This paper looks at the asset class in the context of current market conditions, specifically higher interest rates and the potential for increased volatility, combined with improved access to hedge fund strategies more generally. These factors could create a prime opportunity for liability investors—such as pensions, nuclear decommissioning trusts, and insurance companies—to explore their use. It also discusses the primary risks associated with hedge funds and presents four actionable guidelines for investors aiming to effectively incorporate these strategies into their portfolios. These include defining a clear role for hedge funds, ensuring thorough due diligence, maintaining diversification, and adopting a strategic approach.

Why Consider Hedge Funds Today?

While institutional hedge fund allocations have been reduced in recent years (Figure 1), current market conditions may help to bolster the asset class moving forward.

Higher Interest Rates

Although a “higher-for-longer” interest rate environment can have both positive and negative implications for investors, it tends to be a tailwind for hedge funds. Heightened interest rates and persistent inflation have pushed the short rebate ¹ into meaningfully positive territory for the first time since the GFC (Figure 2), a dynamic that directly benefits hedge fund managers that undertake short selling. While alpha generation remains paramount, the short rebate can function as a stabilizer against volatility for managers with high short exposure, such as long/short equity managers. Higher interest rates also mean increased returns on cash. This is an advantage for managers that have significant amounts of free capital, whether they are operating global macro strategies, relative value strategies, or other approaches involving derivatives.

Increased Volatility Potential

Although volatility has remained relatively low through the first half of 2024, the rapid emergence of generative artificial intelligence is likely to continue to impact volatility in various market sectors over the near term. Moreover, geopolitical uncertainty—including the war between Russia and Ukraine, ongoing conflicts in the Middle East, and US-China tensions—also has the potential to create elevated market turbulence.

What’s notable here is that hedge funds have traditionally thrived amid heightened volatility. This is because greater volatility results in greater dispersion of returns among individual securities and asset classes more broadly, often with projected highs soaring higher than expected and projected lows drawing lower.

As the market identifies winners and losers and companies compete for capital, more alpha opportunities become available to diligent hedge fund managers. Nimble asset managers can also look to capitalize as disparities between a company’s business fundamentals and security price become more defined, creating additional trading opportunities. It is also important to note that hedge fund allocations have the potential to offer portfolios protection from unexpected market headwinds, particularly those designed to be less correlated to traditional sources of return.

Improved Access

Investors allocating to hedge funds today have access to opportunities that they could only dream of a decade ago, partly due to increased openness and innovation within the industry. What’s more, regulatory changes have helped to improve hedge fund transparency. Lastly, technological advancements have helped make it easier to retrieve and analyze information about hedge funds in the pursuit of strategies that are best suited to specific portfolio needs.

Implementation: Four Actionable Guidelines

Even amid more favorable market conditions for hedge funds, investing success depends on effective portfolio implementation. Four important action steps will help institutional investors determine which strategies can complement their broader investment goals.

1. Clearly Define the Role of Hedge Funds in the Portfolio—and Adapt as Needed

Given the wide array of hedge fund strategies available, it is critical to first set clear goals and expectations around the role they will play in a portfolio and seek out managers that match this profile (see Case Study: Enhancing Pension Health with Hedge Funds). Traditionally, hedge funds have been positioned to generate returns between those of bonds and equities, with the expectation of sub-equity volatility.

However, allocations should be carefully customized to an investor’s specific needs and risk tolerance (Figure 3). Where some investors may be willing to take on more risk for more return potential, others many want a highly diversifying hedge fund portfolio that seeks to generate returns with low-to-no equity beta. By setting clear goals, investors can access managers that better align with their risk and return objectives. Regularly reviewing and adjusting hedge fund allocations can help ensure they continue to meet these goals.

2. Rigorously Evaluate Managers to Uncover Top-tier Partners

The hedge fund landscape presents substantial divergence in performance outcomes across managers. Working with top-tier managers is essential, as seemingly negligible differences among managers’ expertise and investment approaches can lead to materially different returns (Figure 4).

Historically, the hedge fund industry has been categorized by notable manager turnover due to the risks associated with the use of intricate financial products and balance sheet leverage. Navigating this universe and underwriting new funds demands a due diligence process that requires considerable time and resources. However, this effort is vital and will help investors uncover managers with high-quality investment processes, fund administration, and risk management.

To ensure thorough due diligence, investors should establish clear criteria for manager selection, including track record, investment strategy, risk management practices, and alignment of interests. A comprehensive quantitative analysis of historical performance, including metrics such as Sharpe ratio, alpha generation, and drawdown analysis, is crucial. Tools such as Monte Carlo simulations can be invaluable for stress-testing performance under various market conditions. Additionally, in-depth qualitative assessments through interviews and on-site visits can provide insights into the manager’s investment philosophy, team structure, and operational infrastructure. Engaging third-party service providers for background checks, legal reviews, and operational due diligence helps uncover hidden risks. Comparing potential managers against a peer group using industry benchmarks and databases offers a well-rounded view of their relative strengths and weaknesses.

Many leading hedge funds today are large and complex organizations whose proper evaluation requires significant industry experience. Investors must undertake comprehensive risk assessment to avoid blowups. With the rise of new trading platforms and the increasing commoditization of fundamental research, it becomes even more valuable for allocators to possess deep expertise and substantial global resources. This is necessary not only to proficiently underwrite funds, but to discern the sustainability of a manager’s competitive edge and identify top emerging talent. Understanding the nuances of the manager’s strategy, including their edge in the market, sources of alpha, and competitive advantages, is crucial. Assessing the robustness of the manager’s operational infrastructure, including compliance, reporting, and fund administration, is also essential. Collaborating with industry experts can provide valuable insights and validate findings.

Among the more than 8,000 hedge funds operating worldwide, Cambridge Associates believes that fewer than 2% merit investment consideration. Accessing these “high conviction” funds can be challenging but can improve as investors build relationships with fund managers. Most managers value their client relationships and are often willing to negotiate capacity. This underscores the importance of a proactive, informed approach that emphasizes strategic partnerships. We believe by actively networking within the industry, investors can build relationships with top managers and unlock exclusive opportunities. Being well prepared when negotiating terms and capacity can secure more favorable investment conditions. Additionally, demonstrating a long-term commitment fosters collaboration that can lead to superior investment prospects.

3. Use Hedge Funds to Optimize Diversification

In today’s investment environment, a thoughtfully diversified portfolio requires iterating beyond the traditional 60/40 split between equities and bonds. Investors should consider increasing allocations to alternative investments to provide valuable and differentiated sources of return, downside protection, and liquidity during times of market stress (see Case Study: Navigating Yield Uncertainty, Insurance Firm Turns to Hedge Funds).

While private equity and venture capital deserve consideration, they are highly illiquid, and cannot be used for regular rebalancing or ongoing cash needs. Hedge funds, however, offer a middle ground. They provide more liquidity than private asset classes and, given the wide array of available strategies, can offer the potential for robust returns in various market environments.

Executed effectively, hedge funds have the ability to play an all-weather role in a portfolio. For instance, in 2022, as equities and bonds suffered material losses, many hedge fund managers generated positive returns for the calendar year. Pensions with hedge fund allocations have tended to show more resiliency amid such market drawdowns (Figure 5).

Investors looking for greater consistency in down markets can consider absolute return-oriented funds, which aim to provide positive absolute returns regardless of backdrop. Those expecting inflated default rates following higher-for-longer interest rate conditions can consider credit-oriented funds that excel in identifying and profiting on struggling businesses and/or dislocated securities. Over the past 20-year period, hedge funds have provided moderate returns with lower volatility than equities, helping to balance risk and deliver diversification benefits in an ever-changing investment landscape (Figure 6).

4. Use a Strategic Mindset to Overcome Valid—But Not Insurmountable—Hedge Fund Challenges

Investors are right to be concerned about hedge fund fees, transparency, and liquidity, but a well-informed, strategic approach can help unlock their potential.

While the hedge fund industry is known for its “2 and 20” fees—2% management fee and 20% performance fee—investor costs and terms are often negotiable, particularly with scale. It is critical to ensure fees are reasonable relative to expected alpha and to only invest with managers offering compelling return potential net of all fees.

Similarly, investors should only invest with hedge funds that offer appropriate transparency. Transparency is central to assessing the strategies employed by the fund. Investors should demand clear, comprehensive reporting on holdings, risk metrics, and performance attribution so that they can make informed allocation decisions. Greater transparency not only aids in understanding a fund’s approach and alignment but fosters trust between investors and fund managers.

In terms of illiquidity, adopting strategies that reduce an investor’s readily available capital may be justified in some cases, as long as the overall portfolio maintains adequate liquidity levels. Investors should complement less-liquid strategies with those that provide quarterly, monthly, or more frequent liquidity options to ensure a capital reserve during stressful periods. For those with greater liquidity needs, building well-diversified hedge fund allocations offering full quarterly liquidity is advisable.

Conclusion

Economic conditions and financial markets are unpredictable. Despite 2023’s equity bull run and its continuation in early 2024, investor circumstances can always change. For pensions, insurance firms, and other liability-focused investors, being positioned to withstand volatility is a critical component of successful portfolio management. Despite the skeptics, hedge funds can offer an attractive option for enhancing portfolio diversification and returns, especially in an environment of interest rate uncertainty and elevated volatility.

However, understanding risk is the essence of informed decision making. Action items for investors include: clearly defining the role of hedge funds within the portfolio; seeking out the highest quality managers; maintaining diversification; and adopting a strategic mindset to navigate inherent challenges. By carefully pursuing these actions, liability investors can successfully leverage hedge funds to help achieve their investment objectives, ensuring a balanced approach to risk and return in an ever-changing investment landscape.

Melanie Mandonas, Managing Director, Pension Practice

Index Disclosures

Bloomberg Aggregate Bond Index
The Bloomberg Aggregate Bond Index is a broad-based fixed income index used by bond traders and the managers of mutual funds and exchange-traded funds (ETFs) as a benchmark to measure their relative performance.

HFRI Fund of Funds Composite Index
Fund of Funds invest with multiple managers through funds or managed accounts. The strategy designs a diversified portfolio of managers with the objective of significantly lowering the risk (volatility) of investing with an individual manager. The Fund of Funds manager has discretion in choosing which strategies to invest in for the portfolio. A manager may allocate funds to numerous managers within a single strategy, or with numerous managers in multiple strategies. The minimum investment in a Fund of Funds may be lower than an investment in an individual hedge fund or managed account. The investor has the advantage of diversification among managers and styles with significantly less capital than investing with separate managers. PLEASE NOTE: The HFRI Fund of Funds Index is not included in the HFRI Fund Weighted Composite Index.

MSCI All Country World Index
The MSCI ACWI captures large- and mid-cap representation across 23 developed markets and 24 emerging markets countries. With 2,760 constituents, the index covers approximately 85% of the global investable equity opportunity set.

S&P 500 Index
The S&P 500 is a market capitalization–weighted stock market index that tracks the stock performance of about 500 of some of the largest US public companies.

Footnotes

1. The term “short rebate” refers to the interest income earned by investors that lend out securities for short selling.

The post A Liability Investors’ Guide to Reassessing Hedge Funds appeared first on Cambridge Associates.

Ultimately, overestimating liquidity risk and the denominator effect can prevent pensions from fully optimizing their portfolio’s return potential. This paper aims to help pension executives better understand how data can enable their effective use of PI. It also discusses how new investment policy approaches may help to take advantage of market opportunities and minimize the risk of portfolio stress when down markets occur.

Following the Data

It is no secret that investing in private markets can add considerable portfolio value. Investors that have allocated to these asset classes over the long term have tended to outperform investors holding only public asset classes. And investors that managed to allocate primarily to top quartile PI managers have tended to perform even better (Figure 1).

As pensions consider PI investments, data analysis based on historical returns for private markets can help them make more informed decisions. This analysis can yield insights about how PI allocations have previously behaved across different market environments.

For example, when a crisis scenario hits, private markets are expected to react. But in reality, the severity and duration of these market reactions are not instantaneous or uniform. In crisis conditions, private market asset values and cash flow generation can decrease—but contributions can also decrease—as asset managers have fewer investment opportunities. In the years immediately following a crisis, exit opportunities present themselves and PI-buying opportunities emerge, albeit typically with lower returns than a more normal market environment.

Figure 2 compares contributions and distributions from a sample private equity fund in hypothetical base-case, crisis, and boom environments. It shows how different market situations can impact the timing of capital calls by fund managers, as well as when capital is returned to investors. Contributions are deferred in crisis scenarios as managers typically wait until opportunities present themselves, while capital is often called quickly in boom scenarios. In both environments, it is typical for most capital commitments to be called by the manager over the total investment horizon. Conversely, distribution trends track nearly parallel for all three scenarios, echoing the returns of the public market. ²

Putting it all together, whenever a crisis ensues, public market portfolios are immediately affected, but the value of a PI portfolio lags because valuations occur less frequently. Furthermore, private markets will call and return capital more slowly. In order to fully understand and interpret the potential impact of PI investments on pension portfolios, this complex web of inputs and outputs requires careful analysis.

Modeling an Investment Portfolio

Liquidity is a key factor for pensions investing in the private market, but at what level does the lack of liquidity cause serious risks to the pension? Figure 3 paints a broad picture of liquidity risk as a function of net distributions. In this case, net distributions is the percentage of outflows required to pay benefit payments and expenses, minus contributions.

Using this simple framework is an effective way to consider the appropriate PI allocation for a pension. However, it’s important to note that because each pension’s risk and payment profile is unique, more detailed and bespoke modeling may be necessary. This is particularly true for those that intend to invest heavily in the PI market.

Modeling can also help to inform PI allocation dynamics over time. Figure 4 demonstrates a potential PI allocation path for a sample pension. In this example, the pension has a 25% target allocation to privates, is currently paying out 5% of assets per year in benefit payments, has benefit accruals equal to 1% of pension liabilities, and is currently above PI target by 5% due to recent market movements. ³

Here, it makes sense to start with a micro view of the assets to ascertain expectations under base-case, boom, and crisis scenarios to inform a more refined application that allows a broader range of randomness like a Monte Carlo simulation model. ⁴ The simulation model cannot be created without the scenario modeling.

In addition to forecasting potential PI portfolio dynamics, simulation modeling analyzes the non-PI portfolio, the liability plan profile, and broader capital market forecasts. The resulting “cone of doubt” in Figure 4 is based on 5,000 return simulations, with PI values informed by the three market scenarios discussed above. As in Figure 3, models such as this can provide a view to the potential liquidity risk inherent in the pension.

In this example, the model suggests an 81% probability that, in ten years, the PI allocation percentage will be less than where it is today. Furthermore, in the few future scenarios where the portfolio exceeds 35% in privates by 2029, there is a 71% likelihood that the proportion of PI in the portfolio will then decrease. These metrics suggest that the likelihood of a liquidity crisis is low—even in a stressed market environment—as is the risk that the portfolio will be overweight PI for a prolonged period. Thus, if an investor is willing to accept an elevated allocation to privates in the near term, then a decrease in private asset commitments, or a sale of private assets at a discount in the secondary market, is unnecessary.

Reconsidering PI Ranges

It is typical for pensions to express predefined thresholds for allocations within their investment policy statement (IPS). A well-constructed IPS dictates boundaries across all asset classes and informs decision making related to trading and rebalancing. However, in the case of a PI portfolio, there are few ways to remedy an overallocation in the near term. As Figure 4 shows, even in a simulation model where the IPS boundaries are breached, an overallocation to PI is unlikely to remain above the threshold for long—and unlikely to cause a lasting liquidity crunch. These scenario projections can help bolster confidence on the part of pension executives, demonstrating that there is enough liquidity in their portfolio and that their allocation is likely to return to their IPS range over time. While the above depicts a sample case, scenario modeling such as this can be customized to specific situations.

Governance and Target Ranges

The topic of IPS ranges brings up the question of what boundaries are necessary for pensions with PI allocations. In fact, it can be optimal to create two sets of boundaries. The first is a soft guideline that, when breached, flags that the allocation is above target and action may be necessary. A second set of boundaries can be used to demarcate the point at which immediate action is warranted. When setting these two boundary ranges, it is important to note that the larger the target of the private allocation, the broader the ranges should be. For example, a 5% boundary on a 10% allocation may be reasonable but is most likely insufficient for a 25% allocation.

What If?

When pensions find themselves in the middle of a market crisis, it can be difficult to stay rooted to analysis conducted during a calmer period. However, it is at this precise moment that a pension executive’s investment decisions can lead to the largest swings in PI value. For plans looking to sell in the secondary market to lower their illiquid allocation, the lost value is clear—their holdings will sell at a deep discount, locking in losses. However, for those interested in cutting commitments to new funds, outcome analysis depicts murkier results.

For example, what if decision makers overseeing the sample pension described earlier determine that the continued risk of the private allocation increasing is too high and move to cut their next three years of commitments by half? What amount of change can they expect in asset values? These questions can be answered using further simulation modeling, but the general outcome is that the pension has more surety of the liquidity profile at the expense of lower returns.

Looking back at Figure 1, a top quartile private equity performer may outperform the US equity market by ~15% per annum and—assuming a one-time, three-year decrease in commitments—the impact to the pension is a net decrease in assets of ~2%. ⁵

Model Outcomes

Scenario modeling of PI holdings can yield a crucial takeaway for pension executives: don’t fear the denominator effect. While the magnitude of this effect is conditional on a portfolio’s broader allocation strategy, analysis suggests that, overall, it is an uncommon and typically short-lived phenomenon. Pensions with an effective investment governance framework that build a PI portfolio tailored to their investment objectives can use modeling to strengthen their conviction in the ability of optimized PI allocations to deliver stronger portfolio returns without imposing too much additional risk. Pension executives can also use scenario modeling to better assess how to balance their pension’s liquidity requirements against PI growth opportunities as they work to meet their investment objectives over time.

Jacob Goldberg, Senior Investment Director, Pension Practice

Footnotes

1. The term “short rebate” refers to the interest income earned by investors that lend out securities for short selling.
2. This is a summary of broad private equity and does not detail any other private asset classes that have a shorter or longer investment horizon. Those separate private assets have a similar contribution/distribution profile.
3. For the sample simulation, a 60/40 portfolio consisting of asset class targets 25% equities; 10% hedge funds; 40% long government/credit; 10% private equity; 10% private credit; and 5% real estate. The PI portfolio is assumed to be mature and returning 25%–30% of capital committed, while continuing commitments to target the 25% target weight.
4. A Monte Carlo simulation model seeks to predict the probability of a variety of outcomes when the potential for random variables is present.
5. It is assumed that commitments decrease by ~2.7% of total assets and that the capital is drawn over six years and returned by year 13 with a total DPI of 2.6x.

The post Role Models: Pensions Can Use Data to Optimize PI Allocations appeared first on Cambridge Associates.

This paper addresses this challenge. It explains the historic role that PI allocations have had in generating strong returns for large investors with longer time horizons. Next, it lays out how target date funds (TDFs), which are professionally managed pools with long time horizons, can serve as the vehicle to provide exposure to PI, while simplifying the plan participant experience. Additionally, this paper explores how to incorporate a range of PI in a TDF glide path, optimize the ability of these funds to take on illiquidity, and maximize the probability of success. Lastly, it touches on keys to successful implementation of a value-generating PI program within a TDF structure. Expanding the asset class opportunity set to include PI can provide DC plan participants with exposure to the same higher return potential seen in the broader institutional investment world, and, if implemented effectively, can result in improved retirement outcomes.

Status Report: Where Are Institutions Allocating?

The investment behavior of institutional investors over the last several decades has been meaningfully different from that of DC plan participants, where diversification away from traditional stocks and bonds has been minimal. By contrast, institutions have steadily increased allocations to alternative assets—including PI, hedge funds, infrastructure, and real assets—which now represent more than 25% of total portfolio allocations on average.

The Use of Alternatives in Institutional Portfolios: First Movers

The first movers in building more diversified portfolios were endowments and foundations, which have been significant investors in the space since the 1990s. Many endowments, as reflected in Cambridge Associates’ own client experience, have had allocations to alternatives above 20% for more than two decades and today allocate well over one-third of their assets to these investments (Figure 1).

Many defined benefit plan sponsors have taken note of strong returns among endowments and foundations and followed suit with increased exposures to alternatives. Public plans have seen the largest increase, especially over the last 15 years (Figure 2).

Corporate plans, particularly underfunded plans that are seeking growth rather than de-risking into liability-driven investment strategies, have also raised their allocations. Family offices have made significant allocations as well, currently investing an average of 43% of their total investable assets in these strategies (Figure 3).

What do these investors all have in common? The longer time horizons and institutional scale needed to reap the rewards of alternatives. While DC plans (particularly TDFs) share these characteristics, they have remained a notable outlier in their allocation decisions thus far.

Better Returns Through PI

Institutional investors have increasingly incorporated PI—along with other alternatives—in search of higher returns, and the data show that they have been successful in that endeavor. This can be seen by looking at the performance of endowed institutions with similar investment objectives. Those with high allocations to PI have outperformed those with more liquid, traditional portfolios (Figure 4).

This is especially true for those who have invested in less liquid assets, such as private equity (PE), which has generally outperformed its public counterpart over the last several decades (Figure 5).

It is also worth noting that PI offers an expanded opportunity set for investors, given that the overall number of investable opportunities in the private and public spheres are moving in different directions. Between 1996 and 2019, for instance, the total number of publicly listed US companies decreased by 47%, while the number of private equity and venture capital (PE/VC) investment opportunities grew by 85%. ⁶

Private Investing: Why?
Participant Benefits
• Higher return potential relative to public markets
• Exposure to innovative, early stage, high-potential growth companies
• Access to larger opportunity set relative to contracting public company universe
• Greater diversification

Forward-looking modeling shows the potential benefits of including alternatives in a target date glide path. An allocation of 10% to PI—divided between PE and private credit—can result in approximately 3% of additional income replacement in retirement, which is comparable to increasing a savings rate by 1%. ⁷

As noted earlier, the institutions that have been most able to benefit from investing in PI are professionally managed pools with a longer time horizon. The question is—how can that approach be adapted for the benefit of DC plan participants? TDFs can help bridge this gap.

The Place for PI

We believe the best place to include PI in a DC plan is through a multi–asset class portfolio, such as a TDF, which can provide the necessary professional oversight. This supervision is key, as the complexity and range of outcomes from PI make them extremely challenging for participants to manage themselves. TDFs can provide plan participants access to more sophisticated investment strategies through an easy-to-use vehicle with professional oversight. In most TDFs composed of traditional assets, a manager oversees underlying asset class exposures, asset allocation changes, and rebalancing. Enabling a professional fiduciary to oversee the inclusion of private assets in a TDF is simply a logical extension of this framework.

Incorporating PI through a multi–asset class pool also means that a participant does not need to focus on liquidity management or overall risk. Plan sponsors can take comfort that they have selected a professional portfolio management team to oversee these investment options without burdening participants with the task of conducting complex due diligence and decision making.

Range of PI Categories

Private investments are often lumped together as a single group of strategies, but their effective use in portfolios requires a more nuanced understanding. The most successful implementation approaches are those that fully recognize how different PI types can serve DC plan portfolios in different ways. Most often, certain allocations are appropriate at distinct parts of the glide path, helping to address participant needs at the appropriate time(s). Figure 6 reviews some of the major PI categories available to DC plans.

Close consideration of the roles that each of these investment categories can play in a portfolio helps to inform how to include them in the TDF glide path. Plan sponsors may be able to make the largest impact on overall performance by replacing a portion of the portfolio’s public equities with PE/VC and secondaries, and by replacing a portion of the public fixed income portfolio with private credit. While real estate and infrastructure provide some diversification, investors generally will achieve more bang for their illiquidity buck through PE and private credit. Making these changes will allow plan sponsors to better optimize the performance impact of taking on illiquidity relative to available traditional assets. The breakdown of these strategies can change across the glide path to reflect the needs of participants at each point in their lives (Figure 7).

Answering the Liquidity Question

Today, the DC system operates in a daily valued—and mostly daily traded—context, which translates into a need for robust liquidity. Assets with less than daily pricing and liquidity are already included within DC plans (for example, private companies as part of a public equity portfolio, or lower quality parts of the fixed income market). However, including a meaningful allocation to significantly less liquid assets requires careful thought and oversight to ensure that the plan is able to meet participant needs. Overall, an allocation of roughly 10% to illiquid investments balances the need to maintain plan liquidity, while still providing sufficient exposure to PI to move the needle and help accomplish participant investment goals. When thinking about liquidity, it is important to remember that the remaining 90% of the portfolio is liquid and available for cash needs.

Combined with available liquidity from the remainder of the portfolio, there is often more liquidity available from PI than is generally assumed. A mature PI portfolio is typically cash-flow positive—distributions are higher than contributions, particularly for a portfolio that includes private credit. These distributions can be used to meet participant liquidity needs or may be reinvested in the portfolio, all while maintaining sufficient total liquidity.

In addition to ensuring sufficient day-to-day liquidity, it is also important to stress test a portfolio to confirm that liquidity will remain sufficient even during down markets. The hypothetical example illustrated in Figure 8 incorporates both capital market and cash-flow stresses and provides some context for a perfect storm, adverse liquidity event.

The Name of the Game Is Implementation

Ultimately, taking advantage of the growth opportunities and diversification benefits of PI in DC plans requires negotiating two challenges: (1) building a well-designed PI portfolio and (2) situating this portfolio effectively within a TDF structure.

Manager Selection Matters

Even more so than with traditional asset classes, how private investments are implemented can spell the difference between success and mediocrity. For example, private markets can provide outsized returns, but the dispersion between the best- and worst-performing managers in PI is much larger than it is for public assets (Figure 9). In other words, while the benefits of getting private market allocations right can be far greater than with traditional asset classes, the consequences of getting them wrong can be markedly detrimental. Thus, working with an expert that has proven capabilities to conduct thorough due diligence on fund managers should be a top priority.

Performance dispersion across managers is just one of many reasons why building a properly diversified portfolio requires significant expertise. Other variables, including time (vintage year), sub-strategy (such as growth, buyouts, and venture capital), and knowledge of underlying general partners (GPs) must also be closely considered. As mentioned, secondaries can also be used to help kick-start a program. This requires proficiency in modeling private exposure(s) over time—how much capital to commit and to which managers—to properly build toward future portfolio success. As liquidity and portfolio size change, this modeling needs to be revisited—and the commitment plan adjusted—to match the evolving portfolio dynamics.

A Pooled Approach

When incorporating PI in a TDF, getting the structure right is essential, as this allows returns generated by the allocation to meaningfully benefit participants. This can be achieved most effectively by creating several pooled funds—or sleeves—for each of the major asset types: PE/VC, secondaries, and private credit. Each sleeve can include a minimal amount of liquidity for purposes of capital calls and distributions, but the primary source of liquidity is derived at the TDF level, as opposed to seeking meaningful liquidity within the private sleeves. These can invest in individual private investments, allowing for appropriate management of each underlying strategy. This structure also allows for a daily valuation process at the private sleeve level, based on the aggregate exposure to underlying managers. Each vintage of the TDF series can invest in these underlying funds, like the structure used by most TDF funds to invest in traditional asset classes. The pooling of PI into sleeves, and the accompanying pooling of cash flows, allows each TDF vintage to individually manage its exposure to each PI asset class.

Private Investing: How?
Keys to Success
• Simplified participant experience through inclusion in TDFs
• Experienced professional investment management
• Diversification across asset categories, adjusted for participant life stages
• Expert manager and fund selection
• Asset class–specific pools, with liquidity management occurring at the total TDF level

It is important to remember that private investments are less liquid than traditional stocks and bonds—each TDF vintage will not be able to precisely rebalance to a specific target the way a portfolio of more traditional assets can. The portfolio management team can accommodate by adjusting the allocations to corresponding pools of public asset classes to maintain the portfolio’s desired risk exposures. To this end, ranges around allocation targets should be designed to provide sufficient flexibility to account for the nature of PI.

Right Mix, Bright Future

A growing number of organizations are considering the use of PI in their DC plans as they strive to offer an optimized line-up of investment strategies to their employees and work to ensure a secure financial future for their plan participants. For those who opt to include them, the most successful approach will be one that is informed by both the growth opportunities and risks associated with more illiquid asset classes. DC plan sponsors should consider building out their plan’s PI allocation options via a TDF structure, using a methodology that matches the efficiency and choice available to participants in the form of more traditional assets. While this approach can result in increased investment management complexity, working with an experienced partner can help. Moreover, PI returns have historically compensated plan sponsors for the additional complications and cost. Regardless of preferred vehicle, having a clear understanding of investment strategy options and how they relate to existing traditional assets is fundamental to success. Proper portfolio implementation, including identifying and investing with top GPs, is also necessary.

Today’s DC plan participants desire—and deserve—institutional-quality investment management, including the diverse selection, robust due diligence, and potential returns that this classification implies.

Hayden Gallary, Managing Director, Pension Practice

Footnotes

1. The term “short rebate” refers to the interest income earned by investors that lend out securities for short selling.
2. This is a summary of broad private equity and does not detail any other private asset classes that have a shorter or longer investment horizon. Those separate private assets have a similar contribution/distribution profile.
3. For the sample simulation, a 60/40 portfolio consisting of asset class targets 25% equities; 10% hedge funds; 40% long government/credit; 10% private equity; 10% private credit; and 5% real estate. The PI portfolio is assumed to be mature and returning 25%–30% of capital committed, while continuing commitments to target the 25% target weight.
4. A Monte Carlo simulation model seeks to predict the probability of a variety of outcomes when the potential for random variables is present.
5. It is assumed that commitments decrease by ~2.7% of total assets and that the capital is drawn over six years and returned by year 13 with a total DPI of 2.6x.
6. This compares the decrease in publicly listed companies from 1996 to 2019 against the increase in unrealized and partially realized institutional private investments from 1996 to 2020.
7. This is based upon Cambridge Associates’ Capital Market Assumptions projected over 60 years using a Latin Hypercube model with 5,000 iterations. We modeled the same participant profile, isolating the change in investment design using 10% of total assets in PE and credit compared to public equities and bonds. For purposes of this analysis, we used a sample 35-year-old participant contributing 11% to 19% to their retirement account, 1.3% to 4.3% real salary increases, and withdrawing 70% of their pre-retirement income at age 65, while offsetting for social security. This analysis compares the assets at retirement and how long those assets last in retirement under the two investment designs.

The post Better Alternative(s): Private Investments May Improve Outcomes for Defined Contribution Plan Participants appeared first on Cambridge Associates.

New Dynamics, Old Strategies?

Plan sponsors today are operating in the aftermath of one of the fastest rate hikes in history and a prolonged yield curve inversion. Discount rate increases, along with strong equity performance since the March 2020 COVID-19 bottom, have powered significant improvements in funded status (Figure 1). These factors have proven especially beneficial to plan sponsors with underfunded and underhedged plans, helping them catch up with those that have spent the past decade contributing to their plans and increasing their liability-hedging targets.

Most DB plans today also have much improved risk profiles. Funding relief regulations such as MAP21 ⁸ and ARPA ⁹ have stabilized the interest rates used for determining plan contributions and lengthened the time periods available to plans for addressing funding shortfalls (Figure 2). These measures have helped to make funding more predictable over the long term by using a moving average yield to determine funding requirements. As a result, pension plans have much lower contribution risk as compared to two decades ago. Even with the steep rise in discount rates devaluing some of the cost savings from these regulations, it is still important for plan sponsors to recognize that these changed dynamics are likely here to stay. What’s more, they may need to reconsider how they manage their plan to remain on track for long-term success.

Shifting Gears

Plan sponsors have four key levers to manage their pensions—asset returns, liability hedges, contribution policy, and benefit management (Figure 3). While these levers do not change over time, how they are operated should, as plan sponsors look to remain on track with plan goals and objectives. Whether a plan is recently closed, frozen, or open, the observations we share below are broadly applicable to ensuring its optimized management.

Growth Assets: Meeting New Goals Amid New Risks

Although many plans today are well funded and well hedged, growth assets remain a critical component of overall plan health, helping to offset administrative expenses, unfavorable demographic trends, actuarial assumption changes, and other unhedgeable aspects of liabilities. As later discussed in the benefits management section of this paper, a properly executed growth strategy can also increase a plan’s overall value to an enterprise by reducing the cost of retirement and other employee benefits and by funding other organizational priorities.

Even though many plans have been focused recently on investing in a higher interest rate environment, these allocations alone may not provide adequate diversification in the event of market volatility. This volatility could be driven by multiple variables, including additional interest rate changes, an economic recession, increased pressure in the banking sector, heightened geopolitical tensions, or any black swan event.

Private credit, high-yield fixed income, hedge funds, and real assets are all strategies with the potential to help enhance diversification, provide downside protection, and achieve superior returns. Of these strategies, private credit can be particularly advantageous. Higher yields, coupled with a floating rate structure, may prove beneficial in a rising rate environment, with some strategies providing risk mitigation due to senior standing in companies’ capital structure. As with any private asset class, however, conducting robust due diligence will help achieve superior returns and avoid strategies that appear favorable on the outside but may contain hidden risks on the inside, such as subpar lending standards, poor execution, and unfavorable deal flow.

As plan sponsors evaluate their growth-oriented options, they should validate their true liquidity needs. Doing so may enable them to unlock their portfolio’s full growth potential by using excess liquidity to take advantage of opportunities in higher return, generating private equity investments (Figure 4). A liquidity coverage ratio of 2x to 3x can help ensure a portfolio is positioned to tolerate periods of market stress.

The liquidity risk of private investments in a pension portfolio varies depending on its net cash flow. As net distributions increase, the optimal allocation to private investments decreases (Figure 5). Partnering with experts in the private investment space is crucial to understanding the implications of these cash flow dynamics. The days of investors shooting in the dark to build out private investment allocations are over, as data and technology improvements make it easier to analyze liquidity requirements in an asset/liability context.

Liability Hedging: Less May Be More

Many plan sponsors have been highly focused on increasing long-duration liability-hedging assets in recent years. However, it may be time to reconsider how to manage liability risk going forward, including the appropriate amount of capital committed to these strategies and the optimal mix of credit duration. As always, a plan’s liability-hedging strategy is informed by its funded status. It follows that improvements in funded status should inspire a revised approach to liability hedging. As plan sponsors consider their options in today’s investment landscape, they now have a better set of tools at their disposal.

For example, because the accounting discount rate for single-employer pension liabilities is based on the Aa yield curve, a portfolio of duration-matched bonds can provide a good hedge against interest rate volatility. The earlier use of a completion manager may also help to keep higher hedging ratios, while also freeing up capital to implement more effective credit risk management and achieve additional exposure to growth assets.

It’s important for plan sponsors to recognize that the old paradigm of devoting the vast majority of plan assets to liability hedging should evolve into a more balanced approach. In fact, with liability durations decreasing relative to many fixed income assets today, more hedging can be achieved with fewer dollars. Less commonly used investment strategies, such as intermediate credit, also can play a role here. They can offer multiple potential benefits, including increased yields, liability carry offset, and better credit curve exposure, which in turn can result in lower volatility and higher returns.

Plan sponsors should also evaluate the overall fit and relative importance of liability hedging for their plans. There is now diminishing marginal utility in hedging the “last-mile risk” in pension portfolios with more capital. In some cases, an excessive hedging effort may result in a lower returning liability-driven investment (LDI) program, which decreases the efficiency of not only the liability-hedging assets, but the entire portfolio. Instead, plans may pick up incremental yield by adding non-traditional instruments for hedging, such as private investment-grade credit, commercial mortgage loans, and securitized assets. This may help the liability-hedging portfolio keep pace with the higher interest cost on liabilities, while still reducing interest rate risk through completion or other Treasury strategies. Figure 6 depicts how allocating only 30% of the liability-hedging portfolio to more diverse hedging assets can result in 50 basis points of extra annual yield.

For plan sponsors whose main objective is controlling or minimizing contribution requirements, hedging liabilities may introduce additional risk. In this scenario, plans should consider blending total return investment approaches with specialized liability-hedging programs to achieve the optimal outcome. The recent rise in discount rates has also presented a new option—adjusting contribution requirements to be based on mark-to-market liabilities. This option allows a liability-hedging program to not only reduce accounting funded status risk, but also contribution risk.

Contributions: A New Paradigm

Even if plans should experience negative asset returns in the near term, they can afford to be less concerned about contribution volatility due to the favorable impact of regulatory changes on funding target ¹⁰ calculations. The significant funding relief options passed in the last decade have resulted in the adoption of higher interest rates for minimum required contribution calculations. For example, plans are allowed to discount liabilities using 25-year moving average rates, which are then bound by interest rate corridors. When higher discount rates are used, liabilities are lower, which leads to higher funded status and lower contribution requirements.

In addition, due to new shortfall smoothing rules, a decline in funded status will no longer result in exceedingly high mandatory contributions. This changed regulatory backdrop, coupled with revamped asset and liability management options, effectively lightens the load for plan sponsors, potentially freeing up corporate assets for other purposes, including critical enterprise goals.

Contribution risk should generally be considered separately from funded status risk, since the duration for liabilities used to determine contribution requirements is essentially zero. While the use of long-duration fixed income strategies is beneficial to hedge long-duration accounting liabilities, it has a countereffect for liabilities with zero duration. While this wasn’t much of an issue when interest rates were low, the disparity is presenting a bigger opportunity in today’s higher interest rate environment. Well-hedged plans can consider aligning accounting and funding target methodologies through the Full Yield Curve approach, which may not only reduce expected contribution requirements, but eliminate much of the contribution volatility risk.

Underhedged plans should be more cognizant of the difference and focus on controlling the risk that is most important for them—balance sheet or contribution volatility. Even under the stabilized interest rate approach, certain aspects of pension management, such as Pension Benefit Guaranty Corporation (PBGC) premiums, are sensitive to interest rate changes. The most risk-efficient plan portfolios often blend traditional investments with LDI strategies in accordance with plan sponsor objectives and circumstances.

Benefits Management: Reassessment Required

Multiple benefits management approaches are always available to plan sponsors. These include plan termination, hibernation, partial risk transfer, future benefit modification, maintaining an open plan, or even re-opening one. Each of these approaches carries direct and indirect costs and risks. A close consideration of the plan sponsor’s specific needs and goals will help determine the right way forward.

Many plan sponsors can evolve their DB plans from feeling like a burden to feeling like an asset, one that supports corporate goals and financial health. Thanks to effective benefit management—combined with more supportive plan regulations and tools for generating asset growth and managing liabilities and contributions—plan sponsors are able to extend the life of their DB plans. Well- and over-funded pensions can become a point of differentiation for these enterprises and a valuable tool in attracting and retaining talent for the organization. Surplus plan assets also can be used in other ways that are long-term value additive to an organization, including mergers & acquisitions activity and retiree medical benefits. As plan sponsors consider a DB plan restart, expansion, or extension, they are likely to find that DB plans come at a marginal cost compared to defined-contribution plans. In fact, the National Institute on Retirement Security estimated that a DB plan costs 27% less than an “ideal” defined-contribution plan—one with fees below the industry average delivering strong performance. ¹¹

Those sponsors closer to the termination side of the spectrum should consider how they can approach de-risking economically. For instance, many lean toward offering a lump sum payment option to plan participants; in this scenario, participants who receive a payment are no longer due a benefit from the plan. While this seems routine enough, it is important that payments be apportioned strategically so they result in less assets transferred than the liability. Generally, cost savings occur during declining interest rate environments that generate a lower lump sum payment relative to the market-to-market liability. However, this strategy can backfire in a rising rate environment and result in many plan sponsors having to contribute capital in order to terminate as lump sums become more expensive than buying annuities. Similar issues can occur for plans opting for pension risk transfers (PRTs) via lump sum windows.

Partial PRTs are commonly used with the idea of reducing plan size for purposes of PBGC premium savings. However, for most underfunded plans, this kind of transaction may actually negatively impact funded status and increase plan costs and PBGC premiums over the long term—even if the amount of assets transferred is less than the liability (or a gain to the plan). All sponsors should fully understand the implications of PRTs in terms of funded status, risk reduction, and future costs for their plan. For many plans, managing risk through asset allocation decisions is more effective.

Achieving a surplus position is never easy or risk free—and may be prohibited by many glidepath designs, especially those that aim to lock in funded status at a point just above 100% funded. For this reason, plan sponsors should reconsider the end stage of their glidepath, given the utility of a surplus and the potentially higher funded status needed to terminate without cost if a previous PRT has already been performed. Plan sponsors wishing to use surplus assets may find that increasing allocation to growth strategies could be advantageous as the plan moves higher in funded status, with the notion that the further away the plan is from becoming underfunded, the more risk a plan can take in pursuit of higher surplus.

Adaptability Is Key

Although pension plans today are experiencing much improved funded status relative to years past, the extent to which they take advantage of the opportunities made available by favorable improvements in funding and regulations will be a key determinant of their future health.

In all market conditions, the four levers that plan sponsors control as they seek to accomplish their objectives remain the same. However, an informed, adaptive approach to the operation of each will help ensure continued plan success over the near and long term. Plan sponsors are strategizing for growth and managing risk in in a significantly different investment environment. To accomplish their goals, it is imperative that these changes be taken into consideration. By taking a fresh look at their investment strategies and plan management, organizations have an opportunity to adapt, evolve, and reap significant benefits.

Serge Agres, Managing Director, Pension Practice

Cathy Xu, Investment Director, Pension Practice

Footnotes

1. The term “short rebate” refers to the interest income earned by investors that lend out securities for short selling.
2. This is a summary of broad private equity and does not detail any other private asset classes that have a shorter or longer investment horizon. Those separate private assets have a similar contribution/distribution profile.
3. For the sample simulation, a 60/40 portfolio consisting of asset class targets 25% equities; 10% hedge funds; 40% long government/credit; 10% private equity; 10% private credit; and 5% real estate. The PI portfolio is assumed to be mature and returning 25%–30% of capital committed, while continuing commitments to target the 25% target weight.
4. A Monte Carlo simulation model seeks to predict the probability of a variety of outcomes when the potential for random variables is present.
5. It is assumed that commitments decrease by ~2.7% of total assets and that the capital is drawn over six years and returned by year 13 with a total DPI of 2.6x.
6. This compares the decrease in publicly listed companies from 1996 to 2019 against the increase in unrealized and partially realized institutional private investments from 1996 to 2020.
7. This is based upon Cambridge Associates’ Capital Market Assumptions projected over 60 years using a Latin Hypercube model with 5,000 iterations. We modeled the same participant profile, isolating the change in investment design using 10% of total assets in PE and credit compared to public equities and bonds. For purposes of this analysis, we used a sample 35-year-old participant contributing 11% to 19% to their retirement account, 1.3% to 4.3% real salary increases, and withdrawing 70% of their pre-retirement income at age 65, while offsetting for social security. This analysis compares the assets at retirement and how long those assets last in retirement under the two investment designs.
8. The Moving Ahead for Progress in the 21st Century Act of 2012, or MAP21, represents the first funding relief since the Pension Protection Act (PPA) of 2008.
9. The America Rescue Plan Act (ARPA) funding relief of 2021 significantly reduces funding requirements by introducing a floor on the interest rates used for discounting liabilities, and a longer amortization period (from seven years to 15 years).
10. The Funding Target methodology is used to determine the plan’s minimum required contributions under ERISA and the Pension Protection Act of 2006 (PPA).
11. See Dan Doonan and William B. Forina, “A Better Bang for the Buck 3.0,” National Institute on Retirement Security, January 2022.

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Although this exemption has been available for years, it has not been used extensively. With an increasing number of plans seeking to settle benefit obligations in the near term, this exemption offers a way for some plans to realize the potential return-generating benefits of a PI allocation without impeding de-risking activities. For plans at or near fully funded, the exemption allows for continued use of PI to enhance risk-adjusted returns.

How Does a QPAM Exemption Work?

A QPAM can facilitate the transfer of private assets under DOL exemption 84-14, where a separate QPAM acts as a fiduciary for each pool of assets (e.g., two unrelated QPAMs). Most asset owners already use a QPAM for discretionary or non-discretionary management of one or multiple asset pools. Employing a separate QPAM for one of the pools allows for the transfer of assets between the pools without running afoul of ERISA-prohibited transaction regulations.

The main area of concern with these sales is the fair market value of the private assets, which is negotiated between the separate QPAMs. Although this transfer can occur between any two pools of assets, it is most practical for a plan sponsor with multiple pools that are under the ownership of the sponsor. Here, the PI assets can be transferred out of the pension plan and into another pool of capital in a more streamlined manner.

In most cases, approval by an external entity is not necessary. Outside of the generally reasonable fees for this service to the QPAM and the time required to agree upon a price of the assets to be transferred, the sale can occur within a few months at a price that is sensible to both the purchaser and seller.

What Plans Qualify for the Exemption?

While the QPAM exemption is available to all organizations with an ERISA-governed DB plan, it is more practical for institutions with multiple pools of investment assets, given visibility within each pool. Assuming there is an adjacent capital pool—such as an endowment—that can add to its PI program, assets can be transferred dollar for dollar to the DB plan as long as the adjacent pool maintains sufficient liquidity for a cash transaction. For this reason, institutions such as universities, healthcare organizations, or other 501(c)(3) organizations—which often manage multiple large investment pools—are prime candidates for the QPAM exemption. Although corporations also qualify, additional approval from the DOL is required for the PI program to be transferred to a corporate balance sheet.

Transfer opportunities for non-related DB plan sponsors with private programs also exist. It is possible to find an unrelated party that is looking to obtain all or part of the PI program in question. If the right buyer can be found, a private transfer may be the best option.

Conclusion

Plan sponsors seeking enhanced risk-adjusted returns can achieve those returns through a PI program, knowing that if they ever have a liquidity need—such as a plan termination, pension risk transfer, or increasing fixed income assets—a QPAM facilitated transfer may be available. Determining whether to sell a private program to another pool is a decision a plan sponsor needs to make based upon their short-, mid-, and long-term pension plan goals.

Serge Agres, Managing Director, Pension Practice

Jacob Goldberg, Senior Investment Director, Pension Practice

Footnotes

1. The term “short rebate” refers to the interest income earned by investors that lend out securities for short selling.
2. This is a summary of broad private equity and does not detail any other private asset classes that have a shorter or longer investment horizon. Those separate private assets have a similar contribution/distribution profile.
3. For the sample simulation, a 60/40 portfolio consisting of asset class targets 25% equities; 10% hedge funds; 40% long government/credit; 10% private equity; 10% private credit; and 5% real estate. The PI portfolio is assumed to be mature and returning 25%–30% of capital committed, while continuing commitments to target the 25% target weight.
4. A Monte Carlo simulation model seeks to predict the probability of a variety of outcomes when the potential for random variables is present.
5. It is assumed that commitments decrease by ~2.7% of total assets and that the capital is drawn over six years and returned by year 13 with a total DPI of 2.6x.
6. This compares the decrease in publicly listed companies from 1996 to 2019 against the increase in unrealized and partially realized institutional private investments from 1996 to 2020.
7. This is based upon Cambridge Associates’ Capital Market Assumptions projected over 60 years using a Latin Hypercube model with 5,000 iterations. We modeled the same participant profile, isolating the change in investment design using 10% of total assets in PE and credit compared to public equities and bonds. For purposes of this analysis, we used a sample 35-year-old participant contributing 11% to 19% to their retirement account, 1.3% to 4.3% real salary increases, and withdrawing 70% of their pre-retirement income at age 65, while offsetting for social security. This analysis compares the assets at retirement and how long those assets last in retirement under the two investment designs.
8. The Moving Ahead for Progress in the 21st Century Act of 2012, or MAP21, represents the first funding relief since the Pension Protection Act (PPA) of 2008.
9. The America Rescue Plan Act (ARPA) funding relief of 2021 significantly reduces funding requirements by introducing a floor on the interest rates used for discounting liabilities, and a longer amortization period (from seven years to 15 years).
10. The Funding Target methodology is used to determine the plan’s minimum required contributions under ERISA and the Pension Protection Act of 2006 (PPA).
11. See Dan Doonan and William B. Forina, “A Better Bang for the Buck 3.0,” National Institute on Retirement Security, January 2022.
12. This may include church plans and other plans defined by IRC 414(e), but applicability depends on specific state provisions.

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What Are Insurance-Linked Securities?

ILS are financial instruments through which investors take on risk of loss from insured natural catastrophes, such as hurricanes and earthquakes. ¹³ They can also cover risks related to “man-made” adverse events, such as marine, energy, and cyber-related incidents, but these are a much smaller part of the market. A capital market alternative to traditional reinsurance, ¹⁴ ILS are designed to provide investors with interest income in the form of insurance premiums, plus repayment of principal, so long as the insured event does not trigger a material financial loss. The most common types of contracts include catastrophe (CAT) bonds, industry loss warranties (ILWs), collateralized reinsurance (CRI), and collateralized retrocession (retro) (Figure 1).

Peril exposures vary by event type and location, and include earthquakes, floods, hurricanes, and wildfires. The industry’s largest allocations are to international and US multi-peril coverage, which include insurance against a specific combination of potential events. Large amounts of capital have also been allocated to specific US states, including Florida, Texas, and North Carolina. Figure 2 breaks down the market by type of risk (or peril).

ILS Historical Performance

The historic track record of ILS is relatively limited, as third-party investment only became more prevalent around the year 2000. A representative measure of subsequent performance is available from the Eurekahedge ILS Advisers Index, although it is far from a perfect benchmark, given the breadth and intricacies of the ILS universe. ¹⁵ The average ILS manager depicted in Figure 3 earned an annualized net return of 3.9% since the Eurekahedge inception in January 2006, compared to 7.0% for the Swiss Re CAT Bond Index ¹⁶ and 2.3% for the Bloomberg Global Aggregate Bond Index during the same period. ¹⁷

Potential Advantages for Pensions

An Uncorrelated Asset Class

Most ILS are exposed to a fairly narrow definition of natural catastrophe risk: loss due to residential property damage caused by natural disasters. Correlations were higher in years prior to 2010, due to widespread use of leverage and collateralization with securitized debt in the lead up to, and during, the 2008 Global Financial Crisis (GFC). Such widespread use of leverage is no longer common practice (Figure 4).

Even in the face of a systemic financial turmoil such as the GFC, ILS have proven to be resilient. Absent Hurricane Ian—one of the strongest hurricanes in the last 20 years—2022 would have been a year of positive results despite the inflation and interest rate shocks that stressed most asset markets.

An Inflation Hedge

Broadly speaking, ILS are a floating rate, low duration asset class: collateral backing contracts are invested in short-term US Treasury money market funds, so higher interest rates feed directly to higher prospective investor returns, offering an attractive inflation hedge. This protection comes with an additional (weather-related) risk profile, but the enhanced return compared to inflation-linked bonds makes ILS well worth considering for many pensions (Figure 5).

Today’s market offers a compelling entry point for ILS. The bond market losses of 2022 reduced reinsurers’ balance sheet capital and—coupled with the last five years of loss events (culminating with Hurricane Ian)—generated one of the best risk-adjusted yield environments since Hurricane Katrina in 2005.

Current Market Opportunities

The losses from Hurricane Ian have eaten into reinsurers’ capital reserves and ability to write new business in a meaningful way. Contractual conditions were already getting tighter, particularly around secondary perils (e.g., wildfires and severe thunderstorms). These trends—plus several previous storms and extensive losses in traditional asset values as interest rates increased—have all contributed to an estimated reinsurance capital supply gap of $80 billion to $120 billion, driving yields significantly higher.

Coming in to 2023, CAT bond spreads—defined as coupon minus average expected loss (EL)—reached their highest levels in more than 15 years. New issues offered yields of cash +10%, the best on offer since Hurricane Katrina in 2005 (Figure 6).

Potential Disadvantages for Pensions

Impacts of Recent Events

Global reinsurer Swiss Re has estimated natural catastrophe economic loss of $284 billion and $125 billion of insured loss for 2022. This year saw the fourth-highest losses since 1970 and, for the first time ever, insured losses exceeded $100 billion for two years running (adjusting for inflation). Insured annual loss totals from natural catastrophes have surpassed the $100 billion mark five times since 1970, and three times in the past six years (Figure 7).

Natural catastrophes in 2021 included winter storms in Texas, floods in Europe, and Hurricane Ida, whereas Hurricane Ian was the main contributor in 2022. These losses impacted total returns for Eurekahedge and resulted in episodes of relative underperformance for ILS (Figure 8).

Headline Risk

The headline risk surrounding individual catastrophe events and climate change often serves as a deterrent for pensions. For example, the buildup and aftermath of a Category 5 hurricane in Florida is likely to garner days or weeks of media coverage. Consequently, the ILS asset class requires proactive education for board members and other stakeholders to reduce behavioral risk. Otherwise, demands to redeem may be loudest just after periods of highly publicized loss—which are often the most attractive times to invest—due in part to rate increases and tighter contractual terms. Pensions need to be prepared for these risks and opportunities. The best ILS managers consistently share their knowledge to help pensions maintain a longer-term commitment to the asset class and avoid attempts to time the market.

In 2022, investors bared their teeth on pricing and showed much less appetite for vaguely worded aggregate cover contracts or secondary perils such as wildfire. Several transactions failed to close due to a lack of investor support. For 2023, this has greatly increased ILS managers’ influence over terms and conditions, leading to cleaner structures and contracts.

Climate Change

An ever-present factor related to ILS is, unsurprisingly, climate change. Empirical evidence suggests that the severity and frequency of some meteorological events have increased over time. ¹⁸ Extreme rainfall and wildfires are two examples. Other primary natural catastrophe perils, such as earthquakes and hurricanes, do not seem to have been affected thus far, but climate attribution research is ongoing. Climate change–related adjustments to underwriting practices are a central interest of the ILS community. Researchers are continuing to analyze how the effects of anthropogenic global warming and climate change will unfold, both in the form of long-term trends and sudden, unpredictable shocks. Indeed, the standard practice of yearly contract underwriting can give investors comfort, as the long-term impact of climate change becomes more observable.

Portfolio Construction Guidance

Portfolio implementation and benchmarking of ILS can be challenging. On the former, investors that don’t intend to formally include insurance in their asset allocation may wish to implement it as part of a diversifying hedge fund portfolio or within an alternative credit allocation. On the latter issue, pensions already exposed to ILS outside of the catastrophe space (e.g., life settlements) can construct a dedicated insurance bucket with specific return targets based on cash plus. Benchmarking to cash plus might represent a viable option for catastrophe risk too. Pensions aiming to use the Swiss Re indexes ultimately need to be wary of their uninvestable nature, as mentioned above. In either case, an investment in ILS is likely to drive active risk at the portfolio level, due to the asset class’s diversification profile versus other capital market instruments. Decision makers need to be comfortable with this potential outcome.

ILS provides allocators with reasonable flexibility with regard to key portfolio construction criteria. Liquidity profiles range from monthly to semi-annual. Return targets may vary from mid-single digits to mid-teens, although higher return requirements will be associated with lower attachment points (i.e., higher likelihood to bear losses following catastrophic events) and potentially more complex structures. In the case of multi-manager implementation, risks can be diversified by balancing funds’ preferred areas of exposure. Some strategies may present an embedded tilt toward specific areas and perils (e.g., >70% of CAT bond notional outstanding representing contracts covering against US hurricane risk) that investors may wish to complement with managers with exposure to broader books of business.

Manager Selection Is Important

The frequency and severity of catastrophic events between 2017 and 2022 have inevitably led to side pocketing and trapped collateral issues throughout the industry, causing less capital available for renewals, decreased ILS liquidity, and diminished expected returns. As a result, a crucial element of ILS manager selection is the ability to identify managers with appropriate capital reserving techniques, necessary in the immediate aftermath of large catastrophic events.

The ongoing effects of climate change also play a key role in ILS manager selection. Investors should know, for example, if an ILS manger takes a more conservative, longer-term approach to warming global temperatures. Furthermore, understanding a manager’s peril exposure and the reasoning behind these allocation decisions is crucial. Is a manager taking on Florida wind due to higher premium opportunities? Is it diversified because of a bias away from peak perils? How does its stance on climate change affect its allocation strategy?

Pension Portfolio Opportunities in ILS

ILS represent an opportunity for pensions to back an often-overlooked asset class at an attractive entry point, one that can complement a pension portfolio’s existing risk factors with an uncorrelated return stream. To gain the most advantage from ILS, pensions should commit to medium-term holding periods rather than be tempted to time the market by capturing dislocations as they occur. More experienced ILS investors may size their investments up or down, depending on a hardening or softening cycle. Increased volatility and uncertainty in both the market environment and the natural world have helped to position ILS as an allocation worthy of consideration by pensions as they work to accomplish their long-term goals.

Joe Tolen, Investment Director, Credit Investment Group

Footnotes

1. The term “short rebate” refers to the interest income earned by investors that lend out securities for short selling.
2. This is a summary of broad private equity and does not detail any other private asset classes that have a shorter or longer investment horizon. Those separate private assets have a similar contribution/distribution profile.
3. For the sample simulation, a 60/40 portfolio consisting of asset class targets 25% equities; 10% hedge funds; 40% long government/credit; 10% private equity; 10% private credit; and 5% real estate. The PI portfolio is assumed to be mature and returning 25%–30% of capital committed, while continuing commitments to target the 25% target weight.
4. A Monte Carlo simulation model seeks to predict the probability of a variety of outcomes when the potential for random variables is present.
5. It is assumed that commitments decrease by ~2.7% of total assets and that the capital is drawn over six years and returned by year 13 with a total DPI of 2.6x.
6. This compares the decrease in publicly listed companies from 1996 to 2019 against the increase in unrealized and partially realized institutional private investments from 1996 to 2020.
7. This is based upon Cambridge Associates’ Capital Market Assumptions projected over 60 years using a Latin Hypercube model with 5,000 iterations. We modeled the same participant profile, isolating the change in investment design using 10% of total assets in PE and credit compared to public equities and bonds. For purposes of this analysis, we used a sample 35-year-old participant contributing 11% to 19% to their retirement account, 1.3% to 4.3% real salary increases, and withdrawing 70% of their pre-retirement income at age 65, while offsetting for social security. This analysis compares the assets at retirement and how long those assets last in retirement under the two investment designs.
8. The Moving Ahead for Progress in the 21st Century Act of 2012, or MAP21, represents the first funding relief since the Pension Protection Act (PPA) of 2008.
9. The America Rescue Plan Act (ARPA) funding relief of 2021 significantly reduces funding requirements by introducing a floor on the interest rates used for discounting liabilities, and a longer amortization period (from seven years to 15 years).
10. The Funding Target methodology is used to determine the plan’s minimum required contributions under ERISA and the Pension Protection Act of 2006 (PPA).
11. See Dan Doonan and William B. Forina, “A Better Bang for the Buck 3.0,” National Institute on Retirement Security, January 2022.
12. This may include church plans and other plans defined by IRC 414(e), but applicability depends on specific state provisions.
13. For this paper, ILS refers to “non-life” ILS instruments and excludes “life” ILS instruments, such as life policy settlements securitization, extreme mortality securitization, and longevity swaps.
14. Reinsurance is the insurance that an insurance company purchases to insulate itself from the risk of a major claims event.
15. The Eurekahedge ILS Advisers Index is an equally weighted index of 26 constituent funds designed to provide a broad measure of the track record of managers explicitly allocating to ILS and having at least 70% of their portfolio invested in non-life risk.
16. The Swiss Re CAT Bond Index itself is not investable. Anecdotally, ILS investors seeking a total return swap arrangement with Swiss Re (the benchmark’s issuer) on the Swiss Re CAT Bond Index would face a cost of ca. 300 basis points (bps) per annum, in exchange of the return of the index. This effectively represents the charge for an investor wishing to replicate the return and volatility of the widely quoted Swiss Re benchmark.
17. All data in USD as of May 31, 2023.
18. NOAA Severe Weather Data Inventory (SWDI), 2023.

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Potential Benefits and Challenges

Private credit providers are able to charge a yield premium to businesses that need capital and have become increasingly important as market conditions have grown more volatile, uncertain, and perhaps recessionary. In many cases, strong relationships between firms, sponsors, and lenders can result in a quicker investment decision-making process that is less dependent on the vagaries of bank credit cycles.

Stronger relationships can also result from private credit transactions using fewer parties, which can help enhance stability and longer term planning for borrowers. While private credit strategies vary in their approach, they usually attempt to control capital structures, which enable them to manage restructurings and achieve good recoveries. As a result, private credit also has the potential to provide diversification benefits to pension plan portfolios in times of market volatility, in addition to steady income and less-correlated returns.

There are also some challenges associated with private credit investments. The risk premium associated with private credit can make it an expensive source of capital for the borrower, placing additional stress on the company’s cash flows—especially in a higher interest rate environment. Another major risk is lack of liquidity. Private credit investments are not publicly traded and, with a nascent secondaries market, they can be difficult and expensive to sell on short notice.

Private Credit Investment Strategies

Private credit strategies can generally be bucketed into direct lending, credit opportunities, capital solutions, special situations, distressed debt, and specialty finance (Figure 1). Risk and return vary across this universe. Strategies such as direct lending focus on lower, more predictable returns with minimal expected capital loss, while more complex strategies—such as special situations and distressed—focus on higher returns through capital appreciation. Strategies that don’t solely focus on capital preservation or return maximization include specialty finance strategies like healthcare royalties or re-discount lending.

Private credit funds lend capital to corporations against physical assets and/or cash flows within a private “lock-up” fund partnership structure. The yields tend to be higher than for public credit, as pricing also includes a premium for its smaller size and illiquidity. In difficult financing environments, private capital providers that have accumulated significant dry powder can become important liquidity providers. Consequently, the demand for both their capital and expertise has the potential to generate strong performance.

Direct Lending

Direct lenders, or senior debt funds, typically lend to corporations to finance their buyouts and organic or inorganic acquisition activity. These companies are most often owned by financial sponsors (usually private equity [PE] managers) but can also be held by individual owners. Direct lenders generate yield from current cash-pay coupons composed of a fixed credit spread and a floating reference rate such as the Euro Interbank Offer Rate (Euribor) and Secured Overnight Financing Rate (SOFR), ¹⁹ and up-front fees or other fees such as repayment penalties. As “senior debt” implies, these funds invest in the first lien, at the top of the capital structure, and are secured by the borrower’s assets.

In the event of default, these lenders typically have first claim over the shares of a company or its assets to recover the principal. While direct lending offers lower relative returns within private credit, it can provide a consistent income stream and strong downside protection through high recovery values. Senior debt funds can be levered or unlevered at the fund level, and investors should focus on the overall amount of leverage, as well as the risks associated with using leverage lines to boost returns. Based on the current pricing environment, expected unlevered net returns is around 8%–10%, which is higher than the historical 6%–8% net return, while levered net returns may reach 13%–15%, higher than the 10%–12% achieved previously. The typical fund life is six to eight years.

Credit Opportunities

Credit opportunity strategies seek to deploy capital opportunistically, wherever the manager sees attractive relative value in the public or private credit universe. Credit opportunity managers adopt a flexible mandate. These strategies can be considered “all weather,” as they include financing bolt-on acquisitions, additional capex, and providing rescue financings, which help performing borrowers stave off liquidity crises and particularly thrive in times of market dislocation. Credit opportunity funds typically deal with performing companies and are able to deliver a consistent income stream, although a portion of the returns are often back ended with an equity component. Target gross internal rates of return are typically in the mid-teens, and vehicles tend to be locked up for six or more years.

Capital Solutions

Capital solution strategies target companies facing complex financial situations and provide them structured solutions to meet their capital needs. They invest across the capital structure and look for returns in the mid-to-high teens range. Most companies seeking capital solutions face a medium-term cash flow crunch and returns tend to be more back ended and upside linked.

Special Situations/Distressed Debt

Special situation strategies target companies that are under financial stress, while distressed debt managers typically target companies that are restructuring. Both of these strategies invest in debt of companies at deeply discounted valuations. The use of these debt positions varies across managers, but they have the same objective of generating outsized returns from debt and equity-linked structures. Return targets are north of 15% and can be PE-like, mostly back ended, and generated by combining a contractual yield component with equity-like upside. Liquidity can vary, as some managers pursue very similar distressed strategies through liquid hedge funds as well as lock-up vehicles.

Specialty Finance

Specialty finance is a catch-all category for a wide range of private credit managers pursuing niche strategies outside of the aforementioned types. Traditionally, this category mostly contained non-performing loans managers, but has expanded to include healthcare and music royalties, re-discount lenders, ²⁰  litigation finance, and funds specializing in life settlements. It can also include trade finance or other receivables- based lending strategies. The highly specialized nature of these strategies makes it more difficult for limited partners to analyze them, as a deeper level of expertise is required to differentiate between managers. The way in which the risk is determined via underwriting collateral, yield, and enterprise value is unique across each strategy.

Target gross returns for this fund type tend to begin in the mid-single digits and can range into the mid-teens, where returns are typically contractual, but with some niches offering upside potential such as a music royalties fund selling a catalogue at a premium.

Portfolio Implementation: Things to Consider

For pensions, a strategic allocation to private credit can broaden the portfolio’s diversifying strategies and provide for attractive yields (Figure 2). Historically, many pensions have used hedge funds and PE strategies as their main sources of diversification and premium returns, respectively. Direct lending and credit opportunity strategies in particular may provide a good fit for pensions looking to generate income and improve their risk-adjusted return profile. Realizations are less dependent on equity market conditions and distributions are somewhat more predictable as they are linked to loan maturity dates. Direct lending strategies may deliver higher returns than historical average in the near term due to increases in base rates and spreads. While very few direct lenders have officially increased their net target returns as of May 2023, most expect at least a 2% increase from the usual 6%–8% net target return.

Opportunistic strategies may also be attractive to plan sponsors as they provide a chance to source and invest in attractive financing deals arising from the weakness in public markets and the banking sector. Because credit markets are constantly evolving, the best approach to private credit strategies is one that aligns with funded status and investment goals.

Well-Funded Plans

Reasonably well-funded pensions can consider senior direct lending strategies, which offer risk-controlled return enhancement with a high degree of predictability and strong cash flow characteristics. These conservative, capital preservation–oriented strategies are almost always floating rate and provide a natural hedge against interest rates, as opposed to liquid fixed income, which is typically fixed rate and can result in volatile mark to market. Senior direct lending coupons are structured with a floating base rate plus a spread. In challenging macro environments, as traditional capital becomes scarce, private credit capital can charge higher fees and spreads, thus making private credit pricing very attractive (Figure 3). With respect to existing investments, a well-constructed and diversified portfolio of direct lending investments provides more protection from deterioration in corporate profitability during such periods than equity or subordinated debt–oriented strategies due to their seniority in the capital structure. One trade-off is relative illiquidity versus liquid fixed income. However, senior direct lending strategies typically distribute cash flow on a regular basis quickly and have a shorter fund life (6 to 8 years) relative to other private credit strategies. Well-funded pensions that are not looking to substantially insure their liabilities in the near term can take advantage of their long time horizon for investments through direct lending without exposing themselves and their sponsors’ balance sheets to volatility.

Underfunded Plans

For underfunded pensions that need to generate high returns, return-maximizing strategies—especially credit opportunities—offer a complement to PE strategies. In particular, these credit opportunities offer a way to reduce volatility in plan funding ratios (which can be detrimental for sponsor balance sheets) without sacrificing long-term returns. In uncertain markets, they can offer similar returns to PE with more downside protection, given seniority in the capital structure over equity. Credit opportunity strategies provide capital to performing companies, which can translate to lower default risks. The returns are derived from a combination of contractual coupons and equity-linked upside, which can provide some cash flow distribution. The “all weather” nature of the strategy allows it to remain a consistent part of a pension portfolio across all market environments.

Portfolio Construction and Active Management of the Allocation Is Key

The implementation of private credit strategies in pension portfolios, especially in the context of an uncertain and inflationary environment and bank sector retrenchment, is not a one-size-fits-all model. While private credit strategies can deliver growth and diversification, portfolio construction needs to be thoughtful. Robust private credit portfolios require diversification across several dimensions, including vintages, types of credit strategies, geographies, and sectors. The rich range of private credit strategies available allows for portfolio customization to particular return, risk, and liquidity objectives. While the faster rate of distributions through coupons and loan maturities is an attractive feature of private credit, it also requires an active approach to reinvestment of the cash flow received to maintain exposure, akin to other fixed income asset classes. This reinvestment process also provides a lever with which to tweak portfolio structure over time to accommodate changes in plan member profiles, or to take advantage of dislocations in the market.

Vijay Padmanabhan, Managing Director, Pension Practice

Melanie Mandonas, Managing Director, Pension Practice

Footnotes

1. The term “short rebate” refers to the interest income earned by investors that lend out securities for short selling.
2. This is a summary of broad private equity and does not detail any other private asset classes that have a shorter or longer investment horizon. Those separate private assets have a similar contribution/distribution profile.
3. For the sample simulation, a 60/40 portfolio consisting of asset class targets 25% equities; 10% hedge funds; 40% long government/credit; 10% private equity; 10% private credit; and 5% real estate. The PI portfolio is assumed to be mature and returning 25%–30% of capital committed, while continuing commitments to target the 25% target weight.
4. A Monte Carlo simulation model seeks to predict the probability of a variety of outcomes when the potential for random variables is present.
5. It is assumed that commitments decrease by ~2.7% of total assets and that the capital is drawn over six years and returned by year 13 with a total DPI of 2.6x.
6. This compares the decrease in publicly listed companies from 1996 to 2019 against the increase in unrealized and partially realized institutional private investments from 1996 to 2020.
7. This is based upon Cambridge Associates’ Capital Market Assumptions projected over 60 years using a Latin Hypercube model with 5,000 iterations. We modeled the same participant profile, isolating the change in investment design using 10% of total assets in PE and credit compared to public equities and bonds. For purposes of this analysis, we used a sample 35-year-old participant contributing 11% to 19% to their retirement account, 1.3% to 4.3% real salary increases, and withdrawing 70% of their pre-retirement income at age 65, while offsetting for social security. This analysis compares the assets at retirement and how long those assets last in retirement under the two investment designs.
8. The Moving Ahead for Progress in the 21st Century Act of 2012, or MAP21, represents the first funding relief since the Pension Protection Act (PPA) of 2008.
9. The America Rescue Plan Act (ARPA) funding relief of 2021 significantly reduces funding requirements by introducing a floor on the interest rates used for discounting liabilities, and a longer amortization period (from seven years to 15 years).
10. The Funding Target methodology is used to determine the plan’s minimum required contributions under ERISA and the Pension Protection Act of 2006 (PPA).
11. See Dan Doonan and William B. Forina, “A Better Bang for the Buck 3.0,” National Institute on Retirement Security, January 2022.
12. This may include church plans and other plans defined by IRC 414(e), but applicability depends on specific state provisions.
13. For this paper, ILS refers to “non-life” ILS instruments and excludes “life” ILS instruments, such as life policy settlements securitization, extreme mortality securitization, and longevity swaps.
14. Reinsurance is the insurance that an insurance company purchases to insulate itself from the risk of a major claims event.
15. The Eurekahedge ILS Advisers Index is an equally weighted index of 26 constituent funds designed to provide a broad measure of the track record of managers explicitly allocating to ILS and having at least 70% of their portfolio invested in non-life risk.
16. The Swiss Re CAT Bond Index itself is not investable. Anecdotally, ILS investors seeking a total return swap arrangement with Swiss Re (the benchmark’s issuer) on the Swiss Re CAT Bond Index would face a cost of ca. 300 basis points (bps) per annum, in exchange of the return of the index. This effectively represents the charge for an investor wishing to replicate the return and volatility of the widely quoted Swiss Re benchmark.
17. All data in USD as of May 31, 2023.
18. NOAA Severe Weather Data Inventory (SWDI), 2023.
19. Euribor, published by the European Money Markets Institute, represents the price at which European banks lend each other money. SOFR is a benchmark interest rate for dollar-denominated derivatives and loans that have been established as an alternative to the London Interbank Offered Rate (LIBOR). SOFR is based on observable transactions in the Treasury repurchase market.
20. Re-discount lenders refer to funds that finance non-bank lending entities.

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Defining Private Direct Lending Funds and Public BDCs

Private DL funds invest in privately negotiated senior-to-subordinated debt issued by small and mid-sized companies. They offer attractive yields relative to traditional fixed income investments as well as lower volatility, especially for strategies focused on senior-secured debt. These funds typically have a five- to eight-year investment horizon, with a focus on generating stable income over time. Similar to DL funds, BDCs primarily invest in privately negotiated debt of small and mid-sized companies. They can also invest in distressed companies looking to restore their financial health. Unlike private DL funds, BDCs are public, closed-end investment vehicles that can be traded daily on an exchange.

Tracking the Juxtapositions

Public BDCs and private DL strategies differ in important ways, including liquidity and leverage, volatility, fees, underlying exposure, and loan origination opportunity. Plan sponsors should consider these differences carefully as they make determinations about their private debt exposure. Figure 1 depicts an example of a public BDC and a private DL fund offered by the same manager and how they differ across key characteristics.

Liquidity and Leverage

Private DL funds are structured as lock-up vehicles, with limited liquidity and redemption provisions for investors. However, the DL market has recently created more evergreen fund structures, which use a two- to three-year lock-up as the fund is invested, followed by the option to reinvest principal or have the position pay down over time as loans repay.

BDCs offer daily liquidity, which allows sophisticated investors to take a more short-term, opportunistic investment approach to these strategies. For example, BDC investors can trade in and out of funds as pricing fluctuates in response to economic conditions, fund-specific performance expectations, and market sentiment. A potential downside to this greater liquidity is the added risk of spikes in selling activity during heightened periods of market stress. This can create forced selling situations and a cycle of downward pressure on fund price and net asset value (NAV), especially if the BDC employs leverage in an effort to amplify returns. Public BDCs can be levered 2:1, with most hovering around 1.2x to 1.25x. This is an additional layer of risk that investors need to be comfortable with.

Volatility

As shown in Figure 2, the realized volatility of BDCs is significantly higher than DL funds. Because they adjust their valuation marks on a quarterly basis—as opposed to daily pricing—the volatility of DL funds tends to be quite low. By contrast, the fact that BDCs are priced daily and can be traded opportunistically could result in greater volatility.

An additional factor that contributes to BDC volatility is the profile of the investor base. As a public, exchange-traded product, BDCs are predominantly owned by retail investors, which, in periods like March 2020, can result in sharp drawdowns in price from retail sentiment that is detached from the NAV of the underlying loans.

Fees

As a publicly traded, marketable alternative investment strategy, BDCs have historically mirrored hedge fund pricing, charging a 2% management fee and 20% incentive fee. While this has moderated over time, public BDCs are still priced at a premium, particularly when compared to private DL. In addition to the higher base fee, public BDCs have administrative expenses as ’40 Act funds that can push total expense ratios up more than 2% in some cases. ²¹ The relative stability and size of private DL limited partners reduce administrative costs for managers, which put downward pressure on base fees. On top of this, private DL funds typically have a lower incentive fee versus public BDCs.

Underlying Exposures

Private DL funds typically provide “pure play” exposure, offering investors privately negotiated senior debt issued by small and mid-sized companies, often underwritten to fairly consistent parameters and senior in the capital stack. BDCs, on the other hand, provide more varied exposure, with investments in both debt and equity securities. Even on the debt front, BDCs will often provide for a range of investments from senior to subordinated in the capital structure. BDCs are required to invest 70% of the portfolio into qualified assets with the remainder—up to 30%—in “non-qualifying” assets, which often take the form of subordinated debt, preferred equity, and/or common equity. As a result, the risk profile of the BDC portfolio is typically higher than that of a DL fund, with more exposure to junior capital as well as equity securities.

Newly Originated Loans Versus Existing Portfolio

When an investor commits to a new DL fund, the exposure to newly originated loans is built over time. On the other hand, when investing in a traded BDC, the investor is buying into an existing portfolio of loans and securities that were originated over the prior several years. While buying into an existing portfolio can mitigate the J-curve effect and reduce blind pool risk, the investor needs to be mindful of the credit quality of the underlying portfolio. ²² This distinction is more pronounced than ever, given recent increases in interest rates as well as improved loan structures and wider loan spreads on new originations, making the current entry point particularly attractive. Buying into a portfolio of loans that originated over the last several years—a time with more borrower-friendly terms and underwriting with significantly lower interest rates—could result in higher impairment ratios, which may explain why the pricing of the BDC is below NAV. Fundamentally, investors in BDCs need to understand the credit risk of the book of loans they are buying into when investing to avoid the potential for unexpected credit losses.

Finding the Right Fit

The current market environment—characterized by high interest rates and tight lending conditions—may be tailormade for private credit. Investors considering private debt strategies should evaluate the risk/return profile of the fund investment and whether it is going into a private credit program or an opportunistic, trading-oriented allocation. Direct lending may be a fit for plan sponsors looking for a steady, foundational investment to add to their longer-term designated private credit allocation. Those looking for a liquid, income-generating, opportunistic trading opportunity may want to consider BDCs. While both strategies can deliver benefits, pension plan sponsors should evaluate their risk tolerance, liquidity needs, and fit with their strategic asset allocation to determine the best approach for their portfolio.

Ian Monteith, Senior Investment Director, Pension Practice

Sheila Ryan, Managing Director, Pension Practice

Footnotes

1. The term “short rebate” refers to the interest income earned by investors that lend out securities for short selling.
2. This is a summary of broad private equity and does not detail any other private asset classes that have a shorter or longer investment horizon. Those separate private assets have a similar contribution/distribution profile.
3. For the sample simulation, a 60/40 portfolio consisting of asset class targets 25% equities; 10% hedge funds; 40% long government/credit; 10% private equity; 10% private credit; and 5% real estate. The PI portfolio is assumed to be mature and returning 25%–30% of capital committed, while continuing commitments to target the 25% target weight.
4. A Monte Carlo simulation model seeks to predict the probability of a variety of outcomes when the potential for random variables is present.
5. It is assumed that commitments decrease by ~2.7% of total assets and that the capital is drawn over six years and returned by year 13 with a total DPI of 2.6x.
6. This compares the decrease in publicly listed companies from 1996 to 2019 against the increase in unrealized and partially realized institutional private investments from 1996 to 2020.
7. This is based upon Cambridge Associates’ Capital Market Assumptions projected over 60 years using a Latin Hypercube model with 5,000 iterations. We modeled the same participant profile, isolating the change in investment design using 10% of total assets in PE and credit compared to public equities and bonds. For purposes of this analysis, we used a sample 35-year-old participant contributing 11% to 19% to their retirement account, 1.3% to 4.3% real salary increases, and withdrawing 70% of their pre-retirement income at age 65, while offsetting for social security. This analysis compares the assets at retirement and how long those assets last in retirement under the two investment designs.
8. The Moving Ahead for Progress in the 21st Century Act of 2012, or MAP21, represents the first funding relief since the Pension Protection Act (PPA) of 2008.
9. The America Rescue Plan Act (ARPA) funding relief of 2021 significantly reduces funding requirements by introducing a floor on the interest rates used for discounting liabilities, and a longer amortization period (from seven years to 15 years).
10. The Funding Target methodology is used to determine the plan’s minimum required contributions under ERISA and the Pension Protection Act of 2006 (PPA).
11. See Dan Doonan and William B. Forina, “A Better Bang for the Buck 3.0,” National Institute on Retirement Security, January 2022.
12. This may include church plans and other plans defined by IRC 414(e), but applicability depends on specific state provisions.
13. For this paper, ILS refers to “non-life” ILS instruments and excludes “life” ILS instruments, such as life policy settlements securitization, extreme mortality securitization, and longevity swaps.
14. Reinsurance is the insurance that an insurance company purchases to insulate itself from the risk of a major claims event.
15. The Eurekahedge ILS Advisers Index is an equally weighted index of 26 constituent funds designed to provide a broad measure of the track record of managers explicitly allocating to ILS and having at least 70% of their portfolio invested in non-life risk.
16. The Swiss Re CAT Bond Index itself is not investable. Anecdotally, ILS investors seeking a total return swap arrangement with Swiss Re (the benchmark’s issuer) on the Swiss Re CAT Bond Index would face a cost of ca. 300 basis points (bps) per annum, in exchange of the return of the index. This effectively represents the charge for an investor wishing to replicate the return and volatility of the widely quoted Swiss Re benchmark.
17. All data in USD as of May 31, 2023.
18. NOAA Severe Weather Data Inventory (SWDI), 2023.
19. Euribor, published by the European Money Markets Institute, represents the price at which European banks lend each other money. SOFR is a benchmark interest rate for dollar-denominated derivatives and loans that have been established as an alternative to the London Interbank Offered Rate (LIBOR). SOFR is based on observable transactions in the Treasury repurchase market.
20. Re-discount lenders refer to funds that finance non-bank lending entities.
21. A ’40 Act fund is a pooled investment vehicle offered by a registered investment company, as defined by the Investment Company Act of 1940.
22. A J-curve is an early period characterized by negative returns and cash flows, as investments are initially made and develop over time before they are in a position to be sold. “Blind pool risk” refers to when a limited partnership raises funds from investors without disclosing where the money will be invested.

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