Dutch public pension fund manager APG’s US$750 million investment in ILX Management’s private credit fund, which is oriented towards Sustainable Development Goals (SDGs), demonstrates the weight state-owned investors are giving to private debt in emerging markets – as well as integrating debt exposures with ESG principles.

The ILX Fund I is targeted at an initial US$1 billion and will provide loans originated and structured by multilateral development finance institutions (DFIs), such as the Asian Development Bank and the African Development Bank. The focus will be on renewable energy, sustainability, and inclusive finance and food security.

Sjacco Schouten, head of Emerging Market Debt at APG, explained why APG has chosen a fund rather than invest via individual DFIs: “This initiative allows us to invest in individual projects and to decide what we do and do not want to invest in. The ILX fund combines loans from various DFIs, allowing it to build a broad and diversified portfolio, whereas individual development finance institutions typically focus on a particular region or sector.

“Investing in the fund offers us more flexibility in terms of our clients’ sustainability requirements, while we still benefit from the underlying DFIs’ long-standing track records in originating and managing private sector projects in emerging markets.”

Schouten noted that the fund enables APG to diversify and improve the risk profile of its EM debt portfolio, adding: “Private credit investments tend to have low volatility and a weak correlation with the more liquid credit investments that trade on public markets.”

From 2020, APG began measuring the carbon impact of its corporate bond portfolio and found a total of 7.3 million tonnes of CO2 equivalent – a 29% share of its absolute carbon footprint.

APG is following a trend observed across all ESG-sensitive investors. Most private debt lenders say they now consider ESG for all their investments, with almost half adding that sustainability best practices are a value-add to their investments, according to an industry survey released in November by industry group Alternative Credit Council in partnership with the law firm Allen & Overy. The research found that for private credit managers, “ESG is also increasingly ‘business as usual’, with the majority having already implemented changes to integrate ESG considerations across their strategies. These changes are being positively received by investors, but our findings indicate that they also expect more to be done.”

Private credit in general is viewed more favorably as low-risk investments with a reliable return have dried up and government bonds offer low yields, while there are fears of an end to a long bull run in public equity and a burst in the private equity bubble. The asset class was notably resilient amid the pandemic with managers successfully protecting their portfolio values as well as deploying dry powder to add assets. With traditional banks restricting lending, private credit will serve as a crucial source of financing in the economic recovery, particularly for mid-market companies.

With their eyes on long-term yield and risk diversification, state-owned investors have been ramping up their exposure to private debt markets since the 2008 global financial crisis, in line with the market trend. According to S&P Global, the private debt market grew 10-fold in 2011-2020 with funds primarily involved in direct lending reaching US$412 billion. Borrowers tend to be smaller, more leveraged than issuers in the syndicated leveraged loan market and unrated. Global SWF has estimated that the asset class has risen from 2.0% of the portfolios of state-owned investors to more than 3%.

By 2021, Canadian public pension funds were leaders in private credit among SOIs, with an allocation range of 8-11% of AUM.  The non-Canadian SOIs in the Top 10 including CIC, GIC, ADIA, Future Fund and CalPERS maintain more modest allocations, but still very significant in absolute terms due to the sizes of their balance sheets.

Emerging Asian markets are in the sights of SOIs, which are willing to take on the high risk as they offer potential high rewards. Asian EM junk bonds look set to be the focus of attention. Although EM high yield corporate borrowers saw an increase in defaults from 3.5% in 2020 to 4.2% in 2021, according to data from JPMorgan, they were still better than the US high yield market and are forecast to decline to 3.7% in 2022, two-thirds of which will come from China and much of the rest from Latin America. At the same time, recovery rates for EM corporate debt are also vastly superior compared to the US.

As with the case of APG’s investment in ILX Fund I, SOIs have favored partnerships with GPs or banks due to their added value and to the lack of internal capabilities, origination function and access to deals. Global SWF believes that SOIs will build up their own in-house management as they increase their knowledge and skills base and deepen and broaden their exposure. The evolution of private credit is set to see SOIs play the same pivotal role in the asset class as they do venture capital in the years to come.

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