By Jonas Wäingelin, NordicInvestor
This article forms part of our upcoming report on alternative credit in the Nordics
Andra AP-fonden(AP2) is the second of Sweden’s five buffer funds within the Swedish pension system. Total assets under management amount to 411,7 bn SEK (EUR 37,9 bn) and the fund has a global mandate which allows it to invest across all asset classes. In recent years, rule changes have allowed more flexibility for the funds to invest in private markets with the funds now being allowed to hold up to 40 % of assets in illiquid securities. In 2020 the rules were further relaxed to allow investments into private debt (previously only private equity was allowed).
We had a long sit down with Patrik Jonsson, Head of Manager Selection Public Markets and Private Debt, to discuss how the fund is building its private debt portfolio from scratch, where they are looking to allocate going forward and the process of selecting the managers he wants to work with in the long run.
“Traditionally, we have had an allocation to what we labelled alternative credit. These were externally managed mandates in public credit such as high yield bonds, leveraged loans, CLOs and structured credit.” Jonsson begins.
The total allocation accounted for 2% of the funds AUM and with rule changes coming into effect in 2020, the holdings were completely divested at the end of that year in favour of unlisted credit.
Illiquidity Premium
“We firmly believe there is an illiquidity premium to pick up in the private markets. As an AP fund, we have a long investment horizon and we can predict our outflows in a way very few investors can. As such, illiquidity is a very attractive premium to us”, he continues.
Patrik Jonsson has been with AP2 since 2015 when he joined to lead the selection and monitoring the funds external managers.
Internal and external alternatives
AP2 has increased its internal management over the years, but 6 % of AUM is still managed externally across 3 different investment buckets which Jonsson oversees. The firm also uses external managers for real estate, private equity, timberland/farmland and sustainable infrastructure, although these are managed by different teams.
“On the public side, we still have some external mandates for Chinese A-shares” Jonsson states. AP2 also have two global equities mandates managed externally and there is an investment bucket for Alternative Risk Premia;
“Following the global financial crisis the fund decided to divest it’s entire hedge fund allocation”, Jonsson explains. “This was before my time but the thinking was that hedge funds were not delivering what they were supposed to and that we were paying for very expensive Beta”, he explains further.
However, the fund did not want to give up on the idea of having absolute return strategies in the portfolio and so started looking at alternatives to traditional hedge funds.
Six alternative risk premia were identified and run as separate strategies. Three of these were managed internally but has since been divested. The other three were handed to external managers (merger arbitrage, convertible arbitrage and insurance-linked securities) and are still active.
“ILS is an interesting one because today it could perhaps be better suited in our private debt allocations” Jonsson ponders. “At the time we had harder constraints in terms of liquidity rules and so were limited to CAT bonds (catastrophe bonds) but there are several interesting strategies within ILS that are worth exploring and it is an asset class that can provide completely uncorrelated returns”.
The main focus over the last couple of years though, has been to build the non-listed credits portfolio.
“We have been looking at private credit and followed the market for quite some time but have not been allowed to invest until 2020” Jonsson says. “We made the first investments in early 2021 and will likely reach our allocation target sometime in 2023”, he continuous.
As the private debt portfolio is a direct replacement for the previous alternative credit allocations the total size is expected to be around the same, at 2% of total assets.
Complexity Premium
“The primary reason for our investments into alternative fixed income, both past and present, is yield pick-up. Although you could make an argument that this pick-up is simply achieved through lower credit quality.” Jonsson contemplates. “The reason we went from public credit to private credit is that we believe there is an illiquidity premium and, in certain areas, a complexity premium. The correlation argument is also something we find compelling. It is of great benefit to our overall portfolio if we can find strategies that are uncorrelated to traditional assets,” he concludes.
Indeed, finding strategies with uncorrelated return drivers seem to be one of the key objectives in Jonsson new role;
“Looking at your average direct lending fund there may be some temporary decoupling as you don’t mark to market. But, at the end of the day, it will produce more or less a one to one correlation to listed credits such as high yield and leveraged loans”, he observes.
Although the fund has already made its first investments the strategy is a work in progress and targets are moving.
“We will probably be re-writing our strategy for how our target portfolio of private debt should look. Private debt is a broad asset class in and of itself and there are many ways to slice and dice a portfolio and classify certain investments”, Jonsson admits.
Site visits
The initial divide was made geographically; “We will likely want to be overweight the US as it is a bigger market than Europe. Looking at Asia and the rest of the world it is difficult to find best of breed managers. Another issue with Asia is of course that we have been unable to travel and we want to meet our potential managers”, Jonsson explains.
The other clear divide was to classify the types of lending on offer in terms of seniority although this get muddy quite quickly as credit quality can vary within a sub asset class or single strategy.
“It is hard to build a portfolio without having a large exposure to corporate lending”, Jonson observes. To get started, a crude split of senior debt and non-senior debt was made by the firm. The latter could include consumer credit, speciality finance, distressed debt etc. This split is however problematic since the sub category (ie consumer credit) doesn’t say anything about the credit quality (senior/non-senior)
“One of the main difficulties in this asset class is that it is so new, it did not exist prior to 2008. Data is therefore lacking and even where data is available, you could question the relevancy of it. Also many of the deals being done are without a credit rating and one has to use one’s own judgement”, he explains further.
Reducing default risk
As an example Jonsson mentions default rates which he believes will likely go up no matter which historical number you chose to compare to.
“We wanted to invest in funds with low risk. Many funds, and specific transactions, we looked at had high leverage multiples. We wanted to find managers who would do deals at lower debt levels than the market in general”, he says.
In terms of return targets the firm has kept it simple and are looking for a certain pick-up against the equivalent listed portfolio but they do not communicate what level that is.
On the current state of the market, Jonsson is quite cautious although he sees better deals being done today than 12 months ago. He is quick to add that as long term investors, ”We don’t expect to see our money for five or ten years and we are perfectly comfortable with that. Exposure is built over some years and we do not have any ambitions to time the market.”
Raising debt levels is his primary fear “Many investors have become complacent toward corporate debt levels and what was considered unreasonable ten years ago are common place today”, he argues. “Add to that weak documentation and poor covenants and you have compounded the risk”, he adds.
Private equity sponsors and non-sponsored deals
This has also been a topic for discussion when it comes to doing sponsored vs non-sponsored deals. “The biggest reason for defaults is too much borrowing. This is not rocket science but the market seems to forget it from time to time. The question is whether the sponsors will still be there when the going gets tough? To me, its not obvious that they will”, Jonsson argues.
Further, he concludes that it is practically impossible to build a portfolio of only non-sponsored deals. “With the right managers we are not afraid to do non-sponsored investments”, he says.
In Jonsson´s opinion, the non-sponsored market has some characteristics that are quite compelling; less competition, better covenants and documentations. “The difficulty is sourcing the assets within private credit”, he adds.
While illiquidity premia is one of the main drivers of AP2´s pivot into private debt, Jonsson is of the opinion that a complexity premium can be at least as big as the illiquidity premium within certain deals. “Many asset owners are reluctant to do anything that sticks out of the crowd”, he argues.
Jonsson is of the firm belief that the private debt markets have some unique characteristics compared to more traditional assets; “In general it is dangerous to equate risk and reward in this space”, he says. “This is not a perfect market, far from it. It is driven by supply and demand of capital in certain segments. For example, sponsored lending with a low risk character has an abundance of capital available while other segments have been neglected. If you can find investments that are a little different and that may not fit in perfectly in certain portfolios, then you can get handsomely paid without necessarily taking on more risk”.
This line of thinking guides AP2 when they are researching sub-asset classes and managers to invest with. “If you are doing sponsored direct lending then you are in a very crowded space. You need to be a top 10 manager within your field for us to have a serious look”, Jonsson says. “We believe that size matters in this field and we are very picky about the managers we track”.
With that said, managers who can differentiate themselves and offer a unique proposition are always interesting; “The key challenge for us is finding niche strategies that can offer us uncorrelated return streams compared to traditional assets. If a manager has a unique position where they can carve out opportunities and create unproportional returns then we will listen with great interest”, Jonsson states.
In house due diligence
All manager selection is done by Jonsson himself and all due diligence is done internally “Due diligence is at least a month on the commercial and operational side, my colleagues help me with the accounting, administration and compliance so this is a team effort”, Jonsson is quick to point out.
It is safe to say that Jonsson is not a fan of cap intro teams or consultants. “I mostly find investment ideas through my personal network and having continuous contacts with managers”, he says. “Conferences are great for getting a sense of what people are talking about and you may be impressed by an individual person which leads you on to looking at the manager as a whole” he continues.
So far, the fund has made five investments (all in 2021) and three of those were with managers that the fund had previously been invested with. “The portfolio has a European tilt right now. This is not so much by design but rather the circumstances around Covid and our inability to travel to the US. This benefitted managers with whom we already had established relationships”, he explains.
Investing in private debt does present a special set of challenges compared to fund investments in the liquid markets; “It is a different space to navigate compared to other asset classes”, Jonsson observes. “The investment process is long and it is important to try to keep track of when managers will be fundraising.”
Hunting fee discounts
Jonsson keeps a calendar to keep track of when interesting managers are likely to be raising capital. His strategy is to be as pro-active as possible and stay one step ahead; ”I try to join launch calls and collect other types of marketing materials. Participating in a first close may give us some fee discounts which is positive. The trick is to try to plan your time so that DD can be done without having a gun to your head.”
In general, he views is the current market and investment structure as being far from perfect.
“Being a state fund, traditional fund structures suit us from the perspective that the Public Procurement Act does not kick in. This would however be the case if we were to do segregated managed accounts (SMA)”, he explains and continues “The closed end structures do have other issues such as us having to doing the work over and over again every time we invest in a new fund.”
Seeking evergreen funds
Jonsson´s opinion is that the market structure, being dominated by closed end funds, is ineffective for both investors and managers.
“We may be invested with a manager we like, everything is going according to plan and you have the exposure you are looking for. But a couple of years down the line the manager comes with a new fund and asks us to re-up in order for us to keep the same exposure as before. It seems to me not an efficient structure. I believe we will see more ever-green structures or hybrid versions in the future”, Jonsson speculates.
Another trend he sees in the space is consolidation where the biggest managers will get bigger and the smaller, specialised managers will be bought up.
“Lately we also see a clear trend of funds being offered with a broader mandate”, he observes. Jonsson was recently approached by a manager who was fundraising for a new fund that could invest across the whole cap structure and do both equity and debt “These types of funds are being offered by the biggest managers and it gives them great flexibility in terms of doing deals and offer “best ideas” solutions to companies”, says Jonsson.
“Personally I see the value in this type of proposition but it does create some difficult questions for us as investors as the returns are too low for our private equity portfolio but at the same time too risky for our private debt portfolio. Looking at our total alternatives portfolio it is hard to make these kind of strategies fit”, he adds.
Another area where Jonsson sees progress being made is ESG. “Managers want to move forward in their ESG work. Europe is perhaps a bit further along than the US but ESG credentials usually appear quite early in the pitch decks,” Jonsson observes.
While ESG is an important part of AP2´s mandate, Jonsson takes a very pragmatic approach to it, both on a philosophical level as well as a practical one.
”ESG ratchets are becoming more common with lower rates being offered to companies for certain projects. But my question is always if these are things that companies should be doing anyway and you just end up giving up returns?” he contemplates.
“The public side has seen a boom and bust when it comes to many things with high ESG credentials. Cleantech is a good example which was very hot a few years ago but has not exactly covered itself in glory for investors”, he continuous.
Certain sectors, such as fossil fuels, are avoided all together although Jonsson points out that these are not big sectors in the private debt markets overall. One investment has been made with Swedish manager PCP and their Transition Partners fund which has a very distinctive ESG theme. Impact investing is not permitted per se as the fund can not give up yield.
“For us, the most important thing is to find managers who have the same overall view on ESG. We are stuck with a manager for a number of years – for better or for worse – but if we have a common vision in terms of ESG then chances are they will invest in companies which we like.” Jonsson concludes.
