By Hamlin Lovell, NordicInvestor 

This article forms part of our upcoming report on alternative fixed income in the Nordics

Evli Plc in Helsinki has total assets of EUR 14.5bn, of which EUR 1.8 billion is in alternatives, including direct investments in domestic real estate and Northern European growth companies, as well as global funds of funds in private equity, infrastructure, forestry. The latest launch is a series of private debt fund of funds led by Investment Director for Private Assets, Ville Toivakainen, who was hired from Aktia in November 2020 to set up this new business line.

The first close for private debt was in May 2021 and now it has over EUR 100 million of assets. There will be a second fund in 2023, and currently Evli is also raising assets for a second infrastructure fund and a third private equity fund. The client base includes professional investors, like institutions, family offices and high net worth individuals.

“The main attractions of private debt are its illiquidity premium versus liquid credit, diversification for client portfolios, downside protection from hard assets and collateral, stable cash flows, and floating rate interest rate exposure,” says Toivakainen.

Evli has allocated to seven managers so far and aims to build diversified portfolios rather than timing the different sub-strategies. There is exposure ranging from direct lending to opportunistic special situations and distressed. Having said that, the relative appeal of the strategies does vary slightly with the environment. “In good times, direct lending is very attractive whereas in more uncertain times the more opportunistic strategies can be more compelling. However, we don’t try to time the market but build diversified, all-weather portfolios over time. The split as of August 2022 is 60% direct lending and 40% opportunistic,” points out Toivakainen.

Currently, most of the exposure is to corporate risk; there is very little in structured credit, mortgages, or specialty finance like various consumer loan portfolios (though Toivakainen is familiar with these sub-asset classes from his career in the industry).

Steady return targets

Though currency hedged share classes exist, most of Evli’s investors into private assets opt to take the currency risk, which also means that return targets vary between regions. “Return targets for senior floating rate direct lending strategies could be 6-7% in Europe and 7-8% in the US while opportunistic strategies might target 10-12% or even as much as 15% for distressed. Total return has increased for loans due to the floating rate nature of loans, and there has been some signs of spread pickup on new loans, but it is slower moving than in public liquid markets,” explains Toivakainen.

There is no fixed target for yield pickup, but some return over liquid markets is sought: “It could be a premium for knowledge, harder to understand assets, and less competition in lending to smaller companies or companies with some short-term challenges. It is hard to quantify exactly where the premium comes from, but it could include complexity, sourcing and structuring. Most borrowers are willing to pay a premium for speed, certainty, and flexibility, which are the main reasons for borrowing from a direct lender,” observes Toivakainen.

Cash drag can dilute returns in multi manager portfolios. Evli seeks to minimize cash holdings in portfolios, and would not use any short-term credit strategies for cash management. 

Secondary markets, in funds or individual loans, might offer better liquidity. “We might use secondary markets to increase allocations to some funds we know. We have not done any co-investments into individual loans,” says Toivakainen.

Default risks

Credit and default risks are what investors get paid for and are always the key risk. “We do expect that private debt will sometimes default. We invest in managers who have the resources, expertise and knowledge to go through challenging times and to avoid becoming forced sellers. In credit investments, the strategy is not about maximizing upside but rather about minimizing downside. We look for fundamental company specific analysis rather than statistical exercises,” he explains. “Political uncertainties, recession, inflation and rising rates are our second biggest fear,” he adds..

Fund structures

Closed end funds are used to avoid any mismatch between fund and underlying asset liquidity. “Open ended fund investors can redeem at the wrong time, which then means the manager needs to focus on that. Closed end funds can really focus on long term opportunities but also allow our managers to take advantage of opportunities caused by other forced sellers,” he argues.

Some hybrid structures are a halfway house between open ended and closed ended, perhaps offering limited liquidity windows. “We have seen hybrid funds but they can turn out to be easy to get into but hard to get out of. The liquidation mechanisms need to be closely looked at. We have not invested in them now in private debt,” says Toivakainen.

ESG: integration prized

On ESG, Europe is ahead of the US and also has a different emphasis. “Europe emphasizes more the E side while the US has had more focus on the S and G,” he adds.

But ESG does not have to be compartmentalized, it can be more holistic: “we like to see managers integrating ESG into their investment and risk processes and really using ESG parameters,” he finds.

Historically, equity owners have had more strategic influence on ESG at company level, but credit investors can also play a more activist role in shaping the design of loan: “Even in US we are starting to see sustainability linked loans where KPIs like carbon emissions or water consumption metrics can lead to lower or higher interest costs. In Europe, most new loans have some ESG margin ratchets,” he notes.

Yet it is still a challenge to find the same KPIs for all strategies and managers:“They are trying to gather as much information as possible from companies, and are starting to harmonise what and how they report, but this is at an early stage”.

SFDR

Most funds are making disclosures under SFDR article 6 or 8, and Evli has only seen handful of credit funds doing so under article 9 so far. “We would want an impact strategy to be making disclosures under article 9. Evli is pursuing impact through forestry strategies, but not currently in private credit,” reveals Toivakainen.

The choice of SFDR category varies between strategies: “most direct lending funds aim to be article 8 but some opportunistic funds are more likely to be article 6, though US funds and managers may not need to disclose under SFDR – unless they set up an EU domiciled structure such as a Luxembourg vehicle,” points out Toivakainen.

“For all managers we negotiate a side letter to make sure we get enough information over time. Direct lending managers in general are providing better quarterly transparency anyway,” he adds

Reporting and ratings

No specific SDGs are being targeted at the moment, but managers are increasingly reporting carbon or other measures.

Evli does its own ESG ratings on a scale from A+ to C, and would not invest in a C rated fund. It can invest in a B rated one but would require enough confirmation through side letters. In any case side letters need to get comfort on excluded sectors.

Manager searches

Evli does not invest in start-ups but about 15-20% of its 150-200 manager meetings per year are with new managers. Evli only invest in about 5% of managers they meet and it might take years to get to know managers before investing in them. In addition to long term relationships in the industry, sourcing comes from conferences, industry peers and news.

Seasoned teams are sought: “there are no hard criteria on the length of track record, but they do need to demonstrate a record of deploying capital and financing and getting money back from companies. It is important that teams have worked together before. Even if each individual has a good track record we cannot be sure they will work well together,” explains Toivakainen.

Similarly there is no hard minimum for assets but the focus on established managers means they tend to have multi-billion levels of assets. The sweet spot size of a fund could be 1 to 5 billion or so. Current ticket sizes of EUR 10-20 million are not a large percentage of any funds, but Evli would not anyway want to be over 10% of a fund.

Most vehicles are Luxembourg or Cayman domiciled comingled funds. There are no separately managed accounts.

Outlook

The outlook is promising. “There is a good balance between growing demand for and supply of private debt. Private credit managers have proven to be good partners for companies and sponsors in good and bad times. When the liquid market shuts down private debt continues to provide financing. Investors are allocating more to the asset class while companies are more comfortable with private loans. Some direct lenders are becoming a primary source of financing while distressed and special situations can benefit from volatility. It is a well balanced asset class,” concludes Toivakainen.