By Jonas Wäingelin, NordicInvestor
This article forms part of our upcoming report on alternative credit in the Nordics
Ericsson Pensionsstiftelse has been investing in private credit since 2011 and see it as a core component in their asset allocation, representing roughly 12% of total AUM and almost a third of the allocation to alternatives, which in turn makes up almost 40% of the total AUM (which was c. SEK 29 billion or EUR 2.7 billion at year end 2021). Most of the exposure is in Europe. NordicInvestor interviewed Ericsson Pensionsstiftelse’s portfolio manager, Michael Levén, who previously worked at AP3, the Third National Swedish Pension Fund.
“Private credit is a very attractive asset class for managers who can select the right sorts of credits,” says Levén. Ericsson Pensionsstiftelse expects to get improved risk adjusted return through yield pickup and downside protection. Rising interest rates – generally linked to LIBOR benchmarks for the time being – can however be a double-edged sword that needs to be carefully managed.
“The low duration risk, and inflation protection due to its floating rate nature, is also a positive as long as the underlying portfolio companies are able to tackle higher interest costs, it is therefore critical to invest with managers that have solid skills in fundamental company analysis and credit underwriting,” Levén explains.
The larger part of the alternative credit allocation is in private debt, including direct lending, in senior and junior structures as well as stressed and distressed. In public markets, the main exposures are high yield bonds, leveraged loans and structured credit CLOs.
Opportunistic private credit may be increased to take advantage of market turbulence and higher returns. “We target net IRRs in low to mid-teens for junior debt and stressed credits, compared with net IRR of 6-9% in local currency (USD or EUR) in direct lending . A large part of the currency exposure being hedged back to SEK,” Levén explains.
Yield pickup on private debt is generated by coupon income and also fees: “we expect between 200-400 bps in pick up over more liquid loans depending on segment and strategy, although we have no fixed target for yield pickup,” he explains further.
Yields make up most of the return, but there is also OID (Original Issuer Discount) and other fees.
The pick-up on private debt comes from several factors including illiquidity, sourcing and structuring. “Borrowers often accept a premium for speed and certainty of execution. However, it is difficult to split the yield pickup into the various parts,” Levén admits.
On structured credit in November 2022, the yield pickup might be even higher: “It is roughly 400-900bps in yield pickup for BBB, BB and B CLOs compared to bond equivalent,” he notes.
Spread per turn of leverage is another big picture metric but it does not allow for all risk factors. “We often see 40-50 bps extra spread per times of leverage, but broad dispersion between different segments should be considered to compare apples to apples”
Most investments in alternative credits are in closed end funds but Levén says that lately he has been allocating to semi-liquid funds with quarterly or annual liquidity. “We do look carefully at the liquidity options in open ended funds to make sure there is no liquidity mismatch between the fund and its underlying assets,” he adds.
In common with most Nordic allocators, Ericsson Pensionsstiftelse is aware of secondary markets, but have not used them. “The secondary markets in areas like direct lending have developed during the last couple of years but we have however not been active on the secondary market, neither as a buyer or seller,” Levén says.
Leven is well aware of default risks, but is confident that good managers can reduce them. “We see default risk as the key risk in our private debt investments,” he says and continuous; “Even if floating rate investments have very low duration risk, companies and consumers may not be able to afford interest costs above a certain level. As long as you have a view on default rates and recovery rates, you can get a clear indication of whether the risk reward is attractive or not.”
To mitigate this risk, Ericsson Pensionsstiftelse seek managers that have solid skills in fundamental company analysis in order to be able to minimize downside by investing in less cyclical sectors and companies.
The reality is however that no manager can guarantee zero defaults in every year, so they must have the resources and expertise to handle difficult situations such as workouts and restructurings when they arise. In Levén´s opinion, private debt can expedite restructurings: “Compared to the syndicated loan market, private debt has the advantage of being a bilateral discussion between the lender and the owner of the company, instead of dealing with several different shareholders and creditors. Therefore recovery rates for private debt are often higher than in the syndicated loan market,” he concludes.
Ericsson Pensionsstiftelse has a dedicated ESG due diligence and has developed its own ESG ranking system where they rate managers on a scale from 1 to 5. There is both an overall ESG score from 1 to 5 and scores from 1 to 5 for each underlying sub section: “Managers generally need to have a minimum overall ESG score of 3 for us to invest in them. If they fall short, we sometimes suggest the manager to make improvements after which we will make a new evaluation. In some instances, we have turned managers down due to them not living up to our ESG standards,” Levén explains. He also point out that though there are numerical scores, the assessment is qualitative: “Instead of hard requirements, the managers need to have ESG policies and frameworks in place and organizational resources to support them and report on ESG,” he adds.
The ‘G’ in ESG needs to consider practical constraints for private credit managers, who cannot usually vote or sit on boards. Though a minority of private debt managers may have board observer rights, Leven, who was once a private equity manager at Ratos, does not expect them to have as much power as private equity managers. “Private debt funds generally have less influence than PE managers on a company’s ESG agenda since they do not control the companies and hence the requirements we have on our private debt managers differ a bit from PE,” he notes.
Some Nordic allocators have a strong preference for SFDR 8 but Ericsson Pensionsstiftelse keeps an open mind, and may also have some managers outside the scope of SFDR: “We do not target any specific mix between SFDR 6,8 and 9. Managers in Europe and especially the Nordics have generally come much further than managers outside the EU and managers with non-EU domiciled structures also do not need to disclose under SFDR,” Leven admits.
Ericsson Pensionsstiftelse does not target specific SDGs within private debt though some managers are targeting various UN SDGs
Ericsson Pensionsstiftelse has invested in some managers for over ten years, and maintains a close dialogue with them, so may be able to complete DD on a new fund from existing managers within a month or two. “For a new manager it might take years to get to know them before investing in them,” says Levén and adds “There are no hard criteria on the length of track record. If possible, we like to see how managers have performed in tougher market environments. It is important that teams have worked together before”.
Ericsson Pensionsstiftelse has no hard hard minimum for assets at the firm or vehicle level but the focus is generally on well-established managers. “Our ticket sizes tend to be EUR 25-40 million which means we are generally neither too small nor too large an investor for most funds,” Levén says. There is no specific limit on what percentage of a fund can be owned.
Generally, the DD is entirely done in house but for legal DD the pension fund either uses Ericsson internal resources or outside legal counsel. In certain instances, they also use external tax advice.
Ericsson Pensionsstiftelse is unusual in the Nordics in occasionally using consultants to help with manager searches: “sourcing mainly comes from existing relationships and networks. In some cases we have also used external consultants to do a broader search and screening,” says Levén.
There are some Cayman funds and Cayman was removed from the non-cooperative list in September 2020: “We have a mix of on-shore and off-shore commingled funds as well as SMAs but avoid domiciles that the EU has deemed to be “non-cooperative” jurisdictions,” Leven concludes.
