Key Takeaways
- • Reason Foundation argues public pension funds should weigh credit default risk, high intermediary fees, and illiquidity before committing heavily to private credit, which it describes as lending to middle-market companies at relatively high interest rates.
- • Arizona State Retirement System has allocated 15% of its portfolio to private credit, with another 7% in related categories such as distressed debt and CLOs, while CalPERS is targeting a 5% private credit commitment in 2022, up from zero the prior year.
- • Per Preqin data cited by The Wall Street Journal, state and local retirement funds' average private credit allocation rose from 3% to a target of 5.7%, the fastest expansion of any alternative asset class.
- • Proskauer's Private Credit Default Index showed default rates for $25M-$50M EBITDA firms rising from 0.8% to 1.8% in Q2 2022, while sub-$25M EBITDA firms fell from 1.6% to 1.3%.
- • South Carolina Retirement System reported private credit fees of 2.58% of assets annually versus 0.10% for its investment-grade bonds.
Summary
Public pension funds are increasingly allocating to private credit, a asset class that involves lending to middle-market companies at relatively high interest rates. According to the article, the appeal lies in the pursuit of higher investment returns and the need to reduce unfunded liabilities, since these loans typically pay regular, high periodic interest and usually carry floating rates tied to benchmarks such as LIBOR or SOFR.
The Arizona State Retirement System has put 15% of its portfolio into private credit, with another 7% in related categories including distressed debt and collateralized loan obligations. CalPERS, the nation's largest pension fund, is targeting a 5% commitment to private credit in 2022, up from zero a year earlier. Citing Preqin data reported by The Wall Street Journal, state and local retirement funds with private credit portfolios are expanding them faster than any other alternative investment, moving from an average allocation of 3% to an average target of 5.7%.
The article identifies several risks. Floating rates cut both ways: as the Federal Reserve tightens, borrowers face higher debt service costs and greater default risk. Proskauer's Private Credit Default Index showed the default rate for firms with EBITDA between $25 million and $50 million rising from 0.8% in Q4 2021 to 1.8% in Q2 2022, while firms below $25 million EBITDA saw rates fall from 1.6% to 1.3%. Proskauer's second-quarter data do not capture the full impact of the 75 basis point Fed hikes in June and July. The Wall Street Journal also noted that private credit is poorly suited to hedging stock-market downturns, citing Cliffwater and Burgiss index returns of minus 6.68% and minus 15.17% in Q4 2008, and quoted Cliffwater CEO Stephen Nesbitt: "When the market turns downward, private debt will not make money or protect capital."
Fees and liquidity are further concerns. Pension funds typically access middle-market loans through intermediaries such as fund managers and private equity firms, which charge fees that can be high relative to traditional fixed income. The South Carolina Retirement System reported private credit fees of 2.58% of assets annually, compared with 0.10% for its investment-grade bonds. Middle-market loans also lack a secondary market, so pension funds should generally expect to hold them to maturity, a limitation the article considers manageable if offset by liquid holdings elsewhere.
The article concludes that private credit may suit some pension portfolios, but given default risk in a rising-rate environment, high fees, and low liquidity, public pension managers should avoid over-committing to the asset class.
The Arizona State Retirement System has put 15% of its portfolio into private credit, with another 7% in related categories including distressed debt and collateralized loan obligations. CalPERS, the nation's largest pension fund, is targeting a 5% commitment to private credit in 2022, up from zero a year earlier. Citing Preqin data reported by The Wall Street Journal, state and local retirement funds with private credit portfolios are expanding them faster than any other alternative investment, moving from an average allocation of 3% to an average target of 5.7%.
The article identifies several risks. Floating rates cut both ways: as the Federal Reserve tightens, borrowers face higher debt service costs and greater default risk. Proskauer's Private Credit Default Index showed the default rate for firms with EBITDA between $25 million and $50 million rising from 0.8% in Q4 2021 to 1.8% in Q2 2022, while firms below $25 million EBITDA saw rates fall from 1.6% to 1.3%. Proskauer's second-quarter data do not capture the full impact of the 75 basis point Fed hikes in June and July. The Wall Street Journal also noted that private credit is poorly suited to hedging stock-market downturns, citing Cliffwater and Burgiss index returns of minus 6.68% and minus 15.17% in Q4 2008, and quoted Cliffwater CEO Stephen Nesbitt: "When the market turns downward, private debt will not make money or protect capital."
Fees and liquidity are further concerns. Pension funds typically access middle-market loans through intermediaries such as fund managers and private equity firms, which charge fees that can be high relative to traditional fixed income. The South Carolina Retirement System reported private credit fees of 2.58% of assets annually, compared with 0.10% for its investment-grade bonds. Middle-market loans also lack a secondary market, so pension funds should generally expect to hold them to maturity, a limitation the article considers manageable if offset by liquid holdings elsewhere.
The article concludes that private credit may suit some pension portfolios, but given default risk in a rising-rate environment, high fees, and low liquidity, public pension managers should avoid over-committing to the asset class.
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