Del Gaudio: ‘Managers must not sacrifice integrity’

Underwriting standards cannot be allowed to slip in the face of growing competition and more cov-lite deals, insists James Del Gaudio of PSERS.

James Del Gaudio, private debt portfolio manager at the Pennsylvania Public School Employees’ Retirement System, tells us about end-of-the-cycle planning, pricing, diversification and current and future performance. One of his biggest concerns is the increase in covenant-lite deals.

There is talk about the end of the cycle and being in the final inning – does that affect your strategic planning at this point?

JDG: Within PSERS, private credit is one of the few asset classes where there is universal support to allocate additional capital which is why I could see this allocation target increasing from the current 8 percent level. We of course will continue to be highly selective given increasing competition but overall we continue to believe in the risk/reward potential of the private credit asset class.

In addition, much of our private credit exposure is in senior-secured, floating-rate loans, which are higher in the capital structure than public high-yield bonds and not nearly as sensitive to interest rate duration. As a result, we are typically able to capture a premium to returns available in the public markets.

As rates increase, our direct lending portfolio should be somewhat insulated in terms of duration risk and our more opportunistic managers should be well-positioned to take advantage of any ensuing volatility. In private credit, we are being paid for the illiquidity, in contrast with public high yield where there is an illusion of liquidity.

How worried are you by levels of competition and the effect this has on pricing?

JDG: Increasing competition, especially across the US and European direct lending space, is something to monitor. During 2016, it seemed like we were receiving direct lending proposals on a daily basis. This risk is usually one of the top three investment considerations that PSERS staff needs to adequately mitigate as part of our due diligence process. It is fair to say that a number of our managers have experienced a moderate negative impact on their unlevered yields.

That said, many of our managers are still able to hit their levered return targets at the fund level. What is more concerning though against this backdrop of tighter pricing is the significant increase in covenant-lite issuance. This is a very important trend to watch and we remain focused on making sure our managers do not sacrifice underwriting integrity.

Are you easily able to achieve the diversification that you would like in private debt?

JDG: Diversification can be evaluated at multiple levels. At the asset allocation level, we believe private credit provides the potential for attractive risk-adjusted returns, while reducing correlation to high yield and equities. At the portfolio level, we are invested across 15 sponsors and have around 1,000 underlying investments with little overlap. We have relationships with a number of core managers that have broad mandates in terms of strategy and geography with flexibility to react quickly to market dislocations.

How is your portfolio performing compared with last year?

JDG: Our private credit portfolio has experienced significant positive year-on-year performance for the 12 months ending 31 December 2016, compared with the same period ending 31 December 2015; the portfolio appreciated around $415 million during 2016, compared with a decline of around $25 million during 2015. 
During 2015, credit markets were less liquid and more volatile with continued weakness in commodities and slowing global growth. CLOs sold off dramatically, underperforming the broader loan asset class. While the heightened volatility expanded the opportunity set for some of our managers, it resulted in mark-to-market losses on existing positions.

In 2016, a vast majority of our managers experienced positive performance with an even distribution of contributions across the portfolio. A couple of our managers were outliers – to the positive – benefiting from the strong rebound in commodity prices and a favourable convexity profile across their structured credit positions.

This positive performance has continued through the first quarter of 2017, with our portfolio appreciating 2.7 percent, resulting in a 14.5 percent IRR for the 12 months ending 31 March 2017.