market has experienced a significant realignment, with a bifurcation across property types, sectors, and tenant types (e.g., corporate vs. individual vs. institutional). In sectors like office, this realignment may mean that broad beta exposure is likely to lead to losses. At the same time, bifurcation between new, sustainable, digitally-enabled assets and older assets without these features means a greater potential for alpha. A more concentrated portfolio of real estate credit, with careful underlying asset selection, may be better positioned to avoid losses than a more diversified, beta-oriented approach.

Specialty credit presents a smaller opportunity set, with typically smaller fund sizes. Many strategies have highly idiosyncratic risk profiles and relatively short track records. These strategies may warrant smaller allocations. Investors can approach this market segment as a satellite allocation to complement the corporate and real asset credit. Practically speaking, since this is still a developing part of the market with few long-term participants, it may be challenging for an LP to fill a specific dedicated allocation on an annual basis with institutional-quality managers.  This implies a more opportunistic or broad-based approach that allows additional flexibility.

Evolving Opportunity Set

The universe of private credit strategies continues to grow and evolve. Private financing has become increasingly important for real estate and asset finance. We believe this offers potential for further segmentation into senior and junior strategies, or along asset-type or investment-style lines. A nascent private investment grade market has been developing, largely supported by insurance companies seeking improved yield on their high-quality credit portfolios. New specialty credit strategies, such as fund financing, have been gaining traction. Others, such as venture lending, are increasingly becoming viewed as conventional strategies. Investors will need to adapt their allocation frameworks to take advantage of these new opportunities as these strategies continue to grow and differentiate.

Important Information

1 Reuters, “ChatGPT sets record for fastest-growing user base – analyst note.” As of February 2, 2023.

 

2 MIT Technology Review, “ChatGPT is about to revolutionize the economy. We need to decide what that looks like.” As of March 25, 2023. 

 

3 World Economic Forum, “The pace of US interest rate hikes is faster than at any time in recent history. Is this creating a risk of recession?” As of October 12, 2022

 

4 Goldman Sachs Global Investment Research, “First to the Finish: Early Hikers and the Rate Cut Outlook.” As of July 27, 2023.

 

5 Bureau of Labor Statistics, Bloomberg, HFRI. Analysis from 1990-2022.

 

6 Defined as inflation less than 2%.

 

7 Defined as inflation greater than 4%.

 

8 Goldman Sachs Prime Services, Prime Insights, May 2023.

 

9  MSCI, See additional disclosures.

 

10 Goldman Sachs Asset Management XIG Hedge Fund Database. As of 2022.

 

11 The other three criteria as part of the XIG process are Governance, Infrastructure, and Process.

 

 

 

Glossary

 

Alpha refers to returns in excess of the benchmark return.

 

Carry is the return obtained by holding an investment for a given period.

 

Price-to-earnings multiple is the ratio of an asset’s price to earnings.

 

Price-to-equity is the ratio of the price per share to the book value per share.

 

S&P 500 index is the Standard & Poor’s 500 Composite Stock Prices Index of 500 stocks, an unmanaged index of common stock prices.

 

Risk Considerations

 

All investing involves risk, including loss of principal. 

 

Alternative investments are suitable only for sophisticated investors for whom such investments do not constitute a complete investment program and who fully understand and are willing to assume the risks involved in Alternative Investments. Alternative Investments by their nature, involve a substantial degree of risk, including the risk of total loss of an investor’s capital. 

 

Alternative Investments often engage in leverage and other investment practices that are extremely speculative and involve a high degree of risk. Such practices may increase the volatility of performance and the risk of investment loss, including the loss of the entire amount that is invested. There may be conflicts of interest relating to the Alternative Investment and its service providers, including Goldman Sachs and its affiliates. Similarly, interests in an Alternative Investment are highly illiquid and generally are not transferable without the consent of the sponsor, and applicable securities and tax laws will limit transfers.

 

Investors should also consider some of the potential risks of alternative investments:

 

·  Alternative Strategies. Alternative strategies often engage in leverage and other investment practices that are speculative and involve a high degree of risk. Such practices may increase the volatility of performance and the risk of investment loss, including the entire amount that is invested.

 

·  Manager experience. Manager risk includes those that exist within a manager’s organization, investment process or supporting systems and infrastructure. There is also a potential for fund-level risks that arise from the way in which a manager constructs and manages the fund.

 

·  Leverage. Leverage increases a fund’s sensitivity to market movements. Funds that use leverage can be expected to be more “volatile” than other funds that do not use leverage. This means if the investments a fund buys decrease in market value, the value of the fund’s shares will decrease by even more.

 

·  Counter-party risk. Alternative strategies often make significant use of over- the- counter (OTC) derivatives and therefore are subject to the risk that counter-parties will not perform their obligations under such contracts. 

 

·  Liquidity risk. Alternatives strategies may make investments that are illiquid or that may become less liquid in response to market developments. At times, a fund may be unable to sell certain of its illiquid investments without a substantial drop in price, if at all. 

 

·  Valuation risk. There is risk that the values used by alternative strategies to price investments may be different from those used by other investors to price the same investments. 

 

Alternative Investments – Hedge funds and other private investment funds (collectively, “Alternative Investments”) are subject to less regulation than other types of pooled investment vehicles such as mutual funds. Alternative Investments may impose significant fees, including incentive fees that are based upon a percentage of the realized and unrealized gains and an individual’s net returns may differ significantly from actual returns. Such fees may offset all or a significant portion of such Alternative Investment’s trading profits. Alternative Investments are not required to provide periodic pricing or valuation information. Investors may have limited rights with respect to their investments, including limited voting rights and participation in the management of such Alternative Investments.

 

The above are not an exhaustive list of potential risks. There may be additional risks that are not currently foreseen or considered.

 

Conflicts of Interest
There may be conflicts of interest relating to the Alternative Investment and its service providers, including Goldman Sachs and its affiliates. These activities and interests include potential multiple advisory, transactional and other interests in securities and instruments that may be purchased or sold by the Alternative Investment. These are considerations of which investors should be aware and additional information relating to these conflicts is set forth in the offering materials for the Alternative Investment.

 

General Disclosures

 

This material is provided for educational purposes only and should not be construed as investment advice or an offer or solicitation to buy or sell securities.

 

THIS MATERIAL DOES NOT CONSTITUTE AN OFFER OR SOLICITATION IN ANY JURISDICTION WHERE OR TO ANY PERSON TO WHOM IT WOULD BE UNAUTHORIZED OR UNLAWFUL TO DO SO.

 

Prospective investors should inform themselves as to any applicable legal requirements and taxation and exchange control regulations in the countries of their citizenship, residence or domicile which might be relevant.

 

Economic and market forecasts presented herein reflect a series of assumptions and judgments as of the date of this presentation and are subject to change without notice.  These forecasts do not take into account the specific investment objectives, restrictions, tax and financial situation or other needs of any specific client.  Actual data will vary and may not be reflected here.  These forecasts are subject to high levels of uncertainty that may affect actual performance. Accordingly, these forecasts should be viewed as merely representative of a broad range of possible outcomes.  These forecasts are estimated, based on assumptions, and are subject to significant revision and may change materially as economic and market conditions change. Goldman Sachs has no obligation to provide updates or changes to these forecasts.  Case studies and examples are for illustrative purposes only.

 

This information discusses general market activity, industry or sector trends, or other broad-based economic, market or political conditions and should not be construed as research or investment advice. This material has been prepared by Goldman Sachs Asset Management and is not financial research nor a product of Goldman Sachs Global Investment Research (GIR).  It was not prepared in compliance with applicable provisions of law designed to promote the independence of financial analysis and is not subject to a prohibition on trading following the distribution of financial research. The views and opinions expressed may differ from those of Goldman Sachs Global Investment Research or other departments or divisions of Goldman Sachs and its affiliates.  Investors are urged to consult with their financial advisors before buying or selling any securities. This information may not be current and Goldman Sachs Asset Management has no obligation to provide any updates or changes.

 

THESE MATERIALS ARE PROVIDED SOLELY ON THE BASIS THAT THEY WILL NOT CONSTITUTE INVESTMENT ADVICE AND WILL NOT FORM A PRIMARY BASIS FOR ANY PERSON’S OR PLAN’S INVESTMENT DECISIONS, AND GOLDMAN SACHS IS NOT A FIDUCIARY WITH RESPECT TO ANY PERSON OR PLAN BY REASON OF PROVIDING THE MATERIAL OR CONTENT HEREIN. PLAN FIDUCIARIES SHOULD CONSIDER THEIR OWN CIRCUMSTANCES IN ASSESSING ANY POTENTIAL INVESTMENT COURSE OF ACTION.

 

The views expressed herein are as of the date of the publication and subject to change in the future. Individual portfolio management teams for Goldman Sachs Asset Management may have views and opinions and/or make investment decisions that, in certain instances, may not always be consistent with the views and opinions expressed herein.

 

Views and opinions expressed are for informational purposes only and do not constitute a recommendation by Goldman Sachs Asset Management to buy, sell, or hold any security.  Views and opinions are current as of the date of this presentation and may be subject to change, they should not be construed as investment advice.

 

This material is provided for informational purposes only and should not be construed as investment advice or an offer or solicitation to buy or sell securities. This material is not intended to be used as a general guide to investing, or as a source of any specific investment recommendations, and makes no implied or express recommendations concerning the manner in which any client’s account should or would be handled, as appropriate investment strategies depend upon the client’s investment objectives.

 

Although certain information has been obtained from sources believed to be reliable, we do not guarantee its accuracy, completeness or fairness. We have relied upon and assumed without independent verification, the accuracy and completeness of all information available from public sources.

 

Any reference to a specific company or security does not constitute a recommendation to buy, sell, hold or directly invest in the company or its securities. Nothing in this document should be construed to constitute allocation advice or recommendations.

 

The opinions expressed in this white paper are those of the authors, and not necessarily of Goldman Sachs. Any investments or returns discussed in this paper do not represent any Goldman Sachs product. This white paper makes no implied or express recommendations concerning how a client’s account should be managed. This white paper is not intended to be used as a general guide to investing or as a source of any specific investment recommendations.

 

Examples are for illustrative purposes only and are not actual results. If any assumptions used do not prove to be true, results may vary substantially.

 

Neither MSCI nor any other party involved in or related to compiling, computing, or creating the MSCI data makes any express or implied warranties or representations with respect to such data (or the results to be obtained by the use thereof), and all such parties hereby expressly disclaim all warranties of originality, accuracy, completeness, merchantability, or fitness for a particular purpose with respect to any of such data. Without limiting any of the foregoing, in no event shall MSCI, any of its affiliates or any third party involved in or related to compiling, computing or creating the data have any liability for any direct, indirect, special, punitive, consequential or any other damages (including lost profits) even if notified of the possibility of such damages. No further distribution or dissemination of the MSCI data is permitted without MSCI’s express written consent.

 

Past performance does not guarantee future results, which may vary. The value of investments and the income derived from investments will fluctuate and can go down as well as up. A loss of principal may occur.

 

‘Albourne ®’ is a registered trade mark of Albourne Partners Limited (“Albourne”). Albourne owns all proprietary rights in the Albourne indices and data presented here (“Albourne Information”). Albourne does not approve of or endorse this material or guarantee its accuracy or completeness, nor does Albourne make any warranty, express or implied, as to the results to be obtained therefrom, and to the maximum extent allowed by law, Albourne shall have no liability or responsibility for injury or damage arising in connection with the use of, or reliance upon, any Albourne Information.

 

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Date of First Use: August 7, 2023  328954-OTU-1846189

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