Despite the regulatory burden being lessened in recent months, the appeal of private debt to defined contribution (DC) master trusts in the UK is still limited. In the US, the model is far more established, leaving unanswered questions as to why the UK has not adopted a similar approach.
Pension professionals may also ask why there is such a wide spread of approaches from UK master trusts in their approach to tackling this increasingly popular asset class. Lessons can be learnt from those who have taken the plunge.
US debt deficit
On the western side of the Atlantic, a shift towards private markets has been a consistent undercurrent for the past couple of decades. At the same time, the number of publicly traded companies has declined, resulting in more organisations requiring debt financing to fund growth. Yet simultaneously, shrinking bank balance sheets, in response to regulation brought in following the financial crisis, has pushed institutional investors to the fore of debt opportunities.
The momentum in the US, garnered on the back of the financial crisis, has not dissipated. Data provider Preqin estimates that the total private debt market grew from $575 billion (£419 billion) in 2016 to $848 billion (£619 billion) by the end of 2020. Moreover, the private debt market is expected to continue increasing in the US. An 11.4 per cent annual increase will raise the market value to $1.46 trillion (£1.07 trillion) at the end of 2025, estimates suggest.
This shift, and the high exposure to private equity in Australian superannuation funds and in defined benefit schemes worldwide caught the attention of the DC pensions sector. In 2020, the Pensions Management Institute identified private markets as a key area of expansion for master trusts, yet barriers to greater adoption are stifling opportunities within the space.
UK stifling strategy
The UK master trusts uptake of private debt strategies has, so far, been tentative. Currently, the outliers in the UK market are Nest and Smart Pension. Nest has initiated a private credit strategy in 2019, utilising BlackRock’s global infrastructure debt fund and Amundi for global real estate debt, alongside the scale necessary to negotiate fees down to make it affordable under the charge cap.
Smart Pension has been working with Natixis Investment Managers to incorporate private markets illiquids into the Smart Pension default fund.
While the illiquid approach is not without its obvious merits, difficulty in integrating the strategy is enough to deter some managers.
“Private debt offers institutional clients excess returns, lower defaults and higher recovery rates, relative to equivalently-rated public assets,” says Phil Dawes, head of sales for UK & Ireland at BNP Paribas Asset Management. In October 2019, the European asset manager offered a diversified private credit fund with Nest.
In turn, the approach can offer managers lower volatility alongside diversification benefits. Given the extensive period before members crystallise their benefits, being able to access the illiquidity premium from private debt can be worthwhile, says Kinna Patel, DC investment consultant at Hymans Robertson, as the approach is less sensitive to external market factors.
“Investing in private debt alongside more traditional asset classes, such as equities and bonds, could increase diversification and provide increased expected risk-adjusted returns. This in in turn could lead to better member outcomes,” she says.
Moreover, for DC funds in the accumulation phase that are seeking equity-like returns, private credit can enhance the overall Sharpe ratio – which describes the risk-adjusted return of an investment – of the default offering.
But the shortage of master trusts that are offering the strategy indicates that it is not in vogue amongst scheme managers.
Adrian Boulding, director of policy at Now: Pensions, says that while none of the scheme members’ assets are currently held in private debt, the organisation’s investment strategy “does permit the inclusion of less liquid investments,” adding that it is keeping an eye on future issuances. Currently, the master trust holds public debt as part of its sustainable bonds mandate. Likewise, People’s Pension is not actively considering the approach.
Barriers to entry
Phil Parkinson, head of DC, UK at Mercer, suggests that the competitive nature of the master trust market is blocking other trusts from making a commitment to private debt opportunities. He fears that increasing costs to introduce illiquid assets will “affect the competitiveness of a proposition,” and that the competitiveness of the market, on the back of the consolidation trend, has resulted in extremely tight margins and little room for costly experimentation.
Dawes echoes this point, adding that the assumption that much of the UK market sticks to is that low costs represent the best value for money for clients, leading to a “wholesale shift to passive default building blocks,” resulting in aggregate fees of approximately 10-15bps.
“Historically, private credit management fees have been high and are inconsistent with this overall downward drive,” he says. “Even where asset managers have demonstrated innovation and lowered fees, it remains difficult for master trusts, who are tendering for new business, to make meaningful allocations to private markets as it raises the cost of the default by 1-2bps, which can impact their ability to win new business relative to their peers.”
Dawes adds the focus on “low costs” can act as a burden on scheme members as it prevents innovation. “A focus on value for money would be more helpful here,” he says.
Daily dealing dilemma
Patel says that many managers struggle to incorporate private debt approaches into DC investment platforms due to strict liquidity and daily dealing requirements. Currently, unit pricing must be quoted on a daily basis and serve both redemptions and purchases.
“The common way to get around these strict requirements is to dilute the illiquid nature of the assets by investing alongside more liquid assets in listed vehicles,” such as liquid credit, listed property, listed infrastructure and listed private equity.
“Although diluting the illiquidity also dilutes the diversification benefit and the expected return, it does provide a relatively low governance solution for DC schemes to access illiquid assets,” says Patel.
Alongside this, there are a wealth of technical considerations that master trusts and fund managers must take into consideration, adds Dawes, which act as a burden on those wishing to integrate the asset into their DC allocations.
“HM Treasury, the FCA and The Investment Association are examining these areas, proposing to make enhancements to the UK funds regime in order to facilitate greater involvement from UK DC schemes in private markets.
“Asset managers in turn have responded with product innovations with enhanced liquidity features, making them more aligned with DC scheme requirements and offering access to diversified private credit portfolios,” he says.
But for master trusts that decide to incorporate a private debt strategy, there are areas where attractive yields can be gained.
One market identified by Patel is direct lending, where there is scope to “access attractive yields through bespoke loan terms and benefit from seniority in the capital structure”.
Patel adds that the lack of secondary markets for these loans means that “investors can be expected to be rewarded for locking up their capital for longer time periods,” and can expect to be rewarded by between 100-200 bps per annum relative to more liquid loans.
Likewise, Dawes says that some clients have replaced listed corporate credit with private debt, making allocations to “senior private credit assets such as infrastructure or real estate debt, with expected spreads of 200-260bps over Euribor”.
All of this raises the question of whether more master trusts will embrace the private debt approach in the future. If the predictions from the Pensions Management Institute are to be fulfilled, then the obvious barriers around costs, feasibility and the impact on the competitive market need to be addressed.