Essex latest pension fund to commit to direct lending

Several high-profile schemes, including the London Pensions Fund Authority and Leicestershire Pension Fund have made large allocations to direct lending in the past year.

As European regulations such as Basel III increase banks’ capital requirements and therefore the cost of lending, pension schemes have been able to move in to fill the gap.

The £4.3bn Essex fund included an allocation of 2.5 per cent to direct lending in its 2015 statement of investment principles, published earlier this month. 

It states: “The investment strategy is formally reviewed every six months... Specific consideration is given to the investment strategy in the light of information arising from each triennial actuarial valuation.”

The rise in pension funds turning to direct lending is also attributed to low returns on government and corporate bonds, leading schemes to seek greater yield – and risk – elsewhere.

Jonathon Land, head of consultancy PwC’s pension credit advisory practice, said: “I do see, in a lot of meetings, people saying, ‘Our covenant is the same as it was last year but the risk of the assets I have to buy to get the same return is going up’.”

He added: “You used to be able to get a gilts-plus return from an A [rated] portfolio and now they need to go to a B or BB portfolio.”

Greg Fedorenko, associate at investment consultancy Redington, said schemes seeking return from debt instruments, including direct lending, should bear in mind the potential for reduced liquidity, increased complexity and potentially higher management fees.

He added: “Pension schemes can mitigate the risks of the asset class by appointing a specialist asset manager who has the expertise to analyse investments appropriately, to monitor asset performance and, where necessary, to ensure that borrowers are pursued when they fail to meet their obligations.”

However, Jo Waldron, director of fixed income at asset manager M&G Investments, said the presence of banks was still making it difficult for some schemes to find appropriate deals.

“To access these things it’s quite a lot of legwork. Most pension schemes would want to outsource that to someone,” she said.

Lending gap

Despite the regulatory concerns, many banks are still operating in the European market, said Arek Zawada, senior fixed income researcher at consultancy Aon Hewitt.

“Depending how you classify mid-market, there’s anywhere between 75-80 per cent of the market… covered by banks,” he said, adding this figure by comparison was closer to 30-40 per cent in the US.

But Zawada said banks’ share of the European market was expected to decline further.

“There’s certainly an expectation of that number decreasing over time,” he said. “[For] Basel III the expectations are of another four to five years of gradual changes.”

Despite this, he warned prices may rise even as banks exit direct lending.

“As more money begins chasing the opportunity naturally it will become more competitive,” he said.