Pension Investments in Private Credit Hit Eight-Year High

The $300 billion California State Teachers’ Retirement System is the latest to show interest in increasing private-credit investment and giving the asset class a permanent place in its portfolio. The Calstrs board Thursday directed staff to include private credit in proposals for the pension’s new asset allocation, which board members will vote on later this year.

“We all think it’s going to be around for a long time,” said Calstrs investment chief

Christopher Ailman.

The $90 billion Ohio Public Employees Retirement System added a 1% allocation to private credit in January, following in the footsteps of the $450 billion California Public Employees’ Retirement System and the $230 billion New York State Common Retirement Fund, which are building out private-credit portfolios of 5% and 4%, respectively. In Canada, some pension funds took advantage of early-Covid market dislocation to expand their already-robust private-debt portfolios. 

The ramp-up is part of a decadeslong pivot by pension funds to private-market assets and other alternatives to stocks and bonds in search of investment returns of 6% or more. U.S. state and local retirement funds are hundreds of billions of dollars short of what they need to cover benefits and market losses in 2022 largely obliterated the funds’ record 2021 gains. Pensions rely on taxpayer funds or worker contributions when investment returns fall short. 

When investing in private credit, a pension fund typically gives money to a manager who also collects money from other institutional investors. U.S. pension funds often turn to the same big managers handling their other private-market assets, including

Ares Management Corp.

,

Blackstone Inc.

and Oaktree Capital Management LP. 

The manager pools the money in a fund that makes loans—typically unrated, subprime loans—to companies or other enterprises for a period of around five to seven years. Often the loans go to private-equity-held firms in areas such as software or healthcare, to pay for an overhaul or restructuring ahead of an eventual sale. But the debt can finance anything from airline leases to credit for online shoppers.

A slowdown in bank lending in 2022 made room for the growth of private-market debt. Investors lent out an estimated $200 billion in private credit last year, up from $156 billion in 2021, according to data from PitchBook LCD, which began tracking those figures last year because the increase was so stark. Meanwhile, institutional leveraged-loan issuance fell by 63% and high-yield bond issuance by 78% from 2021 to 2022, the firm found.

“A year ago it was competitive. Now, though, banks aren’t lending and public markets are shut,” said

Craig Packer,

co-founder of

Blue Owl Capital,

a private-market asset manager, in remarks to investors last month. 

There is more than $1 trillion in total private debt outstanding, according to Preqin. The asset class has taken off over the past decade after rules stemming from the 2007-09 financial crisis made banks more reluctant to issue and hold loans to middle-market companies. 

Retirement officials said private credit is appealing because interest payments adjust to match prevailing rates and give cash-hungry pension funds a steady income stream. Managers and consultants said the rising rate environment creates opportunity because companies struggling to cover interest costs may be willing to take out relatively expensive private loans to keep cash flowing. And, they said, if a private loan is at risk of default, a small group of lenders can intervene earlier and negotiate more easily than is possible in public markets.

A lot depends on how the loans are selected and managed, however. Investment consultant NEPC said in a presentation to the Ohio workers fund last year that many private-credit managers have had trouble liquidating funds by the promised maturity date. Also, a private loan portfolio that isn’t sufficiently diversified or that uses too much leverage can put investors at risk, since one default can potentially wipe out a year’s worth of interest, said Steve Nesbitt, chief executive of Cliffwater LLC, an alternative-asset manager and adviser. 

The default rate on private debt rose to 1.56% in the third quarter of 2022, the first significant bump in 18 months, according to the Proskauer Private Credit Default Index, compiled by law firm Proskauer Rose LLP to track private loans issued mainly to private-equity-backed businesses.

Other private-market assets have already run into trouble. Breit, Blackstone’s nontraded real-estate investment trust aimed at individual investors, limited how much investors could withdraw in December, causing a dip in Blackstone stock.

For the 15 years ended Sept. 30, a period including the 2007-09 financial crisis, private debt outperformed high-yield corporate bonds, which had an annualized return of 5.7%, according to Bloomberg index data. Cliffwater’s direct lending index returned an annualized 8.84% and funds tracked by the data analytics firm Burgiss that don’t include distressed debt returned 7.54%. 

But the small scope of private credit in the late 2000s means it is hard to draw conclusions about how the asset class would perform in another crash. 

“It’s a little bit more of a nascent asset class and so we try to stress caution there,” said Oliver Fadly, head of private debt at NEPC. “It’s not fully tested.”

Write to Heather Gillers at heather.gillers@wsj.com