Pension schemes are "placing too much focus" on a narrow section of the private debt market where competition is driving down "compelling opportunities", according to Willis Towers Watson.
While many schemes have increased their allocation to credit strategies - with this tripling since 2015 - focus on mid-market corporate direct lending means schemes are "missing out on opportunities in less competitive areas of the market which could offer greater returns".
These are the conclusions of the consultancy's Finding value in private debt report, which also argues the mid-market corporate direct lending market approach is "too constraining" and is "demonstrating signs of material deterioration". This is particularly in credit underwriting and future return potential.
Global head of credit and diversifying strategies Chris Redmond said a widening market creates more difficult to understand complexities, pushing investors into a concentrated section.
"The result is large capital flows into a squeezed portion of the market, creating downward pressure on returns and upward pressure on risk," he said.
Schemes should instead diversify into more "niche" strategies which offer "the best" risk-adjusted returns, despite asset managers finding them harder to scale and less profitable to run. This could include US residential mortgages, the consultancy said, or UK real estate bridge lending, which would both allow investors to better use their "precious illiquid budget".
Redmond continued: "We find smaller, niche strategies which are harder to scale and so typically offered by specialist managers are often the most compelling, particularly when faced with higher valuations such as those we see in most credit markets today."
Those investors "willing to pair with specialist lending teams" in selective geographies and assets will "ultimately derive the greatest benefit in the long-term", he continued.
"There are compelling opportunities to be found if investors remain selective, with good value for risk taken for those investors willing and able to go the extra mile and unearth interesting opportunities."
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