Moderated by Jonas Wäingelin, NordicInvestor; Text by Hamlin Lovell, NordicInvestor 

“Given all the uncertainty in the markets, we do not see private debt as being very crowded. It is not crowded for asset owners….”

– Ville Toivakainen, Director for Private Assets at Evli

Allocators and asset managers from Sweden, Finland and the Netherlands discussed geographic diversification, market timing and distressed opportunities, credit ratings, defaults and workouts, sizes of corporate borrowers and consumer versus corporate risk. Most allocators’ existing exposure to private debt is well below their targets and there is plenty of capital to deploy.

The video from the discussion is available below as well as written a summary.

Panelists:

  • Patrik Jonsson, Head of Private Debt at Andra AP-fonden(AP2), 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) . AP2 has been able to invest in private debt since 2020.
  • Ville Toivakainen, Investment Director for Private Assets at Evli, which has total assets of EUR 14.5bn, of which EUR 1.8 billion is in alternatives, including private debt funds of funds.
  • Rens Ramaekers is senior portfolio manager in alternative and private fixed income in the European ABS and Mortgages team, at AEGON Asset Management, which manages and advises on EUR 311bn of assets.

Europe and the US dominate allocations

Economic and credit cycles and opportunity sets can vary between regions so most allocators will have some degree of geographic diversification in their private debt portfolios, though they may not yet be ready to go fully global.

“There is value in building a global portfolio. At the same time, there are so many opportunities in the US and Europe right now that we see no point for the time being in going to Asia, where there are few qualified managers,” argues Jonsson.

Toivakainen agrees: “Diversification is the cheapest lunch in building portfolios. Our exposure is two thirds US and one third Europe. We have not even tried to find managers in Asia because we are not comfortable with the market, have not spent enough time there and can get decent yields in the US and Europe”.

Ramaekers also concurs: “In Asia you would need feet on the ground and local connections to find the correct deals. Our main focus is on the Dutch side”.

Is it worth timing the market?

Some allocators interviewed by NordicInvestor judge that 2023 could be a good time to increase allocations to private debt in general, or specific areas such as distressed debt and special situations, while others do not attempt to time the market opportunities. “Rather than timing the market we try to build a portfolio with good diversification,” says Jonsson.

Distressed debt may be the most popular area for market timing, since the opportunity set can in many cases depend partly on levels of defaults, restructurings, bankruptcies and insolvencies, which will tend to increase to a recession or a sector specific downturn. Distressed can be seen as a cyclical opportunity, to take advantage of dislocations such as Covid, or it may also be an all weather allocation.

“During Covid the market bottomed out in three weeks. The IRR s look great but the capital could not be redeployed at the same levels of return,” points out Jonsson.

“During Covid, quite a few managers raised dislocation funds but were not able to deploy capital,” Toivakainen adds.

Therefore, allocators maintain exposure throughout the cycle. “We think that distressed debt and special situations have a place in portfolios at all times, and we do not try to time the market because that is next to impossible. The best managers can make multiples of 1,5z2x from multiple vintages of distressed debt, even though the average manager makes only single digit returns,” observes Toivakainen.

Funds can be branded as either distressed debt or special situations or a mix of both, but the headline names do not tell the whole story: “we find that labels, definitions and names such as “distressed debt” or “special situations” are less useful because the differences between the strategies are really complex. It is more useful to try and understand where managers are on the risk spectrum, what they do, and how they make money in which environments,” says Toivakainen.

Investment grade or non-investment grade risk or both?

Credit ratings are one way to categorise managers and strategies. Whether or not borrowers, or various structures, in private credit deals have any credit ratings, they can be viewed as equivalent to either investment grade or non-investment grade risk. Some allocators cover both types while others view private credit as being mainly a way to access more risky debt.

“We focus on both investment grade and non-investment grade, where we use certain guarantees to optimise risk return. In the private debt investment grade space, there are good opportunities to earn 200 basis point pickups in AA rated insured credit,” points out Ramaekers.

In contrast, other allocators view the space as a form of high yield debt. “For me private credit means non-investment grade risk,” says Toivakainen.

“We agree that private debt is focused on non-investment grade, but we still avoid the riskiest, junkiest and most over-leveraged companies and we are happy to sacrifice some returns. We are not sure all corporates will survive higher interest rates,” says Jonsson.

Interest rate risk can be viewed from different angles. One risk is whether borrowers who refinance can afford higher interest rates. Another perspective is the interest rate sensitivity of the instrument itself and high yield, with shorter average duration than investment grade, can show less sensitivity in terms of bond prices: “non-investment grade credit seems to have less interest rate sensitivity,” points out Ramaekers.

Changing deal risk profiles and increasing default risks

Whether or not investors are actively timing the market, those that make regular and steady allocations will anyway find that the risk/reward equation for private debt changes over time and could have improved recently.

“Over the last year we have seen some increase in spreads, and original issue discounts have increased to 2,3,4% or even 5% in the US, while leverage ratios have decreased. A combination of those factors reduces risk,” observes Toivakainen.

However much leverage is used, deal structuring is another important way to mitigate risk. “Documents and covenants have improved over the past year,” says Jonsson.

However, it is possible that terms have only tightened up to defend portfolios against increased default risks, and that the risk reward equation has not actually improved. The panellists agree that defaults will rise. “We definitely will see increased defaults,” expects Toivakainen. Jonsson agrees: “The past decade of ridiculously low levels of defaults was not a normal one. Defaults will be increasing but yields are high enough to generate good returns even assuming a reasonable level of defaults”.

When defaults do occur, managers need the wherewithal to handle them. “Limiting downside risk is key in private debt. It is critical that the manager knows how to build documents and set up covenants ion the right level so that they can react early enough so that they do not have to take the keys. Or if they do take the keys they should know what to do,” says Toivakainen.

Jonsson agrees: “A key factor when sourcing managers is their workout experience”.

Ramaekers uses deal structuring and guarantees to mitigate risks: “The sector is about keeping downside risk low. We work with guaranteed funds for the European economy to ensure lower losses and higher floors for recovery values. Even so, losses are currently at all time lows and might increase going forward”.

Consumer versus corporate risk

Ramaekers also prefers his specialist area of consumer risk: “as the economic cycle turns, we find consumer risk is very different from corporate or government risk and adds diversification to portfolios”.

Housing debt still offers attractive risk reward: “There are some similarities between Swedish and Dutch housing markets. Prices are coming down in both as borrowers are quite sensitive to higher rates. Yields can now be 4-5% and consumers still repaid loans even in the GFC of 2008-2009 in Europe,” says Ramaekers.

Diversification benefits of real estate exposure partly depend on existing portfolios.“We already have a lot of real estate exposure because AP2 owns 25% of the largest real estate company in Scandinavia. From a portfolio perspective it’s not a top priority to add more exposure. But there are many interesting things in the consumer space,” says Jonsson.

Some allocators admit that they do not realistically have the bandwidth to cover consumer risk at present. “We have not focused on real estate debt investing. Most of our risk is in corporate credit because it is more time consuming to select outside corporate credit. We need to know underlying risks, and prefer fundamental to statistical analysis,” says Toivakainen

Is borrower size important?

Toivakainen is cautious on very small company risk for similar reasons: “Our managers lend to all sizes of companies, from large to mid market and lower mid market, but not microsize. We would not lend to companies with less than 5 million EBITDA because the risk then becomes more statistical than fundamental. We are also careful to select managers who focus on one size segment because very few of them cover the whole market,” he adds.

Though the largest companies usually find it easier to access public markets, private debt can potentially serve companies of all sizes, especially when public markets freeze up. “The upper end dominated by broadly syndicated loans and bonds shut down over the last twelve months, whereas direct lending is the primary source of funding for the lower mid market,” observes Toivakainen.

“We lend to a mix of larger and smaller companies. Larger companies are in a better position if things turned sour,” argues Jonsson.

  • What is the next frontier?

For real diversification benefits allocators might need to get outside their comfort zone, think outside the box and explore new areas. “Different types of private debt strategies may be a better way to diversify than different sizes of borrowers. We also look outside plain vanilla direct lending because private debt is a huge asset class with different opportunities in different types of lending. We sometimes find more odd managers, presentations and strategies to be quite interesting, though we have not invested off piste yet,” says Jonsson.

Readers should watch this space for more exploration of more esoteric areas of private debt.