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Thursday, Oct 6, 2022
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County Retirement Fund Ponders Making Loans

The board that oversees the $9.1 billion pension fund for San Diego County retirees is considering deploying some of that capital into direct business lending.

While the nine-member board of retirement has only received a report from its portfolio manager on the subject, they agreed to hear more information on selecting possible managers to actually conduct the underwriting and manage the loans.

“This is not a new investment vehicle. It’s fairly well established,” said Brian White, chief executive for San Diego County Employees Retirement Association.

In the report provided to the board by consulting firm Hewitt EnnisKnupp, it says the fund has a lot of opportunity in the direct lending space because there are fewer lenders making the loans, and the attractive spreads that can be earned on the loans.

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It’s also another way to diversify the fund’s investments, said Lee Partridge, SDCERA’s portfolio strategist. “Diversification is a good thing … and this is one way to extract that.”

Partridge, whose firm Salient Partners of Houston, signed a five-year contract to direct SDCERA’s portfolio starting Jan. 1, said that direct lending could generate returns that are twice what the pension fund was getting from its high yield bonds. Consultants said the returns on the loans, net of any fees and expenses to the hired managers, would range from the “high single digits to the low double digits.”

The loans envisioned by the consultants are aimed at middle market companies that are generating operating profits of at least $50 million, with loans ranging from $20 million to $200 million. The terms would range from five to seven years and carry floating interest rates ranging from 5.75 percent to 8.5 percent, according to the Hewitt EnnisKnupp report.

After adding fee income charged to borrowers on the origination, prepayment and modification of the loan, the investments could yield 7 to 12 percent annually, the Hewitt report said.

The lending wouldn’t be done by pension fund officials, but by a hired management firm that specializes in this type of direct lending.

Hidden Dangers?

Several retirement board members expressed skepticism about getting into the lending business, noting that many banks are making fewer business loans.

“What do they know that we don’t?” asked Dan McAllister, a trustee who also wears the hat of San Diego County’s Treasurer-Tax Collector.

Satya Kumar of Hewitt said many regional banks that had been doing this lending were damaged during the last real estate bust and are now focused on repairing their balance sheets as well as dealing with other regulatory issues.

Several other players such as GE Capital and CIT, which went through a bankruptcy, and hedge funds, are doing far less of this sort of lending, Kumar said.

“We see a tremendous opportunity to capture liquidity premium that exists in the marketplace today,” he said.

The prospect of a local pension fund getting into the lending game didn’t impress several local bankers.

Gary Cady, chief executive at San Diego-based Torrey Pines Bank, with about $2 billion in assets, questioned whether the fund’s hired managers would have the same level of expertise to safely underwrite loans and ensure they are repaid.

“This would be something that the banks, which have been in business many, many years, have been doing,” Cady said. “For (the pension fund) to be thinking of participating in this, they’ll need to make sure they have a strong team of consultants or employees.”

Cady was also doubtful about the expected yield on the loans, saying the average margin for bank loans these days was less than 5 percent. Banks generate that spread, called the net interest margin, from the interest rates charged on the loans extended less the rates they pay on deposits, which is the source for the loans.

Another SDCERA trustee, County Supervisor Dianne Jacob, asked what would happen if the borrowing company goes broke.

“That is the risk we bear here in making these types of loans,” Kumar said.

Partridge said that SDCERA already did some business lending through another investment vehicle that generated some above average yields.

Recovery Rates

He also noted the loans would be senior to equity and bond investments, and in the event of a default, would likely have higher recovery rates than what most banks get if loans sour.

In the Hewitt report, the recovery rate on bad loans was listed as 80 to 90 percent of the loan’s par value versus 66 percent of the par value on bad loans made by banks.

Still, some trustees had misgivings and noted the interest rates were well above what most lenders were charging these days.

Kumar acknowledged the rate disparity and the higher risk of the credits. “These are (companies) that are below investment grade and they are companies that can’t access the capital markets.”

The county pension fund returns have been exceptional in recent years. Last year, it outperformed 95 percent of other public pension funds with assets greater than $1 billion. For the fourth quarter, SDCERA reported a gain of 2.1 percent, and for all of 2012, the fund’s return, net of management fees, was 13.3 percent.

In addition to investing in stocks, bonds, real estate and private equity, SDCERA expanded its horizons several years ago by putting chunks of the fund’s money into hedge funds. The pension fund has some 37,000 members including 15,000 retirees.

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