Amid the challenging return conditions, asset owners globally are searching for new sources of alpha. Increasingly, these investors are boosting their exposures to private market strategies, especially private debt, as they look to shore up returns. As more asset owners allocate to private debt and other illiquid asset classes, they will need to meet the new operational requirements of tracking their expanded portfolios, including overseeing and consolidating investments handled by their external managers.

Facing the New Reality

Irregular yields in traditional fixed income, together with equity market volatility – something which has been exacerbated by the pandemic and now the war in Ukraine - are making it harder than ever for asset owners, such as pension funds, to obtain consistent returns.

Given the uncertain state of some of these pension schemes’ finances, this is a serious problem for retirees. Although data from Broadridge shows strong flows into US pensions (see chart below), data from Global SWF shows that the difference between assets and liabilities at US public sector pension plans, otherwise known as the funded ratio, continues to be poor, standing at just 75%.¹ Elsewhere, Mercer also highlights that defined benefit schemes at the UK’s 350 largest companies had accounting deficits of £69 billion and liabilities totaling £837 billion.²

To stimulate returns to overcome these shortfalls, pension funds worldwide are tapping into higher yielding private markets, an asset class now running close to $10 trillion.³ According to reports, public pension allocations into private markets have jumped from 6% in 2010 to almost 9% in 2021.⁴ While private equity accounts for a large proportion of these pension fund inflows, so too does private debt.

Rallying Around Private Debt

A number of high-profile pension funds – including the $496.8 billion California Public Employees’ Retirement System (CALPERS) and the $313.9 billion California State Teachers’ Retirement System (CALSTRS) – are leading by example and ramping up their holdings of private debt.

CALPERS, for instance, is now aiming for a private debt allocation of 5% ⁵, while CALSTRS is also targeting 5% private debt exposures as part of its 13% fixed income allocation.⁶

But what is prompting these inflows? The answer lies overwhelmingly with performance. In the 12 months ending in September 2021, private debt funds produced an impressive IRR (Internal Rate of Return) of 18.7%, driven predominantly by distressed strategies and direct lending.⁷

Unsurprisingly, investors are very satisfied with the returns at private capital more generally, with 90% of global allocators telling Preqin that the performance of the asset class either met or exceeded expectations, while a further 35% intend to increase their exposures over the next year.⁸

In addition to the illiquidity premia, investors point out that strategies such as private debt provide regular, less volatile income streams relative to fixed income.⁹ Private debt’s floating rates are also appealing to limited partners (LPs) as they can help shield returns against rising inflation and interest rate risk.

Pensions Need to Monitor Their Holdings

As indirect lenders into private debt, it is vital that pension funds proactively monitor their underlying portfolio investments. Increasingly, pension funds are asking managers to provide them with a view of their total portfolio exposures at a loan level, as well as positions on a fund-by-fund basis.

By doing so, pensions can measure various KPIs across their entire portfolio and even specific managers. Through enhanced oversight of their private debt positions, asset owners will gain better insights into performance and risk across the entire portfolio, in the same way they have historically viewed exposures in their more liquid holdings.

^{1 Reuters (January 31, 2022) US public pension funds may turn to more aggressive investment, report says
2 Mercer (April 1, 2022) Volatile month for FTSE 350 pension scheme deficits
3 McKinsey (March 24, 2022) McKinsey’s Private Markets Annual Review
4 Cadwalader (March 18, 2022) The Rise and Rise of Public Pensions in private equity
5 Pension & Investments (February 14, 2022) Private credit soars 77% as asset class continues to heat up
6 Pension & Investments (February 14, 2022) Private credit soars 77% as asset class continues to heat up
7 Preqin (April 11, 2022) Private debt average fund size more than doubles in Q1 2022
8 Preqin (March 16, 2022) 86% of investors plan to invest the same or more in private capital over the next 12 months
9 Pension & Investments (February 14, 2022) Private credit soars 77% as asset class continues to heat up}