U.S. state and local retirement funds are pumping billions into private credit, joining the stampede into a booming sector of finance to pursue higher returns.
These systems are collectively allocating at least $100 billion of their roughly $5 trillion in assets into private debt, according to Equable, a bipartisan pension researcher founded by public finance leaders. While that’s only a sliver of their holdings at present, the funds’ private credit positions have been steadily growing and are poised to take off as pension plans including the California Public Employees’ Retirement System — the largest among its peers and a bellwether — show a keen interest in committing more to the space.
“Everybody is looking at private credit,” said Rosemary Guillette, a vice president at Segal Marco Advisors who has advised public pensions for more than two decades. “You are going to see a steady increase.”
For almost two decades, public pension funds have increasingly looked beyond traditional investments such as stocks and bonds and tapped alternatives to help boost returns and fill funding shortfalls. They’ve ramped up their exposure to private credit in recent years as the asset class has ballooned to $1.6 trillion globally. Private debt allocations at state pension funds, for example, may reach 6% over the next two years, up from 3.6% last year and 2.1% in 2017, according to Cliffwater LLC, an investment adviser that specializes in alternative assets.
So-called direct lenders have filled a void left by banks that have retreated from extending credit to some riskier corporate borrowers during a spike in interest rates and tightening regulations. Other aspects of private credit include asset-based finance as well as debt for real estate and infrastructure.
While potentially rewarding for retirement plans, the shift into private credit isn’t without hazards. Amid the explosive growth of the asset class, financial watchdogs have raised red flags about its lack of transparency and regulation, while citing risks around a sector that hasn’t been tested by a prolonged downturn. There’s also the overarching question of whether alternative investments are worth the risk for funds that are devoted to ensuring public servants receive their pensions as promised.
Proponents point to the benefits of private credit as an alternative investment over other options such as private equity and real estate, including that the debt is often senior-secured and backed by the assets of the company. It also offers juicy yields, and interest-rate risk is limited, given its typically floating-rate structure.
“Looking forward, private debt is certainly the biggest new asset class for the industry as a whole,” said Anthony Randazzo, executive director of pension researcher Equable.
CALPERS DOUBLING DOWN
The California Public Employees’ Retirement System, or Calpers, began tracking private debt as a unique asset class within its portfolio last year and is targeting an allocation of 5%. The Chicago Teachers’ Pension Fund is currently searching for asset managers to invest more than $300 million in private debt to boost its allocation from zero to 3% of assets.
The Public Employees Retirement Association of New Mexico first invested in the market in a significant way just over a year ago. The system held $524 million in private credit as of Sept. 30 and aims to increase its exposure, said Michael Shackelford, chief investment officer of New Mexico’s pension system.
“It’s a combination of banks vacating that space and pensions looking for yields,” Shackelford said. Wider spreads and regular cash distributions with investor protections in the event of bankruptcy have made private credit attractive, he said.
The growth of private lending and the lurch toward alternative assets by state and local pensions both trace back to the 2008 financial crisis.
Regulators tightened rules on risky lending by deposit-taking institutions, and in response, banks have pulled back. That has provided an opening for private credit. Meanwhile, funding from state and local retirement plans tumbled from 92% of total long-term liabilities in 2007 to 62% in 2009 as equity markets plunged, according to Equable. Massive shortfalls still persist: The largest 225 U.S. public pensions face a $1.4 trillion gap between the assets they hold and the tally of their future benefit commitments, Equable data shows.
State and local pensions sought to plug funding gaps by increasing holdings of alternative assets such as private equity and real estate to more than a third of their portfolio. With private credit now a serious rival to mainstream lending, public pensions are giving it more of a hard look, too.
“They did toehold investments in private credit going back a few years,” said Stephen Nesbitt, CEO of Cliffwater. “Now, this is real.”
Nesbitt predicts that U.S. state pension assets invested in private credit will double in the next two years to about $200 billion as the taxpayer-funded retirement systems increase target allocations.
To be sure, alternative investments overall haven’t been a panacea for retirement plans. A study of public pension funds from 2001 through 2022 found that “the increasing reliance on alternatives certainly has not helped, although it may have dampened reported volatility,” according to a November 2022 report from the Center for Retirement Research at Boston College.
Amid the excitement over private credit, financial heavyweights — ranging from JPMorgan Chase & Co. CEO Jamie Dimon to UBS Chairman Colm Kelleher — are raising concerns about the market. Executives from investment powerhouse Pimco have warned about the lack of regulation. In an October report, the International Monetary Fund also cautioned about the opacity and potential risks.
Guillette at Segal Marco Advisors said questions are starting to arise about the value of adding more complicated assets from private markets when public markets such as plain-vanilla bonds now offer strong potential. Bond markets as a whole have posted blockbuster returns in recent weeks, for example.
For many, the potential benefits are too big to pass up. Some, though, are taking a measured approach. North Carolina Treasurer Dale Folwell sees opportunity in private debt, but he added that the state is cautious about balancing safety with returns. The state pension plans for which he is responsible hold roughly $1.75 billion in private credit out of overall assets of more than $115 billion.
“There are very robust conversations” how dollars are divvied up between alternative investments such as private equity and private credit, Folwell said. “It’s just a very high level of conversation about what brings the best long-term value to our pensioners with the highest margin of safety.”