manager is aware of these things and then take account of that in the pricing and spreads. If there are people who only buy into companies where the numbers have been massaged, then that chicken will come home to roost at some point. You may be in a perfectly safe, well-underwritten loan, but there will be a mark-to-market pricing issue. It may affect liquidity in secondary markets. Although, these things are important, you have to think of the wider environment. If there is bad behaviour from the borrowers and it’s not taken account of, then you will catch a cold at some point. You do not want a repeat of 2009. Halfon: One of the advantages of this is to avoid being segmented. If you only have access to one or two markets, you are probably going to end up with a diversification issue. For example, let’s consider, hypothetically, that European mid-market loans are over-priced for the moment, but the US ones may at the same time be under-priced. There has not been much value in sterling infrastructure debt for three or five years, but Southern European infrastructure loans are quite good. You can get senior debt for 220 basis points above a government bond. If you can look at the same thing but more dynamically and not limit yourself to one or two areas you can optimise quality, risk and long-term reward.


The attraction for UK pension schemes, especially defined benefit ones, is that you get a supply, which, even though demand is high, remains quite significant. You can find different debt, of different quality, different segments and different types of risk. You have a lot more choice than if you were limited to listed UK corporate bonds. If you are completely stuck in the liquid world, you will not be as able to structure a coherent and successful investment strategy. Wellesley: That diversity is critical because you are taking high risks. All managers say that they are selective, but somebody is doing those covenant-light deals and the ones with the hidden leverage. What I like to hear from managers is about the deals that they are not doing and why they have not done them. That gives me an insight into their underwriting discipline. I hear managers often say that they stayed away from deals because they are in crowded markets and are not appropriately structured. That builds more confidence with me than discussing the deals they have done. Halfon: During the private equity infrastructure craze before 2008, managers were coming to me with the same deal, which was a car park in Chicago. I saw that coming in time and time again. Wellesley: The Battersea Power Station develop- ment came back several times, too. Kwatra: Diversity is something which has hit the insurance sector in the past couple of years. There have been repeated warnings from the regulator about exposure to property risk via social housing, ground rents and equity release mortgages. There was an example last year where the regulator made an announcement on equity release mortgages. You could have suffered if you were not diversified. So being diversified at all levels of the investment process in private debt is important. Martin: People were trying to sell European mid- market products a couple of years ago. They were talking about 10 to 15 loans, which fundamentally was wrong. If you get one wrong, you lose 5%, or


at least a year’s worth of coupon. It is even more important in illiquids. Hamilton: That is one of the challenges for pension schemes. We have large clients who are sophisti- cated and can invest across multiple funds in different asset classes and different regions, but we have smaller clients who want to access illiquid assets but cannot easily. We need to be clear; most direct lending strategies are sub-investment grade loans, so putting 10% or 15% or more of your total scheme assets into an opportunity like that and maybe with one manager


12 October 2019 portfolio institutional roundtable: Private debt


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