Notes from NCPERS: Pension Trustees Query What’s Actually in Their Private Credit Books

I recently attended the Annual Conference and Exhibition of National Conference on Public Employee Retirement Systems (NCPERS) in Las Vegas. NCPERS is the leading voice and resource for the public pension industry in the United States. At the event, a packed room of trustees and investment staff from public pensions across the country attended panels and engaged with service providers across three days of programming. 

I attended three panels focused on how private markets and related investments are interacting with this industry, curious about how pension fund trustees - most of whom are not trained investment professionals - discern quality among private credit managers pitching their platforms. 

There was a clear theme running through each of these panels: speakers were keen to reassure conference attendees that the headlines about private credit and the actual risk sitting in allocator portfolios are not the same.

One speaker walked through the three top risks in private credit, and each of them was a documentation question more than a portfolio question. If you sit on a public pension board or oversee private credit allocations for an institutional investor, these are the points to be clear on, and to press your private credit manager about.

When the deal was done matters

The vast majority of private credit "stress" headlines trace back to a specific vintage of the market: floating-rate loans originated before the Fed raised rates, almost all from 2019, 2020, 2021, and 2022. Borrowers priced their cash flow models around six or seven percent yields. They have been paying twelve or thirteen percent for three years. While that is a key risk area to focus on, it is not the entire asset class.

Legacy vintage loans on floating rates are stressed because rates rose. Future originations are different. If your external manager's book skews to 2021 originations and direct lending, you should know, and there are a list of questions you should be asking. If it does not, the headlines may be entirely irrelevant to you.

Direct lending and asset-backed finance are not the same asset class

The three trillion dollar private credit market splits roughly in half: direct lending on one side, asset-backed finance on the other. They get bucketed together in industry shorthand and on most quarterly reports, but they very behave differently.

Direct lending is corporate credit - cash flow lending against a borrower. These appear in tiered levels of potential risk - ask yourself whether the deal is from a private equity sponsor-backed leveraged buyout. Once that question is ticked off, consider the industry that the borrower is in - software exposure alone makes up around thirty percent of the direct lending market, which is why software disruption risk and private credit risk often end up in the same conversation.

Asset-backed finance is collateral-driven. The lender is underwriting the value of underlying assets: airplanes, equipment, loans, leases, receivables. Some of it is high-quality cell tower paper. Some of it is subprime consumer with effectively zero recovery in default. Asking whether your manager does "asset-backed finance" is not enough. The sub-asset matters as much as the sector.

The liquidity in evergreen and interval funds is a design choice, not a guarantee

Evergreen and interval fund structures are becoming the dominant way pension allocators access private credit. The five percent quarterly redemption cap that defines most of them is not magic. It is engineered around three things: the natural runoff of a three-and-a-half-year average holding period, a liquidity sleeve sitting alongside the credit portfolio, and undrawn credit facilities the fund can tap on a daily basis.

That design works when the three layers actually exist and are sized correctly. It does not work when the fund is over-concentrated in one slice of the market, over-levered against subordinated borrowing, or holding so much cash in the liquidity sleeve that you are paying for private exposure you do not have. When headlines announce evergreen failures over the coming years, this is where those stories will begin.

All three risks live in the loan documents

The documentation is what pulls all of these risks together. The covenant package, the eligibility criteria, the security, the events of default, the call protection, the financial maintenance terms. The 2021 vintage software LBO loan, the subprime consumer ABF facility, the over-levered interval fund: the risks inherent in each one lies in what’s actually in the documents, not in its category label or its quarterly performance report.

The documents are where the risk is. They are also where the disclosure obligations sit, which means they are where a fiduciary should look first when something doesn’t feel right.

What trustee fiduciary duties ask of you

A longtime trustee from Birmingham, Alabama, made a stark point: untrained trustees risk being set up as scapegoats, and I agree with him. Documentation literacy is not just a credit specialist's job. It is a fiduciary one. You do not need to read like a finance lawyer to allocate pension funds to a private credit portfolio, but you do need to know what questions to ask your external managers, and you need to recognize when the answers suggest pockets of risk that put your funds at risk unnecessarily.

This is why we built our allocator education program, and our existing allocator clients tell us they feel more confident engaging in talks with private credit managers. If you sit on a public pension board, run private markets oversight for an allocator, or sit on an investment committee asked to sign off on private credit allocations, this is a discipline worth investing in before the 2021 vintage hits a default cycle.

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