As the search for better retirement outcomes for the 28 million members of the UK’s defined contribution (DC) pension schemes continues, where are the opportunities for DC investors in private debt and how can they be harnessed?
Read this article to understand:
- How the growth of the private debt universe has created a diverse and expanded opportunity set for credit investors
- Why we feel an allocation to private debt could improve DC member outcomes and why a multi-sector approach makes sense
- Specific considerations for defined contribution pension schemes across the full glide path
Investing in private debt is nothing new; in fact, all debt was private before the concept of public debt emerged. In the Middle Ages merchant banks brokered deals to channel private financing into the production and trade of commodities. And during the Industrial Revolution and into the Modern Era, the banking and modern financial system became central to private lending.
Over the centuries, the essence of private debt – channelling funds from lenders to borrowers – has remained unchanged. However, since the 2008 Global Financial Crisis (GFC) restricted the capacity for banks to lend privately, insurers and defined benefit (DB) pension schemes picked up the baton as lenders in this market, sourcing attractively priced assets.
More recently, DC pension schemes are increasingly considering illiquid assets such as private debt in the search for enhanced risk-adjusted portfolio returns and diversification. With this, we are seeing the increased emergence of vehicles to facilitate investment into this asset class, namely Long-Term Asset Funds (LTAFs) and European Long-Term Investment Funds (ELTIFs).
The heterogenous nature of private debt means investors can gain access to different risk drivers offering potential for a predictable income stream. This is compelling in an uncertain economic environment and is of particular relevance to DC pension savers closer to retirement. What’s more, private debt can also provide diversification benefits for all DC pension members given it has a lower correlation with equities and bonds. Investors are also attracted to the ability to invest in assets that have an environmental and social impact in alignment with their own goals.
This article covers three important takeaways from the private debt universe. These include insights into how to access different sector and return dynamics in a multi-sector approach, as well as thoughts on investment considerations for DC investors.
Private debt: An expanded opportunity set
A common misconception about private debt is that it relates solely to direct corporate lending. The opportunity set is much broader than that. Private debt can also cover real estate and infrastructure lending, as well as structured finance, which captures bespoke financing solutions that cannot be addressed through conventional lending (see Figure 1).
Figure 1: Private debt sectors
Real estate debt
Loans to commercial borrowers that support the acquisition or development of commercial properties – offices, retail, industrial, leisure, healthcare and the living sector.
The debt is typically secured against the underlying commercial real estate.
Infrastructure debt
Financing that supports the physical assets and systems that provide essential public services such as transport, technology, utilities and energy (including renewables).
These sectors typically have monopoly-like characteristics, predictable cash flows and a lower correlation to economic cycles.
Private corporate debt
Loans made directly to a variety of corporate and quasi-sovereign borrowers including large and mid-cap companies, across a broad range of corporate sectors, in the investment grade and sub-investment grade space.
Structured finance
Bespoke financing solutions across diverse asset classes such as public and private securitisation, and asset-related financing.
Increased complexity can arise from pooling of assets, deal‑specific structuring or the involvement of third parties.
Source: Aviva Investors, January 2025.
By participating in lending across the various private debt sectors and across different parts of the capital structure, investors can gain access to sectors with limited availability in public markets as well as a wide range of risk/reward profiles. This has implications for professional investors who might be seeking to diversify the risk drivers in their portfolios, with their own return objectives front of mind. Figure 2, which shows Aviva Investors’ five‑year projections for risk‑adjusted returns across the private market universe illustrates the superior returns available across each sub-sector.
Figure 2: Private debt sectors continue to offer the highest risk adjusted returns within private markets
Past performance is not an indicator of future returns.
Note: Graph is illustrated for a five‑year horizon. Risk is ex‑ante, based on the standard deviation of the forward looking, 5,000 internal rate of return (IRR) simulations. Private Markets inherently have different hold periods; this results in differences between the full‑life term modelled for each sector. As such, assumptions are required to normalise the five‑year IRR.
Source: Aviva Investors, Q4 2024.
An expanded opportunity set provides investors with enhanced possibilities to diversify and lower overall volatility.
It's important to look at the pricing dynamics of private market sectors, which move at very different speeds
Alongside the opportunity set, it’s also important to look at the pricing dynamics of private market sectors. Key to understanding this is to acknowledge that the markets move at very different speeds. Real estate debt spreads are very ‘sticky’ and slow to reprice to public credit spreads. Typically, if there is stress and illiquidity premiums get squeezed, activity slows down. Pricing and activity in this subsector is also very much correlated to the property market cycle.
Private corporate debt and structured finance are at the other end of the spectrum. These subsectors are comparable to listed credit and tend to be the quickest to reprice. In fact, during periods of stress, market illiquidity premiums can actually increase, especially if you see bank retrenchment or borrowers needing access to quick capital. This is more likely to be the case where there are pre-existing relationships with the borrowers.
Meanwhile, infrastructure debt spreads are more moderately sticky and sit somewhere between the two extremes when it comes to their responsiveness to the cycle.
Private debt can act as a buffer against market fluctuations
When thinking about investing in private debt over economic and credit cycles, different opportunities tend to present themselves across different sectors based on these dynamics. They also mean private debt can act as a buffer against market fluctuations, ensuring smoother performance across various market conditions.
This is also one of the reasons why we think there is merit in having a multi-sector approach when investing in private debt; it gives you the flexibility to take advantage of these various dynamics.
Portfolio construction considerations – investing with a multi-sector approach
Within private debt, various risk drivers across sectors can be leveraged to create a powerful source of diversification, especially when investing across multiple private debt sectors.
Figure 3 provides a detailed analysis of risk in these sectors. The narrow bars represent the forecasted IRR risk over the asset's life, while the wider bars break down this risk into the key components.
Figure 3: Private debt IRR risk and risk composition (per cent)
Source: Aviva Investors, January 2025.
The two key credit components of risk in private debt are default and recovery risk. As you move up the risk curve to lower credit ratings, these factors contribute more significantly to the total risk level.
Debt with floating payments also play a crucial role in IRR risk (compared to fixed rates) as they reduce cash flow certainty due to the unpredictable future path of interest rates.
A multi-sector approach to private debt can create a powerful source of diversification
By taking a multi-sector approach to private debt, you are combining different private debt sectors, fixed and floating rates, maturity profiles and credit ratings. This can create a powerful source of diversification.
Having the ability to invest across sectors within the private debt universe with flexibility can help with the speed of deployment, to deliver enhanced risk-adjusted returns over the market cycle and capture relative value. A multi-sector approach can also provide portfolio diversification benefits from publicly traded asset classes as well as single private debt strategies.
Where does private debt sit on the glidepath?
We believe there’s a case for private debt across all stages of the DC glidepath.
In Figure 4, we have used scenario modelling to illustrate how private debt could potentially help savers at different parts of their savings journey. Using our Capital Market Assumptions, we simulate portfolio risk and return outcomes over a ten-year forward-looking investment horizon for the early accumulation phase (Growth), consolidation phase (Balanced) and at-retirement phase (Drawdown).
Figure 4: DC illustrative portfolio outcomes (per cent)
Past performance is not an indicator of future returns.
Note: Outcomes assessed over a one-to-ten-year horizon as per June 2024 CMA release. Estimates are based on internal assumptions and simulations. Targets may not be achieved. Data used for assumptions are based on objective data and consider scenarios in different market conditions. The effect of fees would reduce the overall performance. Returns are stated gross of fees on an annual basis. ‘GIG’ refers to Global Investment Grade, ‘MSPD’ refers to Multi‑Sector Private Debt (HY Private Debt).
Source: Aviva Investors, ORTEC Finance. Data as of October 2024.
- Growth phase: The pink marker shows the expected annualised return in sterling that a younger saver might expect to receive for accepting 90 per cent of the risk of investing in listed global equities. It assumes a 90 per cent allocation to global equities and ten per cent allocation to bonds (sovereign and investment grade debt). If private debt were to deliver performance in line with target, allocating either five or ten per cent to it would likely boost risk-adjusted performance, as illustrated by the darker blue circles.
- Balanced phase: The pink marker shows the annualised return someone closer to retirement could expect to receive. In this case, the portfolio invests in global equities and bonds in roughly equal amounts. Once again, adding private debt could potentially improve risk-adjusted performance if returns are delivered in line with its objective.
- Drawdown phase: The pink marker shows the expected return from a portfolio with just 35 per cent of the equivalent risk of investing in global equities. 70 per cent of the portfolio is invested in debt and the remaining 30 per cent in equities. Here too, allocating to illiquid assets could potentially enhance returns for a similar level of risk.
Implementation considerations for DC investors
The DC market is evolving, with an increasing demand for private markets access to achieve enhanced diversification, higher risk-adjusted returns, and reliable income, all with the aim of improving member outcomes.
Historically, barriers such as lack of fit-for-purpose products, high fees, liquidity and implementation issues have hindered entry for many DC schemes. But this is changing.
Having oversight of relative value across the four sub-asset classes helps a manager to optimise risk-adjusted returns
Taking a multi-sector approach can offer advantages when it comes to speed of deployment and governance. Having oversight of relative value across the four sub-asset classes helps a manager to optimise risk-adjusted returns by comparing opportunities across the credit spectrum, sectors and jurisdictions and investing tactically.
For Trustees, this single access point significantly reduces the governance and operational challenges, minimising the burden typically associated with onboarding and overseeing multiple single asset class strategies.
Another deterrent from investing in private markets for DC schemes historically has been that of cost. However, alongside innovative new vehicles like LTAFs, the narrative has shifted from one of cost to one of value for money and improved member outcomes. Superior returns achievable through illiquidity and complexity premia, coupled with enhanced portfolio diversification and reduced overall volatility, have highlighted the appeal. Private debt also offers stability, acting as a buffer against market fluctuations, ensuring smoother performance across various market conditions.
Conclusion
For DC pension schemes, a multi-sector approach to private debt markets brings the potential for enhanced risk-adjusted returns, reliable income and portfolio diversification. It can do this by capturing relative value across the market cycle within a robust portfolio framework and governance.
A multi-sector approach to private debt can be effective across the DC glidepath
What’s more, it can be effective across the DC glidepath, providing a smoother ride through market volatility, value for money and improved outcomes for DC members.
All these factors make a multi-sector approach to private debt a valuable way to help DC pensions meet their goals.
