Finding effective benchmark measures for private debt has proven challenging to even the most nimble-minded institutional investment practitioners. Nevertheless, some chief investment officers and portfolio managers at pension funds and endowments are coming up with their own ways to solve, at least in-part, this diverse asset class’s benchmarking issues. IA’s Managing Editor Leslie Kramer spoke with several New Mexico-based institutional investors who attended MarketGroup’s Southwest Institutional Forum in Santa Fe, N.M., on Sept. 20, to gain insight into how they are approaching the problem. This piece represents her third in a three-part series on private-debt benchmarking. (See also IA, 9/17, IA,9/11.)
New Mexico Educational Retirement Board
The $13 billion New Mexico Educational Retirement Board (ERB) has been active in private credit for some years. The fund manages roughly $3.5 billion in fixed income, with some $2.4 billion of that dedicated to the private side. “My past experience around benchmarking difficult-to-define asset classes is to just design your own custom index, rather than try and pick a generic one,” said Peter Werner, fixed-income portfolio manager at New Mexico ERB. “It’s fairly easy to do these days with all the tools that are available,” he said.
The fund typically builds custom indexes to fit its institutional portfolios by blending existing indices, Werner explained. “Around the private credit space, we blended a 50/50 split between the Credit Suisse Leveraged Loan Index and the ICE BofA ML US High Yield BB/B-Rated Constrained Index. That index is used to benchmark the private credit portfolio as a whole,” he said.
New Mexico EBR has had an allocation to what it calls opportunistic credit since 2008, according to Bob Jacksha, the fund’s chief investment officer. Most of the private credit the fund holds is in that allocation bucket. “That category covers loans, high-yield bonds, high-yield asset-backed, and some distressed emerging market debt and CLOS,” he said. “In the lending category, it’s mostly smaller direct-lending deals, as opposed to big syndicated deals.” The fund’s private debt allocation target has been as high as 20%, but it’s been down over the last couple years and is now an 18% target. “It’s quite big relative to others,” he noted.
For this type of portfolio “there is no good specific benchmark,” Jacksha declared. “It is not like the S&P 500, it’s difficult, especially when you have a portfolio as diverse as ours. But we decided to use one benchmark across the whole opportunistic credit allocation,” he explained.
Private debt has appealed to New Mexico ERB since 2008 because at that time, credit, even investment grade credit, was trading at attractive prices. “We thought, at that time, that you could get equity-like returns for credit-like risk and that did play out—the fund achieved double-digit returns. But we have less of an appetite these days because it re-priced some time ago,” Jacksha said.
Today, the fund is still looking to achieve a fairly high single-digit return on private debt. However, “We think because of repricing and more capital flowing in, it’s unlikely to happen going forward.” That said, Jacksha said he still views private equity as a reasonably priced, attractive asset class.
New Mexico Public Employees Retirement Association
Dominic Garcia, chief investment officer at New Mexico Public Employees Retirement Association (PERA), which has $15.6 billion in AUM, said the fund looks at the private-debt asset class, first, from a portfolio allocation standpoint. “At a very high level, we use a risk budget to determine what active risk we want to take beyond our reference portfolio. We believe any risk we take beyond that should be compensated and used efficiently. Private credit is given an active-risk allocation with the opportunity cost being global high-yield bonds,” he said.
Joaquin Lujan, director of rates and credit at the New Mexico PERA, then narrowed it down. The fund’s credit portfolio, both liquid and illiquid, is all benchmarked against the Barclays High Yield Index, he said. “Again, we use high-yield as a reference portfolio for risk. From there, we break it down further. First, we separate out the alpha and beta. Is the beta implicit in private debt keeping up with the beta in global high-yield bonds? If it is not, then can we buy beta in other parts of the portfolio to match our reference benchmark? If private debt hovers around 0.6 to 0.8 beta to high yield, then we have a whole other roster of credit strategies where we can add 1.2 or 1.4 beta to get us closer to our reference portfolio,” he said. “After we achieve beta 1 versus our reference benchmark, then we add alpha. We think that credit selection and staying away from private credit sponsor-owned flow deals can add alpha in the private debt space, particularly convex alpha or that excess, idiosyncratic alpha you can earn when there is lack of equilibrium or price discovery in the market,” he elaborated.
Looking at the risk budget, in terms of return, the portfolio managers look at “how much of the tracking error the strategy generates beyond the benchmark, and what do we expect for that?” Garcia explained. “For private credit, we think it should generate an extra 2.9 percent excess return,” he said. “That active risk to generate that though is quite high, around 10%, so we think private credit as a whole has a 0.3 information ratio. At the plan level, we are targeting an excess return of 1% with a tracking error of 1.5%, and there are bands around that,” Garcia said.
“So, in that scenario we weight private credit at about a 4-5% capital allocation, which makes it a modest risk contributor to our active budget,” Garcia noted. “We think the risk/return trade-off is good, but not the best, it’s not our best risk/return trade off in the alpha space, he said.
New Mexico State Investment Council
H. Bart Stucky, acting director, fixed income, at the $24.2 billion New Mexico State Investment Council (NMSIC) also has not seen a standardized benchmark in the space. “Each of our peers has their own solution; there are lots of options for benchmarking this strategy, and therefore a combination of benchmarks are being used throughout the industry,” he said.
At the council, private debt is now 10% of its overall portfolio, but it is moving toward a target of 15% for the asset class. Stucky noted that the fund is not pushing to reach that goal in the short term, “given where we are in the cycle,” but is looking to do so in the longer term, over the next two to three years.
“Benchmarking is a discussion we have had with our consultants. We use Aksia for non-core fixed income, and our general consultant is RVK,” Stucky said.The NMSIC originally hired Aksia for assistance in its hedge fund portfolio and then had some crossover assets that ultimately ended up in the non-core fixed income portfolio as well.
For non-core, the permanent endowment has a custom benchmark, which is the product of 20% BofA High-Yield Benchmark, 30% HFRX Asset-backed Index, 30% Credit Suisse Leveraged Loan Index, and 20% HFRX Distressed Series Index. “It matches our target for the structure of our non-core fixed-income portfolio,” Stucky said. The fund has four buckets within private debt: unconstrained; structured credit; lending strategies; and distressed and other.
The NMSIC is the permanent endowment for the state of New Mexico and the third largest domestic sovereign wealth fund in the U.S. Its current AUM tops $24 billion, with 95% of its assets in two permanent funds: the Land Grant Permanent Fund and the Severance Tax Permanent Fund. Combined, these funds deliver almost $1 billion in annual benefits to the state, funding primarily public education and about 15% of the state’s total budget overall.
While their benchmarks regarding private debt may differ, these New Mexico funds have apparently come to the same conclusion: To each its own.