Cashflow-driven investing (CDI) is about meeting the outcome that matters most to pension schemes - being able to pay out liabilities as they fall due.
The approach involves investing in assets that generate predictable cashflows that can be used to match liabilities whilst still having the potential to generate attractive returns. This approach leads to more certainty of outcome in comparison to a traditional approach that concentrates on returns from growth and matching assets (a ‘bar-bell' approach).
In practice, it means building a portfolio of high quality investment-grade debt and debt-like assets that, after allowing for expected defaults, is designed to match liabilities and generate returns. Liability-driven investing (LDI) is also used as part of the strategy to fill in any remaining gaps between the asset and liability profiles.
The approach has been favoured by insurers for years; Now pension schemes are also considering and implementing it. Including private assets in CDI can provide a yield uplift through illiquidity premia, as well as other benefits such as diversification and downside protection when compared to public markets. These factors have enhanced the case for increasing allocations to private assets.1 Until recently, these assets were the domain of larger pension schemes with significant governance budgets. Now they can be accessed by schemes of all shapes and sizes; there are single and multi-strategy pooled funds available, as well as bespoke solutions.
This paper describes the private debt assets that might be suitable for CDI, and considers how pension schemes can make the most of today's opportunities in this competitive market.
1. The world is your oyster - many different types of private debt can be considered for CDI
As long as the predictability and security of income is high, a variety of private debt assets (e.g. infrastructure debt, real estate debt) can be considered for CDI strategies. Suitable opportunities can provide similar characteristics to public debt, while generating higher returns and lower risk - whilst also enhancing portfolio diversification.
2. Challenge convention to get the best outcome out of private debt assets
The long-dated private debt market is overcrowded, with many investors such as insurers chasing the same opportunities, leading to spread compression and longer capital deployment times. However, as pension schemes are not constrained by stringent insurance regulations, they are in a strong position to ‘select against' insurers when investing. The key is not to follow the herd, but use the flexibility denied to insurers, to invest in suitable shorter dated senior secured debt assets. Investing in shorter-dated, floating-rate, private investment-grade debt, in conjunction with a LDI strategy, may result in the optimal returns for the amount of risk taken, even after taking reinvestment risk into account. For schemes without an LDI strategy, there are ways to use a pension scheme's flexibility to achieve better returns on longer duration assets, but the scope is fairly limited.
3. The devil is in the detail - solutions design considerations
Close dialogue is needed between a pension scheme, their advisor(s) and asset manager to ensure the strategy is fit for purpose and the assets acquired meet the relevant criteria. A range of parameters will need to be agreed, including asset types, hurdle rate (e.g. spread over gilts) and investment quality. The time horizon to buy-out and/or the liquidity impact of unexpected transfers out of the scheme also needs to be kept in mind.