private credit - nebraska. private credit...on slide 8, we modeled funding the private credit...

Investment advice and consulting services provided by Aon Hewitt Investment Consulting, Inc., an Aon Company.

Private Credit

Nebraska Investment CouncilMay 2018

Proprietary & Confidential

Investment advice and consulting services provided by Aon Hewitt Investment Consulting, Inc., an Aon Company. 2

NIC Investment Team–Summary of Process

The Private Credit Blank Sheet started in August 2017.

– Managers were chosen from a combination of top managers and managers known to Council

Investment Team. Joe and Chris contacted 23 managers and met with all 23. These two hour

meetings occurred between September 5th and October 3rd.

– 13 managers made onsite presentations to the Team between October 11th and November 17th.

During the manager meetings a few themes kept reappearing that the Investment Team liked:

– The Team met on December 14th to discuss the managers’ Private Credit structure proposals and

prepare to contact Aon with how to proceed. Joe and Chris sent three proposals to Aon to review very

closely in preparation of a follow up meeting with Aon. All of the structure proposals made at the

onsite visits to Council offices were subsequently emailed to Aon.

– In January 2018, Aon met with the Team to discuss the findings of the Blank Sheet Review. The

Team’s themes were included in Aon’s review. There have been a series of phone calls between the

Team and Aon to refine the Team’s recommendation at the May 24th Council meeting for the right

Private Credit structure for Nebraska.

The Team’s preferred themes of a Private Credit structure include:

– Opportunity set to include 1) corporate (i.e., direct lending) and 2) other asset-based lending, but

NOT 3) real estate debt

– Favor performing vs. non-performing to avoid high equity correlation within Opportunistic allocation

– Leverage = OK (prefer senior secured debt with leverage vs. unlevered junior debt)

– Geography – favor US / North America

– Income vs. Total Return – preference for income, all else equal



Opportunities Within the Spectrum of Credit Assets and Strategies*

*Source = BlackRock



Formalizing a Private Credit Allocation

The NIC Investment Team is recommending establishing a Private Credit allocation and moving to the

fixed income component structure outlined above

– i.e., 20% risk reducing fixed income, 5% percent liquid return-seeking fixed income, 5% illiquid

return-seeking fixed income (i.e., private credit)

While the labeling is different, the structure itself is similar to what is currently in place

Risk-Reducing Fixed Income,

20%

Return-Seeking -- Liquid, 5%

Return-Seeking -- Illiquid

(Private Credit), 5%



NIC DB Plans–Current Fixed Income Component Target Allocations

BlackRock (Index), 4.8%

PIMCO, 5.3%

BlackRock (Active), 3.9%Neuberger

Berman, 4.5%

Wellington, 3.0%

Loomis Sayles, 1.5%

Loomis Sayles (Bank Loan),

2.5%

Franklin Templeton

(Bank Loan), 2.5%

Opportunistic Mandates

(PIMCO BRAVO II and Oaktree),

2.0%

By Manager

Core Bonds, 18.5%

Global Bonds, 3.0%

High Yield Bonds, 1.5%

Bank Loans, 5.0%

Opportunistic / Illiquid, 2.0%

By Asset Type

Risk-Reducing Fixed Income,

20.0%

Return-Seeking -- Liquid, 8.0%

Return-Seeking -- Illiquid, 2.0%

Risk-Reducing

vs. Return-

Seeking



Private Credit Allocation Structure

The recommended 5% allocation to Private Credit would be split between Direct Lending and “Other” /

Opportunistic strategies

– Core = Direct Lending --- 75% of allocation (i.e. 3.75% of Total Plan assets)

• Income oriented, relatively conservative

– Satellite = “Other” (Opportunistic) --- 25% of allocation (i.e., 1.25% of Total Plan assets)

• Seeking higher returns, perhaps more focused on transient opportunities

AHIC suggests putting relatively wide ranges around these underlying target allocations

– Ranges would provide flexibility for different market environments

• They would also accommodate the illiquid nature and drawdown structure of these

investments

i.e., NIC would only have so much control over the timing of cash flows into and out of

these investments



Private Credit Allocation Structure–Current State

If we were to divide NIC’s return-seeking fixed income allocation into “Liquid” and “Private Credit”

components today, the current split would be:

– ≈9% Liquid Return-Seeking

– ≈1% Private Credit, with the potential to go to ≈1.5%

• Represents the PIMCO BRAVO II allocation and the Oaktree Real Estate Debt Allocation,

the latter of which could still call additional capital

In essence, any formal 5% private credit allocation already has a 20% - 30% satellite / opportunistic

allocation in place

– The current satellite allocation has a heavy real estate / distressed element, which would not

necessarily be part of the long-term structure of the opportunistic allocation

• The NIC Investment Team favors performing assets and non-real-estate-related assets for

future opportunistic allocations

If the Council adopts a 5% target allocation to private credit, our suggestion would be to first focus on

funding a ≈3.75% allocation to Direct Lending to complement the existing higher risk, higher return

potential PIMCO and Oaktree investments

As the PIMCO BRAVO II and Oaktree Real Estate Debt investments pay down over the next 18-36

months, we could work to identify other opportunistic private credit investments that might be

appropriate for NIC



Risk / Return Expectations* for Various Fixed Income Sub-Asset Classes

The table above illustrates our Capital Market Assumptions for the current structure of the DB Plans’ fixed income

component, as well as for the recommended structure

– We are modeling the PIMCO BRAVO II and Oaktree Real Estate Debt Funds as “Opportunistic”

• We would note that these two strategies, as well as any future allocations to “Opportunistic” mandates, are

exceedingly difficult to model

Moving to the recommended exposure appears to have a favorable risk / return tradeoff, with the caveat that

Opportunistic allocations, and to a lesser extent Direct Lending allocations, do not lend themselves to Capital Markets

modeling / forecasting particularly well

*Based on AHIC 1Q 2018 CMAs

**Modeled as 50% Multi-asset credit / 50% Distressed Debt

Current Exposure

(% of Total DB

Plan)

Recommended

Exposure (% of

Total DB Plan)

Annualized

Return (10 Year

Forecast)

Standard

Deviation (10

Year Forecast)

Core Bonds (i.e. Risk-Reducing) 20.0% 20.0% 2.8% 4.0%

Liquid Return-Seeking

International (Sovereign) 1.5 1.0 1.6 10.0

High Yield Corporate 1.5 1.0 3.7 12.0

Bank Loans 5.0 3.0 4.8 7.0

Illiquid Return Seeking

Opportunistic** 2.0 1.25 7.3 12.0

Direct Lending -- 3.75 8.3 16.5

Total Fixed Income -- Current 30.0% -- 3.5% 4.1%

Total Fixed Income – Rec. -- 30.0% 4.1% 4.6%



Private Credit Allocation–Other Considerations

Other issues related to establishing a private credit allocation that are worth considering include:

– Implications for other fixed income sub-components (i.e., Liquid Return-Seeking + Risk-

Reducing)

– Timing considerations

– Benchmarking



Implications for Other Fixed Income Sub-Components

On slide 8, we modeled funding the private credit allocation ≈pro-rata from the existing liquid return-seeking allocations for

the sake of simplicity

– Distributions from PIMCO BRAVO II and Oaktree Real Estate Debt will also be used, likely to be fund more

opportunistic private credit investments in the future

While this review is focused on the Private Credit (i.e., Illiquid) portion of the return-seeking fixed income component (in

green, above), the NIC investment team’s recommendation would establish a 5% allocation to liquid return-seeking fixed

income (in red, above) by default

– If the Council accepts the NIC Investment Team’s recommendation to establish a 5% allocation to Private Credit, we

would suggest revisiting the structure / weightings of the liquid return-seeking fixed income allocation in the near

future

– Adjustments to the guidelines of certain of the core bond managers may be appropriate as well

Liquid Return-

Seeking FI – 5%

of Total Portfolio

Core Bonds, 20.0%

International (Sovereign),

1.0%

HY Corporate, 1.0%

Bank Loans, 3.0%

Direct Lending, 3.75%

Opportunistic, 1.25%



Timing Considerations

While we realize that the NIC

investment team intends to establish a

long-term strategic allocation to

Private Credit, current market

fundamentals do give us some pause

A measured approach to phasing into

this allocation may have merit

Source: ApolloSource: Constitution Capital

Source: OZ Management



Benchmarking

Fixed Income component benchmarking is something that could stand to be improved in our view

The component as a whole is benchmarked to the Bloomberg Barclays (BB) Universal Bond Index,

but many of its underlying components are not

Manager (Mandate) Benchmark

BlackRock (Passive Agg) BB Aggregate Bond Index

BlackRock (Active Core / Core-Plus) BB Universal Bond Index

PIMCO (Active Core / Core-Plus) BB Universal Bond Index

Neuberger Berman (Active Core / Core-Plus) BB Universal Bond Index

Loomis Sayles (Active Core-Plus / HY) BB Universal Bond Index

Wellington (Active Global Agg) BB Global Aggregate Bond Index

Loomis Sayles (Bank Loans) S&P/LSTA Leveraged Loan Index

Franklin Templeton (Bank Loans) Credit Suisse Leveraged Loan (Split BB)

PIMCO BRAVO II BB Universal Bond Index

Oaktree RE Debt BB Universal Bond Index



Benchmarking (cont’d)

Splitting the fixed income component into three sub-components and benchmarking each separately

has merit in our view

– The table above illustrates what this might look like

More accurate benchmarking, better sense of what is driving outperformance / underperformance,

better risk control

In terms of benchmarking Direct Lending specifically, we would suggest using a bank loan index (e.g.,

S&P LSTA Leveraged Loan index) plus a premium (e.g. 150-200 bps per annum)

Fixed Income

Sub-Component

% of Total

Fund

% of Fixed

Income

Component

Primary Benchmark

(Marketable)

Secondary

Benchmark

Risk-Reducing 20% 66.7% BB Aggregate Bond Index --

Return-Seeking --

Liquid5% 16.7%

Weighted Average of Sub-

Component Manager

Benchmarks

BB Aggregate

Bond Index +

100 bps

Return-Seeking --

Illiquid5% 16.7%


Component Manager

Benchmarks / Marketable

Proxies

BB Aggregate

Index + 200-300

bps

Total Fixed

Income30% 100.0%


Component Benchmarks

BB Universal or

BB Aggregate +

TBD bps



Summary–Recommendations and Next Steps

The NIC Investment Team recommends that the Council:

– Establish a 5% target allocation to private credit

– Invest ≈75% of private credit allocation in Direct Lending strategies; remaining 25% would be

invested in “Other / Opportunistic” strategies

If these recommendations are adopted, the NIC Investment Team would bring Direct Lending

manager recommendations to a Council meeting later this year

– “Other / Opportunistic” allocations would be considered once additional proceeds are received

from the unwinding of PIMCO BRAVO II Fund and the Oaktree Real Estate Debt Fund

If the Council approves a 5% target allocation to private credit, we would suggest reviewing the

structure of the resulting “liquid return-seeking” fixed income allocation that would be created by

default

– Reviewing / adjusting the guidelines of certain of the core bond managers may be appropriate as

well



Appendix I: Questions & Answers



Q&A

Question: Do we really want to add more illiquidity to the portfolio?

– Answer: We are always mindful of liquidity risk, but note that Nebraska is in an enviable position from a cash-flow

/ illiquidity tolerance standpoint. We believe the pension plans can afford to take on more liquidity risk, and in so

doing could take advantage of additional illiquidity risk premia.

Question: Does a 5% allocation to private credit even move the needle?

– Answer: It could, if the implementation of the private credit allocation is successful. With all appropriate caveats

about the difficulty of modeling private markets allocations, our capital market assumptions suggest that adding a

private credit allocation to the fixed income component would increase the long-term return expectations of the

component by about 50 bps per annum. In what we expect will be low-return environment where return objectives

are difficult to achieve, we view this as meaningful.

Question: Is it too late in the cycle to add an allocation to private credit?

– Answer: Private lending is a long-term strategy and NIC’s manager selection would give significant consideration

to institutions with a long-track record of operating through a full credit cycle. NIC’s focus would primarily be on

senior secured loans vs. more junior capital, which should provide more protection during a downturn.

Question: Does the addition of direct lending lower the quality of the fixed income portfolio too much? Is it

worth the risk?

– Answer: The suggested private credit allocation would be sourced primarily from NIC’s bank loan and high yield

allocations, which are also non-investment grade portfolios. Although these strategies are technically more liquid

vehicles, in a downturn prices will fall and liquidity will be less available. Another benefit of the proposed allocation

to direct lending would be increased exposure to fixed income securities with variable coupon rates, which should

provide additional protection should we encounter a prolonged rising rate environment.

Question: Are the extra fees worth it?

– Answer: All of our modeling is done on a net of fees basis. Manager selection will be key, but if the selected

managers are able to deliver performance that approximates their long-term track records, we believe the private

credit allocation will improve the risk / return profile of the fixed income component.



Appendix II: Additional Exhibits



Appendix: DB Plans – Liquidity Profile

NPERS is in a favorable cash flow position relative to other Defined Benefit Plans

– We forecast net outflows to be ≈3% of portfolio assets over the coming decade under the base case,

and not much more than ≈5% of portfolio assets in very poor economic scenarios

Serving as a liquidity provider could help NPERS enhance portfolio returns



Appendix: High Yield Bond Ownership

Retail investors hold just under 30% (≈$296 billion) of total U.S. high yield bond issuance

Exchange Traded Funds (ETFs) account for ≈$42 billion of the ≈$296 billion of high yield bond issuance held

by retail investors

High Yield Market Ownership*

*Source: Peritus Asset Management

High Yield Mutual Funds /

ETFs, 28.5%

Hedge Funds/Other Funds, 7.4%

Equity & Income Funds,

3.1%Investment-

Grade Funds, 6.8%

Pension Funds, 26.3%

Insurance Companies,

27.9%



Appendix: Return of Capital Forecasts for PIMCO BRAVO II and Oaktree

RE Debt

NIC’s investment in PIMCO BRAVO II currently has an NAV of ≈$90 million (0.8% of DB Plan)

– PIMCO is currently forecasting that most of that capital will be returned over the next two years

NIC’s investment in Oaktree’s RE Debt Fund currently has an NAV of ≈$50 million (0.4% of DB Plan)

– Oaktree is currently forecasting that most of that capital (≈80%) will be returned over the next two

years

• ≈40% in 2018

• ≈40% in 2019

• ≈20% in 2020



Appendix III: Glossary of Terms



Glossary of Terms

Risk-Reducing Fixed Income – Generally low-returning, high-quality fixed income investments.

Primary role in portfolio is to provide downside protection in markets where risk assets perform poorly.

Return-Seeking Fixed Income – Generally higher-returning, lower-quality fixed income investments.

Role in the portfolio is to provide some diversification from equity risk, but with higher return potential

than risk-reducing fixed income.

Illiquid – Investments for which no public market is available. Monies invested cannot be accessed

(without incurring significant discounts to NAV) for several years.

Liquid – Investments that can be easily accessed / for which a public market is available.

NAV = Net Asset Value.

Private Credit – A form of illiquid return-seeking fixed income.

Direct Lending -- a segment of the private credit universe that is characterized by non-bank lenders

who are providing capital to middle-market companies, primarily in the form of a loan rather than

equity.

Drawdown Structure – An investment vehicle where capital is committed and then called over a

period of time (usually years), rather than invested all at once.

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