By Jonas Wäingelin, NordicInvestor 

This article forms part of our report on Alternative Credit in the Nordics which you can read in full here

Elo Mutual Pension Insurance company in Finland has been building its private credit portfolio well over a half a decade. Elo has a well-diversified portfolio of direct lending, specialty finance, asset backed lending and special situations strategies in the US and the EU. NordicInvestor interviewed Tuomo Hietaniemi (pictured left) and Antti Kortela (pictured right), Portfolio Managers, Private Debt Funds, to talk about strategies and allocations going forward.

The key reasons for Elo to allocating to private credit are yield pickup, diversification & decorrelation benefits,” says Hietaniemi.

The asset class has demonstrated its advantage amid rising interest rates in 2022: “We highly appreciate the floating rate nature of private credit. Having modest interest rate risk has benefited us over the last year or so,” he continues: “Overall, it provides high risk-adjusted returns, relatively short duration and repayment period with steady and stable cash flows.”

In most cases, Elo is allocating to relatively cautious and conservative managers who deploy capital at the conservative end of their peer group and who have well-resourced and experienced teams. “Therefore, we believe the amount of watch list credits and heavy lifting work outs continues to be below average in our portfolio and our managers can play offence when the time is right,” says Hietaniemi.

Having said that, Elo is expecting some workout situations to emerge but private debt managers are relatively well placed to handle them in general. Fast and  straight forward workout process is one of the key merits of private debt in our opinion,” Hietaniemi says “It is an essential part of preserving the yield pickup and private market alpha.”

Elo has purposely taken a conservative approach. “So far, our portfolio companies have proven to be resilient. However, we think we are in early stages of this credit cycle and the real test is still ahead of us. We should see delinquencies picking up gradually in H1/2023”, Kortela admits.

To mitigate this, we focus on managers who can produce better than average return/risk profile with lower-than-average credit losses. “Our strategy tries to avoid the most volatile sectors and highly leveraged deals,” he points out.

On top of the core allocation to private debt with regular commitments, Elo makes some tactical calls over a 12 to 24 month timeframe. Elo is invested in both direct lending and opportunistic credit strategies. “This has been made possible by being proactive and having done a great amount of footwork over the years”, Kortela says. “We have a good number of managers deploying capital both in the traditional direct lending market and in the stressed/opportunistic credit space”, he concludes.

Within the opportunistic credit space, special situations funds with a broader mandate can decide on the timing of distressed opportunities and invest also outside distressed: “we have approached distressed/stressed credit through special situations funds as timing the distressed credit market has proven to be difficult. Special situations funds which are thoughtfully sized and have great origination capabilities seem to be less timing sensitive. They are able to find interesting situations to invest even in times when the distressed opportunity is not there.”

Elo also focuses on picking less efficient parts of the market as certain segments continue to offer a higher yield premium, including middle market borrowers who are not linked to private equity sponsors. “We do believe that “higher yield premium” still exists in certain alternative credit sectors. These might be non-sponsored middle market borrowers, asset backed specialty finance borrowers or even large cap borrowers with e.g. complex corporate structures and need for speed and certainty of closing,” Kortela and Hietaniemi say.

Elo has recently kept a close eye on the growth of secondaries and is one of relatively few Nordic allocators who have started to participate in this market: “We see a growing Private Debt secondaries market, especially in Direct Lending. PD secondaries is now where PE secondaries were 10+ years ago. We find this an interesting and developing part of the PD investment universe,” Kortela concludes.

Private Credit target returns typically range from mid-single digit to mid-teens. “Historically the target returns have varied between 6% and 15% depending on the strategy. In opportunistic credit strategies we expect to earn double digit returns and in core credit strategies high single digit returns”.

Elo is optimistic that 2022 vintages will likely generate higher returns than recent vintages. “We believe the vintages being now deployed should reach 2-3% higher returns than previous vintages. This is partly due to rising base rates. Interestingly we are observing 50-150bps margin increases in addition to the rising rates”.

Elo estimates that non-sponsored deals currently have 100-150 bps higher yields compared to sponsored deals. Historically the yields have been 200-300 bps higher.  This yield spread is partly a reward for the extra effort involved and capacity constraints. For instance, Originating and underwriting non-sponsored deals is hard and deployment pace typically choppy. We have found less than handful of managers that excel at this. In general, funds that focus on non-sponsored deals also invest in sponsored deals to some extent,” they observe.

In contrast, yields have been less attractive in some relatively more crowded areas of the market such as the US sponsored upper middle market. That being said, he admits that even this segment looks a little better right now, as the yields are so much higher.

Elo is currently quite cautious and more selective when it comes to making new commitments and they aim to navigate potential recession predominantly with managers with whom they have been investing before: “Roughly ¾ of private debt managers are existing managers. As a rule, we don’t invest in first-time funds. We analyze track records mostly based on their current employer track record”.

Kortela and Hietaniemi attend around 100 manager meetings per year of which 10-15 % could be first time meetings. It can take years to get comfortable with a new manager. “Our strategy has been to follow a manager at least one fundraising cycle before engaging in a full scope due diligence.

ESG integration is a welcome and growing trend. “We are glad that nowadays almost all of our managers, even the smaller ones, have an ESG policy and almost all are PRI signatories,” Hietaniemi says. However, “Managers should take their policies and actions to the next and more concrete level”, he adds. Uniform and standardized data and reporting would be appreciated. The team is following the ILPA working group on solving this issue.

Elo is committed to Paris-Aligned Net Zero portfolio.  Besides decarbonizing the portfolio, this also means increasing investment in carbon solutions and engaging in line with the net zero targets.

Elo encourages fund managers to monitor and reduce the carbon footprint of their investments and consider climate change in their investment strategy. “We recommend managers to report their climate risks and opportunities in accordance with the TCFD framework,” says Hietaniemi.

“We have recently surveyed our managers on how they approach climate issues, including policies, targets, metrics and reporting,” he admits and concludes:

“Achieving net zero will require collaboration between all participants: governments, local authorities, investors, businesses, the public and other stakeholders”.