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Public Pensions: Double-Check Those ‘Shadow Banker’ Investments

Private credit has gained a growing share of pension portfolios over the past decade. It’s time to take a second look under the hood.

Bank building
For almost a decade leading up to 2021, bond yields were suppressed by low inflation and central bank stimulus. To make up for scanty interest rates on their bond investments, many public pension funds followed the lead of their consultants and shifted some of their portfolios into private credit funds. These “shadow bankers” have taken market share from traditional lenders, seeking higher interest rates by lending to non-prime borrowers.

Even during the pandemic, this strategy worked pretty well, but now skeptics are warning that a tipping point may be coming if double-digit borrowing costs trigger defaults. It’s time for pension trustees and staff to double-check what’s under the hood.

For the most part, the worst that many will find is some headline risk with private lending funds that underwrite the riskiest loans in this industry. Even for the weakest of those, however, the problem will not likely be as severe as the underwater mortgages that got sliced, diced and rolled up into worthless paper going into the global financial crisis of 2008. And until and unless the economy actually enters a full-blown recession, many of the underwater players will still have time to work out their positions.

The point here is not to sound a false alarm or besmirch the private credit industry. Rather, it’s highlighting what could eventually become soft spots in some pension portfolios in time to avoid doubling down into higher risks and to encourage pre-emptive staff work to demonstrate and document vigilant portfolio oversight.

Although some of the larger public pension funds hire private lenders to manage a custom portfolio for themselves alone in a separate account, the norm for most is to join with other institutional investors in a private credit fund. Most of the managers of these funds are general partners who collect a management fee and carried interest in some of the portfolios’ investment returns. Because their risks and their upsides are presumably lower than those that private equity managers face, their fees and carried interest are often a bit lower as well. Many of them have a performance hurdle of 5 percent to as much as 8 percent for the annual rate of return before they earn their full carried interest.

There are many flavors in private lending. Some firms play on the riskier side of the market, lending money to private equity managers seeking to take companies private, others to keep private companies alive as “unicorns” in hopes for a big score when they go public with an IPO. Some are stepping up to fund venture capital, looking to exploit a void in the wake of the Silicon Valley Bank collapse. A good number of them instead lend money to profitable middle-market companies that are too small to sell junk bonds in the public market. A few of them lend to property developers. There’s even a subset that have successfully lent money overseas from money centers like London and Singapore. Each strategy has its fans and its risks, making it unfair to generalize.

The Leverage Game

To goose up their investment returns, many but not all of these private lenders also use leverage, borrowing additional capital at a lower interest rate than their loan portfolios yield to squeeze out extra returns for their clients. That strategy worked pretty well up until 2021, but lately it’s been harder to lend long and borrow short as the Federal Reserve ratcheted up short-term rates.

But unlike traditional brick-and-mortar banks, the private lenders typically include loan terms that require borrowers to pay a variable interest rate that assures a “spread” over the money market’s short-term rate. In the olden days the spread was “LIBOR-plus, ” pegged to the London Interbank Offered Rate, but now it’s often SOFR-plus a contractual spread above the Secured Overnight Financing Rate. So if the private borrower must annually pay 5.5 percent over SOFR, that would cost them 10.5 percent in total, given today’s prevailing SOFR rate of 5 percent.

When short-term rates were only 1 or 2 percent, the private lenders’ spreads and total rates were relatively manageable and not too much higher than publicly traded corporate junk bonds. Companies that can earn sufficient profits to generate a double-digit return on equity capital are usually able to repay their private lenders. But when the combined interest rates on their loans surge into that double-digit territory, that raises at least a yellow flag and sometimes a red one. So that’s why eyebrows are starting to rise a bit in the world of public pensions and other institutional investors, even as the stock market lumbers its way upward and the hopes of a soft landing for the economy grow a bit brighter.

Despite these potential drawbacks, private lending still has its place in the capital markets. When pension and endowment funds provide their patient long-term capital to these private credit managers, there is far less financing risk than the situation facing traditional bank lenders who rely on fickle customer deposits that flee when interest rates surge, as they have in the past year. The pension funds are locked in, so there is ample time to work out distressed loan portfolios — as long as the credit managers have not used too much additional leverage to fund their portfolios. Any borrowed leverage dollars could be floating-rate debt, or maturities could be mismatched. That’s why it’s so important to know up front what will be the rules and practices for leveraging pension capital for private lending.

Controversial Cousins: BDCs

Some of these private lenders also offer retail investment products known as “business development companies,” typically listed on the stock exchange. The BDCs also make loans to private companies, but a number of them use the retail shareholders’ capital for riskier loan portfolios, and they almost always use higher leverage; indeed, standard practice for many is to deploy double leverage. The gimmick there is that they collect higher management fees and fatter carried interest on profits earned on the interest rate spread. If their bets go wrong, the BDC shareholders pay the price in lower stock values while most managers continue to operate despite pathetic performance. To add insult to injury, many of them lately have been soliciting shareholder approvals to issue yet more stock at prices below net asset value, arguably as a way to garner even more fee income. Critics say that’s potentially dilutive, reducing assets and earnings per share, although credible opinions can differ.

My advice to pension officials is that they should always ask the operator of a private lending fund to disclose the returns, terms and track records of BDCs they operate, as that may provide insights into the quality of their management teams, risk management and underwriting standards. It’s not a universally infallible indicator, but it’s certainly a prudent question for a fiduciary to ask, especially when there could be reputational or headline risk — it’s the kind of story that pension critics and newshounds love to dig up. Not all private credit managers charge fees similar to the way BDCs operate, but enough of them do to make it worth spending some staff time checking out the true cost of retaining them.

Some of the private lending funds likewise charge their management fee on total assets invested, including the proceeds of the borrowed funds. In such cases a pension fund is paying a “total expense ratio” on the investors’ capital of much more than just the nominal annual management fee percentage. Then add in the portfolio manager’s carried interest, and a big chunk of that juicy “risk premium” and “illiquidity premium” from these high-yielding non-bank loans begins to melt away. In today’s market, where baseline risk-free interest rates are 5 percent and the new cost of leverage is even higher, the economics are just not as compelling as they were a decade ago.

Most major pension consultants are well equipped to help their client funds conduct a deeper dive into this market segment and their portfolio holdings. Trustees can sleep better at night if they receive a report-to-the-file that systematically dissects each of their portfolios’ private lending funds and identifies potential risk areas. For pension funds that have never ventured into this space, it’s not too late to tiptoe into the water in a systematic multiyear program to further diversify their portfolios. But in a period “between recessions” in which riskless Treasury bills are paying more than 5 percent, there might be better timing for plunging into any major additions beyond plain vanilla strategies.

For curious retail investors, those BDCs may offer juicy double-digit current yields in today’s market, but there’s a reason for that. Take a look at their long-term stock performance charts, leverage and total expense ratios, default and credit impairment rates, and caveat emptor. As for me, I don’t hate the asset class, but it’s time that the free-lunch sign should be taken down from the door.

Governing's opinion columns reflect the views of their authors and not necessarily those of Governing's editors or management. Nothing herein should be construed as investment advice.
Girard Miller is the finance columnist for Governing. He can be reached at
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