Lending to un-listed firms has come out as one of the most popular strategies for LGPS investors. But how is the LGPS seeking exposure to the asset class? Mona Dohle reports.
There are few asset classes that have gathered as much appetite among the LGPS as private credit. More than 50% of LGPS investors plan to increase their allocations this year, according to a survey conducted by Room151 and Schroders at the end of 2023.
This trend continues despite rates in listing markets rising, with more than 90% of survey respondents saying they will continue to invest in private credit.
But the term private debt, the catch all term for loans to privately held companies, covers a broad array of strategies. What exactly are LGPS investors planning to do with their allocations?
Demand for direct lending
Over the past decade, institutional investor demand for private credit has surged to more than $1.5trn, compared to less than $500bn in 2012.
Within private debt, investors usually distinguish between four main sub-asset classes. Direct lending is by far the most popular strategy. As the name suggests, it involves direct loans to support the growth, acquisition, or refinancing needs of a specific company. Direct lending is typically senior in the capital structure, tends to be backed by collateral and offers floating rate coupons which are seen as attractive in a rising rate environment. While overall fundraising volumes slowed down over the last two years, direct lending still accounts for approximately half of all private debt being raised.
This is followed by mezzanine debt, subordinate debt which sits between senior debt and equity in a company’s capital structure. Its appeal is that it tends to offer higher returns than senior debt, albeit with less protections against defaults. Mezzanine debt currently accounts for approximately a quarter of all private debt fundraising, according to Preqin data.
On the riskier side of the private debt spectrum are distressed debt and special situations funds. While distressed debt, loans to companies in financial distress, gained popularity during the pandemic, investors appetite for mezzanine and special situation debt focused on niche sectors increased.
This pattern is also broadly mirrored in the LGPS. Some 54% of LGPS investors from pools and administering authorities plan to increase their allocations to direct lending strategies, about a third intend to keep them the same and only 6% plan to reduce their exposure, according to the investment survey conducted by Schroders and Room151. There is also some appetite for investments in real assets, with about a third of investors planning to increase their allocations to infrastructure and real estate debt.
LGPS asset allocation
Source: Schroders, Room151 LGPS Investment Survey
In contrast, many LGPS investors remain wary of relatively riskier mezzanine, venture capital or distressed debt.
LGPS allocations
Among the first pools to venture into private credit on a large scale is Border to Coast, which over the past couple of years has expanded its private markets portfolio to exceed more than £12bn in assets, including some £3.3bn invested in private credit. This includes a $302m commitment to Blackstone’s Real Estate Debt Strategy and another £226m investment in Ares Capital’s Europe VI fund, which invests in European mid-market and large cap companies.
The pool’s allocations also include some investments in distressed and mezzanine debt, for example a £78m commitment to the Fortress Credit Opportunities fund, which specialises in distressed debt.
Similarly, LGPS Central has also significantly expanded its private credit holdings over the past years. It now holds more than £2.5bn in the asset class spread across four distinct strategies with varying risk and return profiles.
London CIV has also launched a private credit strategy in 2021, offering administering authorities access to funds by Churchill and Pemberton Asset Management. Over the last three years, the strategy has grown to £625m [JH1] in commitments of which £420 have been drawn.
Brunel is also no stranger to the asset class; it launched a private debt fund in 2021 which as of 2022 has drawn just under £1bn in commitments and is invested in six different asset managers.
Wales Pension Partnership also ventured out into private markets, starting with the launch of a private credit investment programme jointly run by bfinance and the host authority Carmarthenshire County Council in 2022.
Meanwhile, Northern LGPS, which is an active investor in infrastructure and private equity has so far had only very limited exposure to the asset class, but individual funds, including West Yorkshire, are considering increasing their allocations to private debt going forward.
Overall, private credit has now become widely available across the pools, with administering authorities being able to select from a range of strategies, depending on their risk and return appetite.
Risks on the cards
Having said that, LGPS investors remain acutely aware that the rising rate environment could bring additional risks to private credit investors.
Both LPPI and LGPS Central outline default risks as a key concern on their radar. But the paradox of private credit is that despite the sharp surge in rate hikes, default rates in private credit have remained low.
Proskauer’s Private Credit Default Index shows that while defaults increased in Q1 2023, particularly among larger lenders, they subsequently dropped to just over 1% by the end of 2023.
A key explanation for that are refinancing cycles in private debt, which often extend over multiple years, meaning that the impact of higher rates has not yet been fully priced in, as LGPS Central CIO Gordon Ross explains.
Ross is nevertheless wary of a lack of transparency in private markets, particularly in secondaries, where debt was sold at a discount by many corporate DB schemes in the wake of the LDI crisis.
Another key concern is dry powder, which currently stands at more than $400bn according to Pitchbook, suggesting that almost a third of all money invested has not yet been deployed. Pitchbook data shows that as of 2023, more than a third of dry powder was raised in 2021 and had not yet been deployed, some dates back as far as 2014.
Direct lending dry powder ($B) by vintage
Ross remains concerned about the interconnectedness between private equity and credit, with the slowdown in private equity origination having potentially detrimental knock-on effects for debt.