San Francisco may invest as much as $4.5 bln in private credit over next six years

San Francisco Employees’ Retirement System is preparing to make a major push into private credit.

The $22.4 billion retirement system could deploy between $700 million and $750 million annually to private credit funds over the next five to six years, according to an investment plan prepared for the retirement system’s May 16 investment committee meeting.

The actual amount San Francisco will deploy hinges on which firms raise new funds during that period, as well as on the market opportunities for private credit managers, according to the plan, which was prepared by pension investment staff.

San Francisco has just 2 percent of its assets in private credit investments, well short of the 10 percent target allocation it set for the asset class. The system based its investment plan on a pacing model developed by its consultant, Cambridge Associates.

The portfolio will likely grow to include relationships with 15 to 25 firms, including separate accounts with as many as five managers, according to the plan.

“The separate accounts are expected to be structured as strategic partnerships between SFERS and a select few managers who have the expertise and track record of investing across multiple credit strategies,” according to the plan.

The pension expects the private credit portfolio to deliver annualized returns of 8 percent to 10 percent.

San Francisco, which launched its private credit program in 2008, valued the portfolio at around $380 million as of Sept. 30. The portfolio was netting a 10.8 percent internal rate of return and 1.33x multiple as of that date.

The private credit industry has exploded in recent years as non-bank lenders stepped into the void left by banks hamstrung by regulations implemented in the wake of the global financial crisis.

A recent white paper from Hamilton Lane said the private credit managers owned roughly $700 billion of assets, roughly double what they owned a decade ago. San Francisco, whose investment plan cited estimates indicating the private credit market — i.e., the size of the market private credit funds could invest in — had grown to between $2 trillion and $3 trillion.

The growth in that market created a supply/demand imbalance created by the absence of traditional bank lenders, according to the investment plan.

“We believe the private credit markets represent a large and new investment opportunity,” the investment plan says. “In addition, we believe that investment managers who are skilled at sourcing opportunities and underwriting credit will earn meaningful excess returns.”

The market naturally holds its share of risks for investors.

Competition among lenders, along with the wave of cash injected into the market by retail investors, has led to a resurgence of covenant-lite loans. These loans offer fewer protections for lenders and investors and now account for 77 percent of the outstanding U.S. leveraged-loan market, according to S&P Global Market Intelligence data provider LCD.

“Private credit is in a similar spot today compared to where we were roughly a decade ago on the equity side of the private markets,” wrote Hamilton Lane’s global head of credit investments, Drew Schardt, in the white paper.

“There has been much written of late about the rapid growth of the private credit asset class and the potential of a ‘bubble’ forming. Our view, rather, is that we are again just experiencing the growth and natural evolution of a nascent asset class.”

San Francisco did not respond to requests for comment.

Action Item: For more on San Francisco Employees’  Retirement System, visit mysfers.org

The San Francisco Bay Bridge at sunset, with the city in the background, on Aug. 11, 2017. REUTERS/Alexandria Sage