Ailman: Debt funds pose LP dilemma

Distressed debt and credit vehicles of all kinds have surged in popularity as institutional investors scramble to take advantage of credit market turbulence.

Two months ago, the Oregon Investment Council made a $3 billion (€2 billion) commitment to a separate managed account to be managed by KKR Fixed Income, the newly reformed debt investment wing of KKR.

A month earlier, the California Public Employees’ Retirement System disclosed that it had committed $1 billion to a similarly structured separate account to be managed by Apollo Global Management. The fund will focus exclusively on senior bank debt and hung leveraged buyout loans.

But for the limited partners contributing to these funds, the question arises: from which allocation should these commitments be made?

Since distressed debt investments often blur the lines between fixed income and private equity, the issue can be challenging to institutional investors, especially when brand-name private equity houses like KKR and Apollo get in on the action.

“It varies across the board,” Chris Ailman, chief investment officer of $162.2 billion California State Teachers’ Retirement System, recently told sister magazine Private Equity International. “Distressed debt is one of those real complicated areas.”

Ailman said that CalSTRS keeps its distressed debt investments spread between the pension’s private equity and fixed income allocations, depending on how “deep” the debt is – in other words, how far a leveraged company needs to go for a profitable turnaround.

“It depends on the strategy and how aggressive it is. And what you will see is a real break in the fee. The true deep, distressed debt” funds, like those managed by Howard Marks’ Oaktree Capital Management, often charge a 1 percent management fee and 20 percent carry, as opposed to the classic 2-and-20 structure, Ailman said.

For funds targeting that type of “deep” debt, CalSTRS invests from its private equity allocation. For funds “concerned with buying bonds really cheap and helping the company improve a little”, CalSTRS invests from its fixed income portfolio.

Oregon is making the $3 billion commitment to KKR from the pension’s fixed income allocation. But the pension also classifies other debt investments in its multi-strategy “opportunity fund” and private equity allocation.

CalPERS’ commitment to Apollo is part of the retirement system’s $4 billion in debt-related strategies placed firmly in the fund’s private equity programme. But the bending of asset definitions is encapsulated in how the pension’s investment team approached the proposed commitment.

According to the minutes from the pension’s investment committee, CalPERS’ alternative investments staff conferred regularly with the fixed income staff and the chief investment officer to evaluate the transaction.

A more in-depth article on how institutional investors position debt investments within their portfolios will be featured in the September issue of Private Equity International.