Many in the industry may be wary of securitised debt arrangements, given the role that these bundled investments played in the global financial crisis.
But as the workplace pension sector looks to diversify into private markets, this raises the prospect of schemes investing in securitised assets in private credit markets.
Big pension providers have signed various undertakings, including the Mansion House Compact and Mansion House Accord, committing to boost private market investing in the UK and beyond.
As well as investments into private equity, venture capital and infrastructure this will include significant allocations into private credit investments. But there are concerns being voiced that this may include assets that have previously been partly responsible for financial crises, both large and small.
There are already signs that the UK pensions market is starting to look at securitised private credit arrangements. In November, People’s Partnership, working with Invesco, announced it would be looking at Collateralised Debt Obligations (CDOs), a type of collateralised loan obligation (CLO).
The launch was accompanied by a white paper from both the pension provider and the asset manager, acknowledging some of the potential reputational risks associated with these assets — although the document stresses that not all these investments should be tarred with the
same brush.
It said: “CLOs have been around for decades but their reputation took a hit after the Global Financial Crisis. Many investors still associate securitised products with the risks that surfaced during that period. In reality, CLOs – especially the AAA tranches – performed well through the crisis, with very low impairment rates. But perceptions have been slow to change.”
In another section, it continued: “They do a job. AAA-rated CLOs offer income, floating-rate risk mitigation, and diversification. That’s useful in today’s market, especially for schemes looking to get more from their
bond allocations.”
It also added the heading: “They’re not as scary as they sound. The structures are well-tested, and the top-rated tranches have a strong track record – even through tough markets. There are complexities, for example liquidity risk, but these are manageable with the right support.”
A spokesperson for People’s Partnership said they did not view these investments as being private market investments, due to the fact they were often traded in public markets thanks to the way they were often structured and accessed.
She explains: “Our view is that CLO AAA tranches are not considered private market investments because they are typically rated by credit agencies, offer daily pricing and liquidity, and are often traded in public markets.
“In our case, much of our exposure to CLO AAAs is via ETFs, which are themselves public market instruments. ETFs are listed on stock exchanges, provide real-time pricing, and can be bought or sold throughout the trading day — characteristics that are fundamentally different from private market assets, which are generally illiquid, opaque, and not publicly traded.”
Ratings risk
But this does not mean that there aren’t wider warnings about investments into private credit markets. The latest came from the chair of UBS Colm Kelleher.
He suggests that insurers, particularly in the US, were engaging in “ratings arbitrage” akin to what banks and other institutions did with subprime loans before the 2008 financial crisis.
Essentially, he said insurers were shopping around for ratings agencies to tick boxes, often using smaller players to do so. None of this means that the pensions sector has to buy these assets, but it does set the context, and points to the potential dangers for a UK market where big schemes are rapidly looking to build exposure to this sector.
Looking back, a number of large UK pension and asset management brands got their fingers burned in the 2008 global financial crisis, when higher-risk asset-backed securities, were included in supposedly low risk money market funds.
Shareholders had to take a substantial hit – to the tune of hundreds of millions of pounds – although this was not the existential threat faced by many retail and investment banks caught up in the carnage.
Regulation has moved on since 2008, and is arguably more alert to these dangers. Those running pension schemes are also keenly aware of the range of risks to navigate when building portfolios. This includes current concerns about an ‘AI bubble’ in valuations, which could potentially affect both publicly listed and private assets.
That said, there may be specific questions about whether the DC pension sector has the experience to assess these risks across different private credit investments, and manage them in terms of liquidity, diversification and, perhaps, contagion.
The complexity of the private credit market is highlighted in a recent report from State Street Global Investors, which lists the various different types of lending covered. This includes agricultural lending, equipment finance, corporate loans, inventory finance, corporate fleet finance, home improvement, rental car finance, residential mortgages, commercial real estate debt, commercial property, assessed clean energy financing, railcar leasing, infrastructure debt, franchise finance, music royalties, supply chain finance, auto loans, aviation finance, fund finance, structured finance and private corporate senior secured and unsecured debt.
Ready to invest?
Yet whatever the type of asset status, pension providers are in the process of shifting allocations. Are they ready? Ben Lewis, head of investment proposition, Mercer UK, said: “Consolidation of pensions, particularly among DC master trusts, is likely to enable greater investment into more sophisticated markets, including private assets. Any new allocation must be justified on its own merits and supported by strong governance, rigorous due diligence, and robust liquidity and operational planning to protect member outcomes. Mercer supports giving pension schemes the ability to invest in a wider variety of assets, which can improve diversification and longterm returns.”
Maiyuresh Rajah, director of investments at Aviva adds: “Any decision we make to allocate to a given asset class, whether it is liquid or illiquid, is made with a view to delivering better outcomes for our members, in a risk-managed way.
“We acknowledge that different asset classes can carry different risks, which highlights the importance of extensive research and due diligence prior to making any investments. Aviva has been investing in a range of private markets asset classes for some time now, and all of these investments have been subject to this level of due diligence.
“Private debt is one such asset class and, whilst DC pension funds are increasingly considering investments into it, the asset class itself is not new. These investments can help diversify risk and returns within private markets allocations, as well as from traditional fixed income. Private debt itself can include real estate and infrastructure lending, bespoke financing, as well as corporate lending, meaning it can create a powerful source of diversification.”
Fund expert, strategist and author of New Fund Order JB Beckett has been vocal about the implications of the shift to private markets across pensions and wealth management.
He says: “There is a clear push to move into private markets. There are opportunities and risks ahead. The push is both political and commercially driven. Some firms would love to sell their balance sheet liabilities
to UK investors. With so much hubris around then adviser scepticism is healthy.”
Adviser concerns
There are clearly some concerns about this shift towards private markets more generally, and private credit in particular. Financial Inclusion and Markets Centre director Mick McAteer says: “There’s definitely a concern that pension scheme trustees are being persuaded to invest in high-risk supposedly high-return assets in private equity and private credit markets. There are two big concerns about that. First, that the claims about high returns are based on flawed investment data, and very broad methodologies for calculating the investment performance. Linked to that is the [assumption that]private assets are meant to provide more investment diversification.
But if the underlying methodology for calculating the return is flawed, then by definition the methodology for calculating risk and diversification is also flawed. “Trustees in particular need to up their game when it comes to governance and due diligence before considering increasing exposure to private assets.
“If trustees and corporate sponsors ever encounter the word exotic when it comes to investing then they should be concerned that is another word for complex, poorly understood investments that don’t always deliver. To get a higher return you have to take a higher risk and if some investment guru, investment consultant or investment adviser tries to tell you you get a higher return and a lower risk through diversification into exotic assets or private assets, you should think twice before engaging with them.”
Advisers can certainly quiz providers on such things as private markets liquidity, capital structures, financial risk, valuation and IRR efficacy. But those questions are complex in nature and far better for advisers to query whether governance structures are challenging and asking the right questions on their behalf. With the right opportunities, the right questions and right governance then diversified returns are possible.
But should some assets be beyond the pale? JB Beckett says: “As has always been the case, credit quality, seniority in capital structure and strong covenants will command a premium. More junior loans may lure with attractive rates, but we should reflect on lessons learned post global crisis.
“What is key for advisers to understand is the net portfolio effect, an investment into private markets probably equates to a divestment of other assets. This can shift the ex ante risk profile of a fund rapidly. Given the quoted volatility of private markets can be understated then capturing the change in allocation is important.”
He does think that generally scale helps but adds: “Allocators and committees will need to carefully monitor that demand for private markets does not outstrip supply and lead to deteriorating paper.” As he points out in this new investment world, an absence of external credit ratings and less transparency makes good governance more important than ever.