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Alternative credit risks

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While many private sector defined benefit pension schemes have embraced alternative credit, the Local Government Pension Scheme has been less enthusiastic. With signs sections of the market are overheating, local authorities need to be cognisant of possible pitfalls and seek out well-valued assets.

The perfect time to invest in the private debt markets was after the financial crisis in 2009 and 2010. Many banks had pulled out of the lending market, so companies were prepared to pay a higher rate to secure a source of funding.

This asset class has, however, continued to prove popular with pension schemes as bond yields remain at punishingly low levels. In addition, the benign economic environment has kept default rates at low levels.

Gregg Disdale, head of alternative credit at Willis Towers Watson, says: “While many private companies have embraced the full breadth of alternative credit assets, it’s less prevalent among local authorities.”

Bridget Uku, group manager of treasury and investments at Ealing LBC, agrees: “The LGPS has been slightly behind the curve.”

Some alternative credit assets are more popular than others. Mr Disdale says: “There is has been dramatic increase in the number of local authorities investing in middle-market direct lending over the last 12-18 months.”

Many LGPS funds are comfortable with the concept of corporate credit, through their investment-grade and high-yield bond holdings. Mr Disdale says: “Direct lending to middle-market players is a natural extension of this asset class.”

Local authorities that have not invested are now thinking of allocating to this asset class. Mr Disdale says: “While there are pressures on returns and covenants in the direct lending market, they are worse in the high yield and leveraged loans markets.”

Ealing is considering investing in direct lending. The authority is aware, however, that yields are lower than they once were and that it needs to pay attention to covenant strength.

While some investors are prepared to have less security for higher returns, this is not feasible for Ealing. Ms Uku says: “We are not prepared to move away from senior, more secured debt even if it means the yields we achieve are lower.”

Instead the authority will look for other ways to improve the returns on this investment. Ms Uku says: “We trying to keep our management fees lower by collaborating with others.” A bigger pot will give the fund greater ability to negotiate a better fee.

Ealing is spearheading a search for a direct lending investment, along with four other local authorities. Ms Uku says: “Working with a number of local authorities allows us to be innovative as well as combine talent and ideas.”

It could give the authorities the necessary heft to set up a segregated mandate, which will allow them considerable control over the type of lending made on their behalf.

Ms Uku says: “For example, we might be able to say the manager had to come back to us before agreeing to lend to a company with a very weak covenant or we could specify acceptable leverage multiples.”

Working with other authorities makes it possible to raise enough money to control a private debt fund, as most fund raisings are around £250m. This also might make it easier for Ealing to deploy our funds more rapidly, adds Ms Uku.

It also allows these local authorities to manage their risks better. Ms Uku says: “We can ensure we can diversify the lending across different sectors and geographies as well as ensuring we only lend to those which have resilient across different economic cycles.”

While Ealing is carrying out this project outside of the London Collective Investment Vehicle, the collaboration will still achieve economies of scale. But the option of working with the London CIV in the future is being kept open, Ms Uku adds.

Local authorities that have not yet allocated to this asset class could also consider other forms of alternative credit. Ms Disdale says: “Better value can be found in the real estate debt both within residential and commercial property markets.”

There are signs the credit market is late cycle. Stuart Fiertz, co-founder of Cheyne Capital, says: “Around 75% of direct corporate lending in Europe is covenant-light.”

In addition, about 90% of deals have no subordination and leverage levels are back to where they were before the crisis.

That means most of the lending today is ‘stretch senior’: a combination of traditional senior plus mezzanine. Investors are now picking up a lot of mezzanine risk. As a result, recovery rates are falling. “All of these factors are a potentially toxic combination,” adds Mr Fiertz.

Change in banking regulation in both US and the UK has created a funding gap similar to the one which existed in the private debt market after the global financial crisis. Those regulatory pressures have made it uneconomic for banks to hold assets like securitised commercial mortgages on their balance sheets.

This absence of bank competition has created value in this market. Mr Fiertz says: “While the underlying assets are lower than they were before, we are still able to make senior, first-lien mortgage loans at attractive rates.”

But investors still have pay attention to which type of assets they are willing to finance.

The fundamentals still apply: investors need to find property in areas where the demand remains strong and is less vulnerable to economic downturns.

While alternative credit still has appealing investment characteristics, the LGPS needs to be aware of the pitfalls and have an open mind about how to make the most of this asset class.

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