Big investors grow nervous about private credit boom

Pension funds and other big investors are reducing the amount they allocate to private credit as they become increasingly concerned about the risks that high interest rates pose to the $1.7tn sector.

US-based private credit funds raised $123.1bn from investors last year, according to data group Preqin, based on fundraisings that were completed, down from $150.8bn in 2022. In the first two months of 2024 funds raised a combined $11.7bn, compared with $30.4bn in the same period last year.

It is also taking longer for funds to reach their fundraising targets, with Preqin data showing the average time to close to new investors jumped to 39 months in the first two months of this year, from 25 months a year earlier.

The tougher fundraising environment comes as seven public pension funds said in recent interviews and board meetings that they or their peers are making smaller commitments to private credit or spending more time searching for managers to invest with, despite the sector’s record of high single-digit or even double-digit returns and low defaults.

Some big private credit managers should be “worried” about the high interest rate environment, said Jess Larsen, chief executive of Briarcliffe Credit Partners, a fundraising consultancy. “One thing for certain is . . . we will see more defaults.”

The private credit sector stepped in to the gap left by banks after post-financial crisis regulations forced them to scale back lending to small businesses. When interest rates were at ultra-low levels, billions of dollars flowed in to such funds from investors hungry for yield.

But with rates having risen steeply over the past two years, investors are growing nervous that more companies could struggle to meet debt interest payments, particularly as economic growth cools.

“Widespread defaults have not yet occurred,” said the $105bn Ohio Public Employees Retirement System in a board meeting agenda last month, “however, indications point towards trouble ahead”.

Opers, which only recently started investing in private credit, added it planned to write “smaller cheques in this environment”. Growing interest expenses and “potentially depressed” corporate earnings could undermine borrowers’ ability to pay off their debts, it said.

Pension funds are the biggest group of investors in the high-yield private credit market, driven by a desire to diversify away from government bonds, which have been hit in recent years by the prospect of higher borrowing costs, and public equities.

Greg Samorajski, chief executive of the $40bn Iowa Public Employee Retirement System, said Ipers decided in 2020 to raise its allocation to private credit from 3 per cent to 8 per cent of assets, while reducing its fixed income exposure from 28 per cent to 20 per cent.

The move came after the US Federal Reserve cut borrowing costs to near-zero during the early stages of the coronavirus pandemic, which Samorajski said made it difficult for the scheme to hit its 7 per cent annual return target.

The calculus became more complicated in 2022 as the Fed began to aggressively raise rates to fight soaring inflation. Most private credit loans come with floating interest rates that are tied to benchmark rates. That offers protection against inflation, unlike fixed income securities.

However, higher borrowing costs have also weighed on private equity dealmaking. This has reduced the number of opportunities for private credit funds to lend to companies with a private equity sponsor.

As a result, average interest coverage — the ratio of earnings to interest expenses — for private credit loans dropped to 2 per cent in the third quarter of last year from 3.1 per cent in the second quarter of 2022, “indicating weakening debt service capacity”, according to the Fed’s research.

Pension funds are now taking a more cautious approach to private credit.

“It’s fair to say the number of [company] names on the watch list of all the [private credit] managers have increased,” said Samorajski of Ipers, adding that he was waiting for investments to happen “little by little”.

Fundraising for private credit has become “less rushed” because of the “more challenging” market conditions, said a spokesperson for the $50bn Connecticut Retirement Plans and Trust Funds. Its allocation to the sector was 4.4 per cent as of January, well below the long-term target of 10 per cent.

While the Fed is expected to start cutting rates in June or July this year, pension funds are divided on what this means for the outlook for these funds.

Samorajski said easing monetary policy could benefit private credit as borrowers are less likely to miss debt interest payments. “We view it as a positive sign if rates come down somewhat for the private market, because while we earn a little bit less, the default risk is probably lower,” he said.

But Chris Ailman, the departing chief investment officer of the $327bn California State Teachers Retirement System, believes higher rates are attractive for investors in private credit, because of the higher income, and expects a slowdown in private credit fundraising if rates are cut.

“If you have the view that [the Fed] is going to lower rates back down, you are not going to rush into it as much — actually you are more interested in fixed rate income,” he said.

Despite the concerns, some pension plans continue to bet heavily on private credit.

Steven Meier, chief investment officer of the $264bn New York City Employees Retirement Systems, said his fund was expanding into private credit when “everyone else has pulled back”.

Meier said the double-digit returns offered by private credit made it a “cheap asset”, despite the “dislocations” arising from a slump in mergers and acquisitions activity.

“It’s the right time to be putting more money to work,” he said. Nycers was considering accelerating its investments so that it met its latest private credit allocation target, which it set in 2023, in three years instead of the initially planned five, he added.