According to a report released by Gapstow Capital Partners, an investment advisor that focuses exclusively on credit, many U.S. pension funds are now beefing up their alternative credit allocations, in many cases by decreasing investment in traditional fixed income. “We saw a lot of interest in alternative credit coming at the expense of traditional fixed income,” said Michael Yannell, head of research at NY-based Gapstow. He noted that this finding suggests that demand for alternative credit will likely remain even through the next market downturn. The Gapstow report indicates that U.S. public pension plans currently have about 7% of their assets invested in alternative credit.
In compiling its research, Gapstow also looked at how investors are incorporating alternative credit into their asset allocation policies and what implications these trends have for the investment management industry. Gapstow’s definition of “alternative credit” includes long-only strategies, credit hedge funds, direct lending and distressed debt.
The report, titled How Do U.S. Public Pension Plans Allocate to Alternative Credit, also found that pension funds are making alternative credit a part of their asset allocation strategy, rather than a tactical opportunity. There are increased instances, the report found, of alternative credit strategies being addressed comprehensively and grouped together in a unified asset allocation category, Yannell said. “This shift will assure alternative credit demand remains in place, even during the next downturn in the market cycle,” the report said.
For example, the researchers found that Los Angeles County Employees Retirement Association has 9% of its portfolio allocated to alternative credit across multiple asset classes. In July 2018, the pension approved a 12% target allocation to a newly dedicated credit asset class. This credit allocation will include high yield, bank loans, emerging market debt and illiquid credit–all types of alternative credit.
Private credit to grow, direct lending on the rise
Results of the research have lead the Gapstow team to predict that because the transition to alternative credit is only partially complete, allocations to the asset class should keep growing. This is particularly true of private credit strategies.
The Gapstow team was surprised to find that only eleven pensions in their sample had a defined allocation for private credit within their strategic asset allocation policy. These eleven pensions on average have a target allocation of 6.4% to private credit, but only 3% on average is currently invested.
Other findings of interest in the report were that 70% of pension portfolios had allocations to direct lending. “That was a large number, given that much of the interest has been in just the last few years,” Yannell said. Also, direct lending strategies were found in a broad range of asset allocation categories. “From fixed income, to private equity and real estate, and across a number of other credit-related or alternative-related asset categories, there was not a lot of commonality in terms of what part of the asset allocation they were coming from.”
Implications for investment managers
Overall, the Gapstow findings showed that many plans are still looking to build up and meet their alternative asset allocations targets and that should provide strong tailwinds for future interest in private credit, Yannell said. Gapstow also expects institutional investors to seek greater use of strategic partnerships with managers to fulfill their alternative credit objectives.
To compile its research findings, Gapstow collected and analyzed 915 individual credit investments by 40 U.S. public pension funds, with assets under management (AUM) ranging from $5 billion to $100 billion, and more than $1 trillion in (AUM) collectively. The 40 pensions were randomly selected as long as Gapstow was able to locate the pension’s strategic asset allocation policy and underlying holdings report. Gapstow then mapped these individual investments to a common set of credit sub-strategies regardless of how the pension may have identified them.
“While interesting to a look at the average numbers for the overall set, it was striking to see the range of different approaches in the use of credit,” Yannell said. “There is definitely a wide dispersion in terms of how plans allocate to credit, from those who have no alternative credit at all in their portfolio, to those that use long-only strategies, all the way to allocations including the full range of alternative credit strategies,” he said.
“The reallocation away from fixed income is likely coming from its inability to meet plans’ return requirements,” Yannell reasoned. “Therefore, private credit specifically, or alternative credit more generally, has taken over some part of the portfolio sought out for stabilization. While not truly diversifying or negatively correlated the way fixed income can be relative to equities, alternative credit offers a stable source of returns that are high enough to meet an actuarial rate of return requirement,” Yannell said.
Within the past 18 months, 6 of 40 pension plans in Gapstow’s sample have made significant changes to their asset allocation policies in order to incorporate space for alternative credit investments, said Shelley Criswell, investor relations associate, at Gapstow.