Pension funds plug the credit gap

Large pension schemes are starting to make direct loans to credit-starved companies, potentially plugging the gap in the debt markets caused by the rapid contraction of the global banking sector.

The banks’ retreat has pushed up the cost of borrowing, enhancing the returns pensions schemes are able to generate from lending to even highly rated companies at a time when returns from mainstream assets have been poor.

As a result, a slice of the $22,000bn (£15,523bn, €17,410bn) sitting in the world’s pension schemes could now be lent to the corporate sector.

“The whole market is crying out for liquidity. Banks don’t have any, corporates don’t have any, but pension funds are sitting on loads. This is, hopefully, a one-off opportunity for pension funds to put their money into something that will be for the greater good,” said James Trask, partner at Lane Clark & Peacock, a consultancy.

“There is talk of major pension funds loaning directly or joining forces to create large pools and effectively do what the banks would do if they were able to lend, loaning tens or hundreds of millions of pounds to large corporates.”

Sian Hurrell, head of European pensions and insurance solutions advisory at Royal Bank of Scotland, said a number of pension funds had taken the plunge.

“We have had interest from some of the larger pension schemes in the provision of loans direct to corporates. They might be working in conjunction with a bank that has the appetite to loan 50 per cent. The pension fund may come in and do the other 50 per cent.

“That is probably the preferred route and some of the larger schemes have made investments in that way.”

Asset managers are also exploring the possibility of creating funds that would aggregate pension fund money, allowing greater diversification.

M&G is planning to launch a UK Companies Financing Fund that would lend tranches of up to £100m to mid-size UK companies. The fund will go ahead if M&G can raise at least £1.5bn from pension funds to add to £500m of seed money from Prudential, its insurance company parent. It is targeting returns of 4-6 per cent above Libor.

M&G, which has been in discussions with pension funds since November, said a number of funds “have expressed interest”. Other asset managers are believed to be looking at following suit, potentially creating a market in which banks are disintermediated from the corporate lending process.

Although bank loan funds have existed for some time, this structure differs in that pension funds are providing the loan principal, rather than merely buying tranches of loans made by banks.

The concept appears to be gaining initial traction in the UK but other countries with large defined benefit pension industries such as the US, Canada and the Netherlands are also seen as well placed to follow suit.

Compared with corporate bonds, pension funds’ traditional means of accessing the credit markets, loans rank higher in the capital structure in the event of a
bankruptcy.

Mr Trask also believed some borrowers were willing to offer “sweeteners”, such as seniority and equity
warrants to scheme lenders.

However, there are potential drawbacks. Ms Hurrell argued lack of liquidity for corporate loans meant investors would probably have to hold them until maturity, typically five to seven years, while many funds’ statements of investment principles would prevent them from initiating loans.

Alasdair Macdonald, senior investment consultant at Watson Wyatt, said: “There are hurdles. Banks were invented for a reason, they have the ability, specialist resources and an aggregation role as a wholesaler of risk, and it’s difficult to replicate. A pension fund won’t have the in-house skills to know who they want to lend to and how much to charge.”