The message for investment staff at a recent board meeting of the $211 billion Washington State Investment Board (WSIB), guardian of the state’s $172 billion pooled retirement assets, contemplating a standalone allocation to private credit was clear.
The success of the portfolio will hinge on investing with the very best GPs and the patience to wait for spaces in these funds, placing manager selection front and centre to the strategy.
Institutional investors have steadily increased their allocation to private credit since the GFC, when new restrictions limited banks’ ability to lend to companies. However, WSIB, famed for its 25 per cent allocation to private equity, still only invests in private credit via a small allocation in its innovation sleeve.
Ongoing discussions will come to a head this autumn when the board will decide on the extent of the new allocation.
Their role making the right decision was also underscored by staff. WSIB’s long-term returns are driven by allocation decisions that have allowed the investor to weather significant downturns and recover over the years. Previous important asset allocation decisions include the early adoption of private equity in 1992, integrating a global focus to equity over time, and shifting from fixed income into real estate and tangible assets.
Risk and returns
Investment officers DuWayne Belles and Julia Ferreira sketched out the shape of the new allocation in a detailed presentation.
Ferreira said losses are part of the course in credit investing, and are allowed in the underwriting. However, because credit sits at the top of the capital stack and investors have priority claims over assets, it is less risky than other types of investment.
Equity investors gain exposure to the upside and growth, but credit investors can control losses and are compensated for risk with a contractual return. In a downturn, there is a higher chance of recovery.
WSIB could expect a 6.6 per cent return over the course of 15 years.
Key risks for corporate credit investors include the borrower not repaying the loan in times of market stress or higher interest rates. Moreover, investors’ ability to derive forecasts from historical data is limited because private credit doesn’t go back as far as other assets and the sector hasn’t experienced a severe downturn.
Staff explained that it will be difficult for the investment team to know the specifics of the individual companies in which WSIB invests. They will have “a good sense” of the managers’ strategy and the sectors, but one portfolio could have hundreds of positions. Moreover, managers’ strategies are not clean cut. Some have crossovers between buckets with senior loans alongside a few subordinated deals, for example.
Mid-market firms make up a large proportion of the investable universe and are often backed by private equity firms. A key element of strategy would involve limiting the overlap with debt strategies in real estate and tangible assets to reduce aggregated risk, and the board heard how staff favour unlevered strategies.
Belles and Ferreira added that the overlap with private equity is limited because private credit is more diversified at a manager level and ticket sizes are smaller; the US and European mid-market is a large space and WSIB’s private equity allocation is more focused on large buyouts because of its size. Preventing the risk of overlap requires understanding the dynamics of the whole portfolio and its most concentrated holdings.
Shape of the strategy
Staff suggested an even split between core (direct lending) and satellite (opportunistic and distressed debt) strategies.
Direct lending allows investors to tap into recurring cash flows and is lower risk. They represent the core of today’s private credit market and loans are usually floating rate, providing an alternative to fixed-rate investment-grade bonds.
Opportunistic credit strategies in the satellite allocation would typically involve lending to a company that has gone through a period of underperformance or change of leadership but is on a path back to profit. Distressed investment involves lending to companies in need of capital where revenue streams have been impacted. In this case, investors can purchase investments at a discounted level and benefit from returns from a higher recovery value. Distressed investments are counter-cyclical, and are attractive in market dislocations.
WSIB would invest via SMA as the sole investor in customised vehicles, however satellite investments would remain in traditional drawdown vehicles.
