For UK pension schemes moving towards their end game, private credit such as infrastructure debt, real estate debt and direct lending can offer an attractive risk/return profile and a source of regular contractual income. Accessing a diversified, or multi private credit, strategy delivered through a pooled solution, is now a reality that most schemes of all sizes can take advantage of to meet their long-term objectives.
Private credit refers to any credit (non-sovereign) instrument which is not financed by a bank and is not issued or traded in an open market. Although simple in definition, the private credit universe comprises of a diverse array of strategies which can perform a range of roles within an investor’s portfolio. The most common and largest private credit asset classes include infrastructure debt, direct corporate lending and real estate debt. However there are other smaller parts of the market too which is what we would classify as specialist credit – these include things like royalty backed lending, litigation and trade finance.
As Defined Benefit (DB) pension schemes mature, their focus moves from simply generating returns to either balancing their continued need for returns with a reduced risk tolerance or more specifically looking to meet cashflow requirements. Private credit can help achieve both of these things:
Private credit has the potential to offer a illiquidity premium in comparison to publicly traded fixed income asset classes, meaning that yields available can often be higher than public fixed income asset classes and equities
Private credit has historically lower average defaults and higher average recovery rates than equivalent rated public corporate bonds
Private credit asset classes have a lower correlation to more traditional asset classes (such as equities and fixed income) and therefore offer diversification
Volatility risk: The value of investments and the income from them may go down as well as up and investors may not get back the amounts originally invested.
Liquidity risk: There may be very limited liquidity available via the secondary market of the proposed Fund given the underlying private credit assets and investors should consider an investment only if they intend to hold it for the life of the proposed Fund. Liquidity of the underlying investments might not be sufficient to meet investor subscription and redemption requirements.
Interest rate risk: A rise in interest rates generally causes bond prices to fall.
Credit risk of underlying issuers/lenders: A decline in the financial health of an issuer/lender can cause the value of its bonds/ loans to fall or become worthless.
Currency risk: The fund can be exposed to different currencies. Changes in foreign exchange rates could create losses.
Counterparty risk: The counterparty to a derivative or other contractual agreement or synthetic financial product could become unable to honour its commitments to the proposed fund, potentially creating a partial or total loss for the proposed fund.
Derivatives risk: A derivative may not perform as expected, and may create losses greater than the cost of the derivative. Concentration risk: The proposed Fund may be concentrated in a limited number of geographical regions, industry sectors, markets and/or individual positions. This may result in large changes in the value of the fund, both up or down, which may adversely impact the performance of the fund.
Gearing risk: The proposed fund may borrow money to invest in further investments. Gearing will increase returns if the value of the investments purchased increase in value by more than the cost of borrowing, or reduce returns if they fail to do so.
Valuation risk: The underlying private credit assets may be subject to inadequate pricing reliability. In addition, property-based vehicles invest in real property, the value of which is generally a matter of a valuer’s opinion.
Industry/country risk: Legislative changes, changes in general economic conditions and increased competitive forces may affect the value of investments. Additional risks may include greater social and political uncertainty and instability and natural disasters.
Infrastructure asset risk: Infrastructure assets expose investors to additional risks, in particular construction risk (e.g. construction delays, cost overruns, etc.) and deployment risk (e.g. capital being deployed in several instalments during construction period rather than upfront for brownfield investments).
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