MOORLACH UPDATE — Direct Lending — January 24, 2014

It’s not big news that the fixed income market has played out and may be reaching the conclusion of its long-term bull run, now that interest rates are expected to rise in the next year or so. Investors are moving funds out of the bond market and into the stock market, which may explain recent highs for the Dow Jones Industrials, NASDAQ, and the S&P 500. Even Orange County’s PIMCO is incurring the change in the environment, reporting that $41 billion was redeemed from its Total Return Fund last October and that its CEO has resigned. When interest rates rise, the value of the bonds decline. So why purchase a long-term bond that pays 3 percent and can dramatically decline in value? One axiom that we used when I managed the County’s investment portfolio as the County’s Treasurer, now more than $7 billion, was “the trend is your friend.” And the market is adjusting to the change in the trend.

The market has also provided new opportunities. With tighter regulations on large banks, resulting from the recent liquidity crisis of 2008, many qualified businesses looking for a lender have been turned away and have had to look elsewhere. Consequently, some money managers have stepped in to fill the void, matching investor funds with reliable borrowers. Banks are still charging 8 or 9 percent for business loans, which is an attractive yield. And the terms require the rates to increase if the industry rates rise, such as the London Interbank Offered Rate (LIBOR), a strategy known as a floating rate. This protects investors from a decline in principal value. When a strong middle-market business needs funding to retire existing debt, complete a leveraged buy-out, consummate a merger or an acquisition, pursue stock repurchases, or to finance continuing operations, than a direct lending fund may be the answer. Earning 900 basis points plus LIBOR on a strong bank loan, net of fees, is much more attractive than, say, earning zero in a money market fund. And, when you have pressures to earn 7.25 percent on an annual basis, this is an opportunity worth considering. This topic made it to the front-page, top-of-the-fold, in today’s OC Register and is the first piece below. As the piece refers to a “presentation by NEPC,” as a bonus I’m including it immediately below the article.

Speaking of the pension system, the second piece is from the Voice of OC and continues on the Super Bowl of Negotiations theme (see MOORLACH UPDATE — Super Bowl of Negotiations — January 21, 2014). The irony in the piece is that Gov. Jerry Brown has approved raises at the State level, but he’s funding it with $73 million per year that he’s taken from the County of Orange’s annual budget. If only our public employee bargaining units had more sway with our Governor . . .

OCERS invests in direct lending

Experts advise caution in dealing with borrowers that banks turn down.

In the past year, the Orange County Public Employees Retirement System board has agreed to loan $450 million to companies in the U.S., Europe and the Asia-Pacific region, mostly little-known companies with poor credit ratings that need cash.

Officials are hoping the loans, made through investment managers, will supercharge earnings. But they acknowledge some of the investments are risky and each loan’s principal could be lost.

Retirement boards across the U.S. are exploring more exotic investments – well beyond stocks and bonds – to keep pace with promised pension benefits and large unfunded liabilities. Experts vary on the wisdom of chasing high-return investments, but most agree they should be limited in a public pension fund.

OCERS has invested more and sooner in direct lending than most other large public pension funds. Direct lending accounts for slightly more than 4 percent of the assets in the $10.9 billion OCERS fund.

“There’s no such thing as a 15 percent safe investment … There are reasons banks aren’t doing these loans,” said John Shoven, director of the Stanford Institute for Economic Policy Research. “It would be risky in the extreme if this became a large part of the portfolio. But at the 5 percent level, I (would be) willing to take the risk.”

Direct lending is part of the “shadow banking sector,” as one Standard & Poor’s report described it, which boomed after banks slowed their lending. Regulators tightened banks’ requirements, hoping to avert another credit crisis like the one that triggered the Great Recession. With demand for loans outstripping supply, specialized lending funds stepped in and courted institutional investors such as OCERS.

In 2013, pension funds committed $2.4 billion to direct lending, compared with $611 million in 2012, according to iiSEARCHES, an investment database run by the publisher Institutional Investor. Roughly 30 U.S. funds, small and large, have entered the market, including the Los Angeles County Employees Retirement Association, which earmarked $400 million, and the Detroit General Retirement System, which set aside $5 million.

Some are skeptical that members of the OCERS board, most of whom are not finance professionals, can effectively oversee these investments.

“Does the investment committee have the fundamental knowledge to monitor this and all the other little things they put the money into?” asked Peer Swan, an Irvine Ranch Water District board member and former director of Southern California Bank. Swan was one of the first to question the risky investments that caused Orange County’s 1994 bankruptcy.


Most of the borrowers are midsize companies with “non-investment grade” credit that cannot get traditional sources of capital. OCERS’ managers will be making loans typically from $10 million to $50 million.

Compared with fixed-interest bonds, these loans are attractive, experts say, because they have a “floating” interest rate typically tied to international bank lending rates. A floating rate could be beneficial when the Federal Reserve stops its quantitative easing, and interest rates rise. It’s less attractive if interest rates fall.

Bonds saw terrible returns in 2013, and pension funds have been searching for better alternatives.

“It’s a very creative niche,” said county Supervisor John ‍Moorlach. “If you’re doing all the proper analysis to determine if your borrower is a good risk, this seems like an appropriate investment.”

Orange County has invested in loan funds with eight investment firms that vet companies and negotiate terms. Beginning in April 2013, the OCERS board voted to invest $240 million in U.S. lending, $150 million in Europe and $60 million in the Asia-Pacific market. Ultimately, the pension fund is on the hook for the loans.

The companies might need to open a line of credit, to buy some new equipment, or to finance a leveraged buyout. In Asia, officials expect to lend for natural resource development.

OCERS’ direct loans will typically be secured by collateral – real estate, equipment, inventory and the like –but there are no guarantees investors will get paid in the event of a default. Most of the loans are “senior,” meaning OCERS would be first in line among creditors during a bankruptcy.

“You’re putting a lot of faith in these brokers that they’re operating in your interest,” said Shoven, the Stanford economist. “This is really a tough thing to do – sorting through some companies that by definition are not strong enough to access traditional credit markets.”

OCERS officials are confident they hired the best investment managers after months of evaluation and research.

“Consistent with best practices for pension board governance,” CEO Steve Delaney wrote in an email, “the OCERS board does not micromanage our money managers. We hire competent professionals with proven track records.”

The lure of direct lending is high returns. Typically, the underlying loan interest rate is in the high single-digits. With other fees and interest, OCERS expects at least one firm’s annualized returns to top 15 percent. Taken as a whole, officials expect all their direct lenders to return in the high single digits. Its Asian manager boasts a 27 percent annualized return since 2004, before taking its management fees, according to a memo by Orange County’s general investment consultant, NEPC.

“You can’t afford to avoid opportunities that are there, so you have to push somewhat in order to get the return,” said Robert Griffith, a retired county employee and former OCERS board member who voted to invest in direct lending before his term expired in December.


Early returns from two funds are low. During the month of November, the most recent for which figures are available, one of the direct lenders earned 1.4 percent, and the other lost 1.5 percent. OCERS officials say some of the loss is due to that fund’s startup costs. They cautioned against judging performance based on short-term returns.

To date, about $150 million has been transferred to the investment managers, out of the $450 million allocated to direct lending. OCERS officials point out the fund’s broader credit investments – the larger umbrella that will cover direct loans – account for its highest-earning asset class over the past five years.

For all its potential high returns, direct lending comes with significant downsides.

Nearly 3 percent of borrowers on average couldn’t make payments between 1995 and 2012, according to a presentation by NEPC, the consultant for OCERS, on leveraged loans, a comparable investment. Also, lenders were unable to recover the value of collateral in 35 percent of these loan defaults, the presentation said.

Both measures were better than those for high yield, or junk bonds.

Another disadvantage with the loans, officials say, is the relatively long time an investment is “locked in” – some managers want commitments up to five or six years. If banks loosen lending, experts say, direct funds might not command such high interest rates.

Tightened banking regulations – specifically the requirement for more capital –forced many European banks to withdraw from these types of loans.

European managers will lend OCERS money in the United Kingdom, Germany, France and other developed countries. Some money is going to pan-European companies based in Spain.

Asian-Pacific borrowers are spread throughout developed and developing economies: China, Indonesia, India, Australia, Singapore, Malaysia, South Korea and Japan.

Only two other public pension systems had invested with the Asia-Pacific manager as of late last year, according to OCERS – the Missouri Department of Transportation and another fund that couldn’t be disclosed publicly. OCP Asia, the investment firm, offered OCERS discounted fees because it was one of the first investors.

After Chief Investment Officer Girard Miller returned from a due-diligence trip to Hong Kong and Singapore, the board unanimously approved the $60 million allocation to OCP Asia.

Any potential losses there would be “negligible in the big picture,” Miller wrote in a memo to the board. He called this investment a “high-income cashflow generator.”

“Anything like this that’s new requires significant due diligence and research, and I felt Girard Miller had done that,” Supervisor ‍Moorlach said. “It’s a business decision. You’re being compensated for taking the risk.”



County to Sheriff’s Deputies: Pay Full Pension Share


With the Super Bowl of labor negotiations in overtime, the last offer has been sent out to the most politically powerful labor group.

The Orange County Board of Supervisors this week delivered their last, best and final offer to more than 1,800 deputy sheriffs.

And it’s a rough one.

The county offer asks all deputies to pay their full employee share of their monthly pension contribution, which has continued to soar in recent years.

Estimates show that deputy pension costs — between employer and employee — will soon represent nearly 75 percent of each deputy’s total compensation.

In the current offer, deputies will be asked to contribute as much as 16 percent of their paychecks toward pension costs. It’s a stark increase, up from about 6.6 percent for those currently receiving the lucrative 3 benefit (3 percent of pay for each year worked up to age 50).

County officials now pay just over 60 percent of a deputy’s compensation to pension costs as part of the employer share.

In addition, the county offer includes steep reductions in premium pay ranges.

Both concessions are offset by a proposed 1.25-percent pay raise is meant to offset those two major concessions.

While the Association of Orange County Deputy Sheriffs has sent an email to its members announcing the offer, it’s not clear whether members will be able to vote on whether to accept the deal.

Association President Tom Dominguez blasted county supervisors in a statement sent to Voice of OC Thursday:

From the very beginning of this negotiations process, we have put prudent economic solutions across the table. We proposed paying 100 percent of our share of pensions in January 2013. Unfortunately the Board of Supervisors has expressed little interest over the last 17 months in exploring numerous cost saving measures and working toward a fair and equitable deal. This is purely political for the Board of Supervisors.

The Supervisors’ last, best and final offer as it stands will destroy the quality law enforcement residents have come to expect from the Orange County Sheriff’s Department and the Orange County District Attorney’s Bureau of Investigation. It is unconscionable for the Board of Supervisors to propose what amounts to between a 15% and 18% pay cut to deputy sheriffs and district attorney investigators, especially in view of the numerous concessions, givebacks and pension modifications AOCDS initiated and made to help the County successfully navigate the recent difficult economic times and save the taxpayers millions.

We remain hopeful that the Board of Supervisors will fulfill their duties as elected officials and continue to maintain quality law enforcement services for the people they serve.

Most county supervisors did not return a call seeking comment on their opinion of the offer extended to law enforcement officers. Supervisor Todd Spitzer is the only Republican on the board who voted for the lucrative 3 pension benefit for deputy sheriffs in 2001 during an earlier term in office.

Supervisor John Moorlach did step forward to comment on the issue. He said the offer is a sign of the times.

“We’re dealing with a situation where the state has made our budget going forward very austere,” Moorlach said.

To date, the only bargaining unit that has been offered a raise was the county managers, which achieved a 1.25-percent raise through mediation after initially refusing the county’s offer.

The one group getting a raise this year is the county supervisors. They got an automatic 1.4-percent raise, because Gov. Jerry Brown increased the compensation for judges and supervisors’ pay is set to 80 percent of a judge’s salary.

While Brown authorized the raise for county supervisors, Orange County taxpayers get to fund it, because it comes out of the county general fund.

Moorlach said he is looking into whether he can legally decline the raise. It seems he will have to fight a county counsel opinion, which has not been disclosed, that was issued to all supervisors advising them that they cannot refuse the raise.

“I have certainly taken a 5-percent pay cut during the height of the recession," Moorlach said. "I’ve also started to pay toward my pension. This is new and came as a surprise.”

“I haven’t yet come to a conclusion about what I’m going to do. But I will give it a serious review,” he added.

Moorlach said he has already contacted other attorneys to look over his options.

“I’ve have contacted some key people about options and alternatives, and I’m waiting for answers.”

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