By Hamlin Lovell, NordicInvestor 

This article forms part of our upcoming report on Private Assets in the Nordics

NordicInvestor interviewed Tero Pesonen, Director of Private Equity and Private Credit, to hear more about the firm’s focus areas in private equity and private credit, where it is finishing fundraising for its private credit fund of funds and recently held first closing for Private Equity fund of funds.

LocalTapiola allocates to external private equity and private credit funds, while real estate investments have been made directly in Finland. Infrastructure has not yet been allocated to in any kind of scale. “The main reason for allocations is to earn illiquidity premia and differentiated sources of returns; reducing portfolio volatility is not an objective, though it is an inevitable outcome”, comments Pesonen

Private Equity: Mid Markets Sweet Spot

Private equity allocations are mainly mid-market buyouts, with secondaries being the other main focus area. “To focus on mid-market buyout is a strategic decision for us. Buyout’s main return-driving strategy, buy and build, works well in the mid-market. Growing underlying companies is easier than in the large company space and all three exit routes are available: i) IPOs, ii) sales to industrial players iii) and sales to bigger buyout funds. In contrast, the largest funds running more than $20 billion have more limited exit routes,”.

Be Selective in Buy and Build

At the moment, buyout math is slightly challenged, but not broken. “High entry valuation multiples and fat equity tickets in addition to higher financing costs require buyout managers to truly show their skills in growing and making the target companies more efficient. However, if history has taught us anything, it is that equity always tends to find a way in the end. When times are better, buyout managers can do a dividend recapitalization or refinancings smooth things out to create desired outcomes.“

Secondaries’ Disappearing Discounts

The secondaries book has more buyouts and less venture capital. Also, it avoids large leveraged secondaries players.

Many media reports have highlighted discounts in secondaries, but there was only a brief time window when everything had a discount. “That window has to some extend gone now. It was mainly related to the denominator effect and overall uncertainty, though some of that still lingers in the market. Going forward, we are not counting on abnormal discounts because a lot of money has been raised creating a considerable amount of dry powder,”.

Avoiding Venture Capital

“We are concerned that venture capital needs to go back a long way in history to get a positive DPI and we still see more room for venture capital valuations to come down”.

Credit spreads too tight

“On the credit side, it is surprising how tight spreads are on the listed side of the world. Markets are surprisingly liquid and there also seems to be a technical bid in the market which is partly because of limited new issuance. High Yield and Leveraged Loans are not really getting paid for credit risk. Total yields look compelling, but most of it is the risk free rate, and pricing is not that good on a spread basis. Also, documentation remains weak which will create issues down the road”.

Direct lending yield pickups down – and documentation deteriorating

A lot of capital has been raised in the direct lending space. Also, banks have returned to the market to regain market share. These developments have led to direct lending spreads compressing. “In Europe, direct lending spreads in the middle market are 525-575 bps (and there is continued pressure for tightening) so the illiquidity premium on spread basis to leveraged loans has come down to 100-125 bps. In US the spreads are even tighter. Among other things, the amount of retail money raised to the sector in US means the supply of capital is extremely high”.

Documentation is getting worse too: “The market is being standardized and commoditized. Club deals represent nowadays majority of the financing transactions, so that direct lending looks a lot like syndicated bank loan market some years ago. Documents and covenants are still better than in leveraged loan market, but are nowhere near as tight as 10 years ago”.

Macro and Defaults Outlook

The macro outlook differs between Europe and the US: “In Europe, it is much harder to keep rates high for very long (though surprisingly and opposite to recent history, Southern Europe has slightly better macro)”.

Higher for longer could anyway cause problems. “The longer rates stay high, the more we should expect an eventual lag effect on consumers and companies”.

Fundamentals have not yet deteriorated, though there are some signs of weakness: “with no covenants, defaults may be delayed and we will see deterioration long before companies actually default. A better indicator could come from operators like Lincoln, the biggest third party valuation agent in the US. Their data is showing the percentage of loans with PIK interest is up from 5% to 15%, a clear sign of stress”.

Defaults will eventually happen: “When defaults finally do occur, recovery rates will be much lower than in the past. Personally, I predicted them to be below 50% but recent examples have shown even lower numbers. We do not however expect a systemic event, but more prolonged period of constant flow of challenged balance sheets. Hopefully there will be a darwanian Survival of the fittest shakeout that eventually would lead to some form of a distressed cycle”.

Private equity fund of funds launch

LahiTapiola’s private allocations were originally only internal, but in 2019 the firm decided to commercialise the strategy by accepting external investors, currently making up about 10 – 20% of assets (depending on asset class). In private equity, where ticket sizes are increasing, it is raising Fund VI.

There is a mix of strategic and tactical allocations. “The aim is to keep the private equity allocation at a strategic level whereas in credit, we are more opportunistic. Tactical allocation decisions take place within each vintage, depending on macro, fundamentals and demand/supply of each sub asset category. In private equity, Secondaries are one way in which tactical decisions can be pursued”.

Private credit fund of funds launch

The third private credit fund of funds can allocate across all areas of private credit. “Real estate credit is probably the most interesting at the moment given the stress in the real estate market. Due to higher interest, assets are being underwritten at about 15-20% lower levels. It is possible to get relatively safe loan at a reasonable LTV-level with decent pricing. Direct lending is still part of the strategy mix, but significantly smaller part than in the past. In case we see signs of a real credit cycle during the next 6 to 12 months, more opportunistic corporate credit will most likely be the biggest allocation from fund III. The overall portfolio construction will include some litigation finance and possibly some more esoteric strategies. Solvency II treatment of each target fund needs to be carefully analyzed for regulatory capital charge purposes”.

Return targets

Return targets are as high as 13-15% net for private equity. The credit fund target was originally set at 7-9% in April 2022, when the original documentation was done. Target has since been revised so that the fund targets double digit returns from it’s underlying funds.

Pesonen expects some more spread tightening, though investors do need an illiquidity premium.

Types of risk premiums

Direct lending no longer offers a complexity premium. “Liability management exercises are one example that could create a complexity premium. Managers with differentiated dealflow can sometimes earn a sourcing or structuring premium. It is still a people business, though efficiency is improving through auctions to get better pricing and terms”.

ESG

ESG questionnaires and checklists are part of the due diligence process, though it is very difficult to get the data. “We expect managers to be UNPRI signatories and/or have an ESG policy based on the UNPRI principles. If they are not there, it is extremely difficult move forward with that manager”.

Reporting under SFDR article 8 is becoming standard in Europe, and the reality is that it may restrict access to some opportunities.

Climate remains the top priority. Some managers are reporting DEI (Diversity, Equality and Inclusion) data for their own staff. DEI has been more of a US phenomenon, but increasingly also in Europe.

Manager selection and sourcing

Managers are selected mainly from networks rather than conferences. Third party marketers can play a bigger role as well. “We are also proactively reaching out to funds in databases, and it can be frustrating when managers’ compliance function prohibits managers from responding due to unsatisfactory wording”.

The private equity roster of managers is more stable, than the credit book which is seeing more new managers.

No minimum length of track record is set in stone managers, though first time funds are more difficult to allocate to. There is also no hard minimum level for fund assets. The sweet spot in the buyout universe tends to be in a range of 1-5 billion. Within credit funds, the range is far wider as different strategies work better with different fund sizes.

LocalTapiola would generally not want to be over 10% of a fund, which is easily achieved with a typical ticket size of EUR 25-30 million and the smallest fund being EUR 300 million.

Luxembourg is often used as a domicile. Legal and tax due diligence are outsourced.

More evergreen structures are being seen in the credit space.