VFMC has developed a private credit risk model that provides better and more timely investment insights. Already, VFMC is starting to see the benefits both at an asset class and total portfolio level.
Victorian Funds Management Corporation (VFMC) has been investing in private credit for well over a decade. In 2019, private credit became a standalone asset class and in 2022 the triennial strategic asset allocation (SAA) review further upweighted the allocation.
Throughout this process, the need to have a more objective, quantitative understanding of the risk profile became increasingly important. A key question was: how much risk is there really in private credit?
VFMC’s funds have performed well since the GFC, but how would the current portfolio actually perform in another major downturn? And beyond downside risk, where are the best risk-adjusted returns to be found? Only by comparing the risk and the return by manager, by strategy and by other factors can this question be answered.
We were thinking about splitting out private credit from an opportunistic bucket that had a whole lot of other things, such as hedge funds, into an asset class in its own right. So really understanding how much risk at the whole-of-portfolio level was coming from private credit was important in terms of portfolio construction - Mark Aarons
As part of the wider Investment Risk Uplift Project at VFMC, the Portfolio Risk & Solutions team together with the Absolute Returns team and strategic partner Silver Creek started to search for a model that could reliably and credibly help to answer these questions.
It took over a year to develop and implement, but VFMC is now starting to see the benefits of this new model in its risk management and investment decision making.
“When we embarked on this project three years ago, we really wanted to know at a whole-of-portfolio level how much risk was coming from private credit,” Mark Aarons, Head of Investment Risk & Absolute Returns at VFMC said during a presentation at the [i3] Fixed Income, Credit and Currency (FICC) Forum last month.
“Back then, we were thinking about splitting out private credit from an opportunistic bucket that had a whole lot of other things, such as hedge funds, into an asset class in its own right. So really understanding how much risk at the whole-of-portfolio level was coming from private credit was important in terms of portfolio construction,” he says.
Triennial SAA Review
More recently, VFMC’s triennial SAA review indicated that the challenging investment environment of lower expected returns meant clients were at risk of not meeting their investment objectives.
VFMC needed to make some key asset allocation decisions but didn’t just want to increase the exposure to growth assets in order to meet objectives, as this could result in imprudently high levels of risk in the portfolios.
Instead, it decided to increase the weighting to private markets asset classes, including private credit, for its major client portfolios.
“We came to the conclusion pretty rapidly that we couldn’t increase the weighting to equities too much further because of the risk budget that our clients have, not to mention stretched valuations” Aarons said.
“But if we could better understand our so-called “mid-risk” asset classes and see if they truly are mid-risk, and whether we can tolerate the illiquidity that comes with higher allocations to private market assets, then we can actually achieve our clients’ original objectives, notwithstanding the reduced expected returns,” he said.
VFMC has a broad private credit portfolio that contains a range of different assets, including direct lending, corporate distressed, non-performing loans (NPLs), structured credit and specialty finance, amongst others. In total, the portfolio holds over 2,000 different underlying investments across seven managers.
We came to the conclusion pretty rapidly that we couldn’t increase the weighting to equities too much further because of the risk budget that our clients have, not to mention stretched valuations - Mark Aarons
To get a good handle on the risk in this portfolio, Aarons and his colleague Dom Beckers, Senior Portfolio Manager for Absolute Returns at VFMC, developed a model that requires each underlying investment to provide 24 key data points across various metrics including yield, maturity, seniority, security, industry, leverage etc. Conversations with managers can also provide further information around covenants and other deal-specific elements.
Based on this information, they then sought appropriate proxies with long histories for each investment to inform them of changes in the risk profile of the portfolio quickly. The model also takes into account the fact that private credit holdings are illiquid and reporting can be infrequent, causing a lag between insights into the portfolio and current developments in markets.
“There are common families of proxies where we find that if we risk-adjust them appropriately then they do give us a good handle on the risk,” Aarons says. “It is a little bit factor-like, but the heart of the model lies in the risk-adjustments we make to the proxy, based on the idiosyncrasies of each investment,” he says.
Manager Engagement
A substantial amount of work was involved in quantitatively determining specific risk adjustments, including decomposing 20 years’ worth of constituent-level data for some major credit indices into sub-categories.
Beckers says that a key challenge in developing the model was getting the managers to provide them with all the relevant information.
“When we started conversations a few years ago with our managers the first response was: ‘Why would you want to know that? This is our information and we are not going to give you that information’. An education process with the managers explaining why we were developing the risk model and how the data would help VFMC in risk managing our growing allocation to private credit, ultimately led to all of our managers providing this data on a quarterly basis” Beckers said.
“One of our key focus areas over the last few years has been to deepen our strategic relationships with our managers. The data provided by our managers is a win-win scenario”.
“Win-win in that this data and information allows us to measure and manage the risk in our portfolio better and allows us to better tailor the portfolio, be there when there are dislocations and allows us to provide more money to the manager by taking advantage of those situations,” he said.
When we started conversations a few years ago with our managers the first response was: ‘Why would you want to know that? This is our information and we are not going to give you that information’ - Dom Beckers
Once the information was provided, the team then needed to find the right proxies to base their risk model on.
“We developed, together with our partners at Silver Creek, a model of 160+ proxies and assigned one to every single item in the portfolio,” Beckers said.
“Proxies include leveraged loan and other credit indices, property indices and equity proxies. It is really a large scale of different proxies that are transparent and most of them are daily or weekly priced, so it is something that we can update frequently,” he said.
“Our private credit asset class consists of very idiosyncratic trades across diverse segments. How do you compare the returns of an RMBS (residential mortgage-backed security) deal, against a distressed loan from a widget maker in Nebraska? Having this risk model goes a long way in being able to compare risk in different assets/portfolios and allows VFMC to make better risk-adjusted investment decisions.
“In one example, we found that the risk in a direct lending fund was substantially higher than we might have thought due to the amount of leverage. Insights like those have enabled our team to reconsider the relative risks across the different private credit strategies.
“We can now slice and dice the portfolio in very different ways than we were able to do 18 months ago,” he said.
The new model not only gives the team a better handle on risk, it has also reduced the information asymmetry between VFMC and its external managers. This could potentially see VFMC exploring co-investments in the private credit sector in the future, and possibly also exploring derivative overlays in this asset class.
“We’re starting to think about: are there different ways that we could use credit derivative overlays or co-investment programs down the track to further enhance the management of our private credit portfolio?” Beckers said.
“Up to now, it was very much a classic LP/GP structure; we didn’t embark on a co-investment program.
“But now that we’re able to measure risk better and are able to understand where the pockets of relative value are in our portfolio, we can explore adding new levers to our portfolio,” he said.
__________
[i3] Insights is the official educational bulletin of the Investment Innovation Institute [i3]. It covers major trends and innovations in institutional investing, providing independent and thought-provoking content about pension funds, insurance companies and sovereign wealth funds across the globe.