The Role of Investment Grade Private Credit in a Pension Portfolio

Guy: John, Private Credit has come a long way from 20 years ago when it was an obscure and fragmented market; but has now become a mature institutional market that has had significant and steady, annual growth and deal flow. Its aggregate size is now well above $1 trillion. I’d like to focus our discussion, today, on investment grade private debt and the beneficial role it can play in a multi-asset portfolio, particularly for a defined-benefit pension, or any portfolio with a stream of long-term liabilities. But before we drill-down, could you tell us a bit about how we should think about Investment Grade Private Credit?

John: At the most basic level, the sector involves a private lending agreement with a borrower. It can encompass corporate, infrastructure and private structured debt/asset-backed securities. The proceeds can have wide-ranging uses.

The borrowers may be public or private entities: it is the lending agreement that is private; that means the security isn’t listed on a publicly tradable exchange.· A main attraction of private lending is that everything in the lending agreement is negotiated and aligned to fit the needs of both the lender and the borrower. This leads to a long-term lending relationship.

When we talk about private credit here, we’re predominately focusing on the investment grade end of the spectrum. We find that the risk-reward trade-off is best within the investment grade and BB space. So we’re not focusing on the higher yielding riskier below investment grade private debt world that is the preserve of some of the private equity houses.

Guy: What are some of those benefits that you are referring to that might enhance portfolio performance?

John: A Private Credit portfolio has several key potential benefits, but I think the biggest one is the amount of diversification an investor can get. Diversifying portfolio holdings can certainly lower portfolio correlations, plug holes in a concentrated portfolio and in turn move the efficient frontier up and to the left – potentially increasing return and/or lowering risk. This is something we can talk more about…..

….But sticking to diversification, The universe of public and private companies that we can enter into a private lending agreement with is large and diverse, and contains many niche sectors. The public markets can be dominated by certain sectors, such as financials, telecoms and tech. Adding an allocation to private credit can help complement your public bond portfolio bydiversifying into sectors that are less prominent in the public markets, such as infrastructure assets or unique family-owned businesses.

Private credit assets have also performed well during economic disruptions. This was particularly evident during the 2008 global financial crisis when Private Credit performed wellⁱ relative to many other asset classes.

Historically we have found that downturns can be the best period for private credit to outperform as covenant structures keep issuers on track, and when there is issuer financial deterioration these covenants allow for economic adjustments such as amendment fees and coupon adjustments to compensate for the issuers’ increased capital structure risk.

New issuance in a downturn also tends to come with an increased illiquidity premium.

All of these private credit characteristics can help balance out the performance of a public bond portfolio.

Guy: So, let’s come back to your comment about the Efficient Frontier. Besides diversification and correlation, does the enhanced return-per-unit-of-risk profile come from other potential benefits as well?

John: One way to seek extra yield in a fixed income portfolio is to invest in lower rated credits. But extra yield can also be done by adding Private Credits and obtaining an origination premium over similarly rated public bonds.· Increased potential return can be obtained this way but with the acceptance of increased illiquidity risk. Investors who can handle greater illiquidity can achieve a more resilient portfolio through diversification and negotiated covenants that help mitigate downside risk.

Historically, private credits have lower loss rates than similar public credits, which is a combination of lower default rates and higher recovery ratesⁱⁱ.

Guy: Can you tell us more about covenants? What exactly is being negotiated? What type of metrics are they tied to?

John: Sure. The covenants in Investment Grade Private Credit are typically in line with an issuers senior bank facility. They are negotiated by private lenders and seek to provide terms that lay the framework for an issuer to maintain its rating profile. Covenant terms will differ across issuers and sectors, but typically include a leverage ratio metric such as debt to EBITDA and/or a debt service calculation to measure available cash flow.

The metrics used are designed to monitor the financial health and maintain the rating profile of the issuer.

Any projected shortfall on a covenant will bring the lender and issuer back to the table for renegotiation to avoid an issuer default. The results of the negotiation can include an economic adjustment to correspond to the added risk such as a fee or an increased coupon, or could entail the issuer providing additional collateral, or in extreme cased could require a full prepayment.

However, I’ll note that private credit lenders are long term lenders and certainly value long-term issuer relationships, and reputation absolutely plays an important part of a successful platform,so both lenders and issuers are incentivized to act prudently and fairly with each other even in challenging times.

Guy: It makes sense to me that reputation and long-term relationships play a role in long-term success. What else do you feel is necessary to find success in a Private Credit Platform?

John: For an investor to maximize success in a Private Credit relationship, it’s important to partner with a manager that has vast experience in structuring transactions, has acute knowledge in seniority levels of a capital structure, and has a platform that sources transactions in diverse sectors and geographies. Infrastructure and sports lending are a couple of excellent examples of unique private sectors that add diversity and stability to a debt portfolio.

Managers that are experienced private lenders have built many strong relationships, which lead to better access and first looks at new financing deals.

Successful private managers have built multi-channel sourcing platforms that include working with bank agents and advisors, equity sponsors and directly source transactions with issuers. Such platforms will improve private credit access and uncover diverse and bespoke deals.

It is essential that a platform has a consistent and comprehensive research process and a highly disciplined approach.

Guy: Let’s talk a bit more about insurers or private pensions or any others who might be focused on liability management or cash flow management. I would think that the flexible structure of Private Credit - that we discussed earlier - can play an important role in this regard?

John: Absolutely. The most successful managers have a good understanding of an investor’s liabilities and investment objectives. Private deals can be structured to better match the investor’s liability and cash flow obligations. Longer duration income streams also mean less reinvestment risk for an investor.

I believe Private and Public Credits acting together is an excellent portfolio completion strategy and Private Credit is an ideal vehicle for better matching assets and liabilities. The flexible structure of Investment Grade Private Credit with a wide range of maturity dates, sector, country, and currency - and even fixed or floating rate issues - can all be used to optimize and match long-term liabilities and cash flows.

Guy: Do you have anything else you wish to add?

John: Yes. The current headlines are dominated by challenging topics including inflation, rising rates, the tail end of a global pandemic with continued supply chain disruptions, and the emergence of a major war in Europe. These are all serious macro issues. I often get asked about what the current economic and geopolitical issues mean for private credit.

My answer is that private credit has been ‘road tested’ through multiple challenging crises. MIM has been investing in private credit for over 100 years as the asset class emerged during the Great Depression in the 1920s as a way to stimulate the US economyⁱⁱⁱ. We have invested through the .com bust, through 9/11, through the global financial crisis to name a few more recent disruptions. We build our portfolios credit by credit always with long-term buy and manage philosophy. We talk to our issuers on a regular basis to understand how they’re managing current challenges. We’ve certainly seen many economic ups and downs over that period, and the asset class has not just survived but thrived.

Guy: Thank you for sharing your thoughts and insights with us today.

John: Thank you.

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ⁱ Moodys
ⁱⁱ Attractive Opportunities in Investment Grade Private Credit, Institutional Investor 2020
ⁱⁱⁱ https://investments.metlife.com/insights/private-capital/private-placement-debt-investments/