By Hamlin Lovell, NordicInvestor 

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

Local Tapiola manages funds of funds, allocating to alternative and private credit, on behalf of the 21 Local Tapiola companies and other investors. Its last two pooled vehicles had commitments of around EUR 300 million. NordicInvestor interviewed Tero Pesonen, Director of Private Equity and Private Credit, at Local Tapiola Asset Management Ltd in Helsinki, Finland.

“The main attractions of alternative and private credit are yield enhancement, diversification and potential for alpha through structuring,” says Pesonen.

Inflation or liability matching are less relevant, and fortunately Solvency II is generally not a significant constraint because the firm has a surplus. “It can be a slight hindrance, for example, in investing into structured credit where the treatment is less favourable,” clarifies Pesonen.

Sub-strategy diversification

The strategy mix in the fund of funds is starting to change. “Direct lending is being reduced and the mandate is being broadened out to include a wide variety of private credit categories. Tactically, allocations also take account of the current cycle, which could be opportune for distressed debt,” points out Pesonen.

“Generally speaking, the idea is to broaden the available universe of risk-/return combinations, diversify the exposures and give portfolio management more tools to react to the changes in the market environment. This does not mean increasing the risk, on the contrary, the more flexible approach allows the use of wider collection of return drivers, hence better diversification,” he explains.

Target returns and premia

Target returns in the underlying funds range from 6% to 15% net in Euros. The blended mix works out at between 7-9%. This range remains relevant in 2022: “So far we have noticed spread widening of perhaps 150 basis points at the upper end, with less movement visible thus far in the mid market and smaller size deals. However, lenders are able to demand slightly better terms,” observes Pesonen.

Since most direct lending is to unrated companies, it does not always make sense to look at spread pickups versus credit ratings. “But leveraged loans could be a useful comparator, and there historically the pickup has been 200-250 basis points over levered loans,” says Pesonen.

He argues that, “the premium is mainly for illiquidity, since direct lending has become more standardized and competitive over the past 10 years”.

It is in other strategies where there could be a larger premium for complexity and sourcing: “distressed networks and legal knowledge could be needed for more esoteric transactions such as secondary purchases from banks, it is a different ball game. Larger portfolios may also need servicing capabilities,” he finds.

Vehicles and structures

The fund of funds could have a life of 10-12 years and the underlying funds will tend to be 5-8 year closed end fund structures. The firm has not invested in open ended or hybrid structures via current fund of fund-structures.

“On the private equity side, we already have a sizeable allocation to secondaries, and might invest in private debt secondaries, but have not been active so far,” says Pesonen. “Co-investments into individual deals could be contemplated, but they would need to be a bit special,” he adds.

The fund of funds products minimize short term cash holdings.

Default risks and recovery rates

After hardly any defaults since GFC, one risk is a resurgence in default rates, especially for more mature deals. “Losses may also be larger than historically: recovery rates have been coming down, so historical recovery rates are probably not achievable. Covenant-lite is one problem and more broadly, more and more businesses are asset light with no hard collateral, which will also bring down recoveries,” Pesonen fears.

In this environment, managers need the skillset to take over and restructure assets for exit. Higher defaults also improve opportunities for distressed and more opportunistic special situations-managers.

Economic outlook

Matching his concerns about defaults, Pesonen is somewhat pessimistic: “I am not an economist, but as a credit guy I always see a half empty glass. There is profit margin pressure for companies, and if consumer spending starts to fall, there may also be top line revenue issues. Higher rates would then be a triple whammy as well”.

He does not necessarily see permanently higher inflation: “Long term sustainable inflation may not happen until wage inflation pressures appear”.

ESG

External help is needed for ESG data because manually collecting it takes too long and is inefficient: “we are looking to outsource the data collection – and then query the data quality!,” says Pesonen.

The fund of funds will initially be making disclosures under SFDR 6. “We do not want to limit the universe to managers labelled as SFDR 8 or 9. This may change over time as the industry evolves if SFDR 8 becomes the standard,” explains Pesonen.

The firm is not allocated to any SFDR 9 funds yet in credit or private equity: “if we wanted to pursue impact investing through credit, we would launch a separate fund of funds vehicle.

Targeting the UN SDGs is an ongoing process and LT are wary of greenwashing.

Due Diligence

The team has 200-300 manager encounters a year, and it is hard to say how many are first time meetings but many come from long standing relationships: “networks of relationships built up over 20 years are the most useful for sourcing managers. Third party marketers can also be useful, particularly for niche strategies. Conferences are sometimes attended. Capital introductions are less relevant for private strategies”.

Due diligence typically takes three months and it is rare to invest in a completely new manager. “We might do so if we know the team from their previous employers. We would want to see managers have at least one fund under their belt,” says Pesonen. Most DD is in house but tax and legal are outsourced.

In general LT forms long term relationships with managers and stays with them so long as their performance is good and within guidelines. “We are happy for managers to grow funds but not to mega size. The range of fund size on the private equity side has generally been from € 1 bn to € 5bn. It is very hard to see us investing in a fund smaller than 200-300 million. Managers may have more assets overall – PE managers might be running 10 billion, although private debt managers may be smaller”.

LT would not want to make up more than 10% of a fund, and there is a hard limit at 20%.

Domiciles are a mix of onshore and offshore. Funds are comingled.