By Hamlin Lovell, NordicInvestor 

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

NordicInvestor interviewed Petri Lehtola, Portfolio Manager at OP Asset Management ltd, which allocates to credit mainly in the US and Europe. OP Group has several billion invested in Alternatives in various formats. Alternative Credit investments are about EUR 750 million in total, and the average ticket size is 20-million Euro. The fund investments team oversees investments in Hedge Funds (OP manages R2 Crystal Hedge Fund of Funds), Alternative Credit (OP advises OP Group’s balance sheet investments in this area), and also manages a broad open ended Alternatives Fund called OP-Alternative Portfolio Special Mutual Fund.

In common with many Nordic allocators, OP’s main reasons for allocating to alternative and private credit are yield pickup, diversification and decorrelation benefits and stable returns and cashflows. In addition, Lehtola finds that, “Alternative credit is a good way to promote sustainability / ESG in private markets”. 

In public debt markets, OP could consider adding to special situations or distressed debt, possibly via flexible alternative credit funds.

In private debt markets, opportunistic credit strategies are being increased, which is partly a tactical move on top of the strategic allocation: “Higher inflation and rapidly rising rates are creating market turbulence, and this should benefit Special Situations and Distressed/Restructuring funds & strategies,” says Lehtola. Conversely, if the macroeconomic backdrop normalizes back to low inflation and lower interest rates, this move could reverse. “Perhaps in that scenario we would put more weight in Direct Lending vs opportunistic credit,” says Lehtola. For now, the direct lending allocation is being maintained and could be increased.

Meanwhile, OP is monitoring asset backed lending and specialty finance as well.

Yield pickups

OP normally targets 7-8% in direct lending and 12-15% in opportunistic credit, though in late 2022 both yields were widening, albeit slower than in public debt markets. “They are rising more slowly, as there is no need to over-react as in public markets,” says Lehtola.

However, the raw numbers do not tell the whole story. Private debt yields have arguably risen further on a risk-adjusted basis: “the quality of underwriting is improving in 2022 which makes it harder to compare to the levels we saw in 2021,” points out Lehtola.

Relative to public debt, OP expects an average pickup of around 3%, including illiquidity and complexity premia. Complexity premia could range between 1% and 5% depending on the strategy, and sourcing or structuring premia can be in a similar range.

Liquidity and vehicles

Higher interest rates mean that there are now more choices for cash management. “We tended to keep cash in bank accounts, but recently short-term credit and money market funds have become an option in many portfolios,” says Lehtola. The cash is still being quite conservatively managed, with no alternatives used for short term investments.

OP offers both closed and open-ended vehicles. “Most internal and institutional client money is in closed end funds, but we also run open ended vehicles for those who prefer to have the liquidity option,” says Lehtola.

OP is amongst a distinguished group of allocators in the Nordics that have made use of secondary markets: “We are not very active in this space but have taken some opportunities on the way if wide discounts have been available,” he points out.

The new economic climate

OP is closely monitoring macroeconomic risks around the default and interest rate environment. “Default risk is key in credit investing, and it should also create good opportunities after a volatile period, when managers’ underwriting skills, restructuring skills etc. are really important,” says Lehtola.

“Rising interest rates; how high rates will rise and what it will mean for the economy and companies is a concern. The pain is already becoming visible for consumers and many companies,” he observes.

The coming months and years could mark a real test for private lending funds. “Overall, direct Lending funds are facing their first real market turbulence that is lasting longer (than was the case in Covid period), and central banks are not there this time as QE has turned into QT, at least not now,” he expects.

Expanding and Improving ESG Data and Reporting

Exclusions are consistently applied internally and externally: “we have applied our exclusion criteria, including e.g. weapons, and limits for thermal coal, when screening potential external managers, with the aim to ensure that their exclusion policies are in line with ours,” says Lehtola.

Climate policies are steadily being expanded from direct and liquid investments to external and illiquid investments: “climate is a priority for us. We are a signatory of the Net-zero Asset Managers Initiative and have submitted our medium-term targets that currently cover listed equity and fixed income portfolios. Our short-term targets include expanding the analysis and targets to cover indirect investments and illiquid assets. As metrics and analysis become more available and widespread, we expect better estimates for carbon emissions and environmental impacts to become a standard in private markets as well”.

To further these objectives, OP is building up its proprietary ESG data analytics and reporting: “data availability is a challenge, and we are looking into applying climate and environmental impact metrics in our alternative credit portfolios. We collect the data through our annual surveys for external managers and this currently already includes some climate metrics. Our current KPIs, that we use in our ESG reporting, relate to ESG policies and procedures, available resources, exclusions, and climate commitments”.

Moving onto the social side of ESG managers are taking the initiative as well: “manager reporting on DEI (Diversity, Equality and Inclusion) data for their own staff is becoming more common in reporting, especially in American markets,” says Lehtola.

A growing SFDR article 8 universe

Lehtola expects to see a growing universe of SFDR article 8 funds: “Credit market (both public and private) trends in Europe point to more demand for Article 8 products. We expect this trend to continue and as such there will be more opportunities available for Article 8 products. There is likely to be a strong tilt towards article 8 strategies in European markets, even in the short term”.

Currently it is not realistic to allocate only to article 8 funds, if you wish to keep diversification geographically and by strategy, our balance is around 30/70 between article 6 and 8. This is partly because managers are being slower to adopt article 8 for some strategies: Article 8 is becoming a norm in European Direct Lending, where it does not restrict these strategies. In Opportunistic Credit, article 6 is still the standard due to the nature of these strategies, where article 8 could be restrictive. We are starting to see article 8 funds now also in Special Situations or in Distressed debt universe. It’s interesting to see how this develops in the near future.”

“And course SFDR is not that relevant for many US managers, yet,” he adds.

Impact Investing and Article 9

Article 9 partly awaits clarity and finalization of the regulations: “For article 9 products we expect to see some adjustments as the level two reporting requirements have now come into effect,” says Lehtola.

Although OP does not currently have any Article 9 alternative credit products, it manages an Article 9 OP Finnfund Global Impact Fund that has both equity and debt investments in emerging markets. It pursues a wide range of impact goals: “We don’t target any specific SDGs at the moment but in our Impact Fund we aim for high impact through several SDGs that address job creation and financial inclusion, gender equality, and climate action: SDG 1, SDG 2, SDG 5, SDG 7, SDG 8, SDG 9, SDG 12, SDG 13, SDG 14,” explains Lehtola. (Note: We have also interviewed OP Asset Management’s Head of ESG. Click here for full article)

Manager Selection

OP’s due diligence process usually takes 3-6 months. Investment due diligence is done in house, but external, legal and tax advisors can be used where needed. OP has 300-500 manager meetings a year, of which 15-20% could be first time meetings. Around 75% of investments are repeat investments into new vintages from existing managers.

On assets,we like to see about 1bn firm level AUM or a clear path to it. Fund level minimum size is about EUR 300 million. We generally do not want to make up more than 10-20% of a fund and given our ticket sizes, and for us funds make more sense than managed accounts given our ticket sizes”.

Managers are sourced from a wide variety of routes: Seminars and Conferences; Cap intro teams; Industry colleagues; Third party marketers; Online databases; Investment advisors and existing relationships/networks.

Domiciles are a mix of onshore eg Ireland and Luxembourg, and offshore eg Cayman, Jersey and Guernsey.