By Hamlin Lovell, NordicInvestor 

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

Pensam allocates approximately 15% of its EUR 25 billion assets to alternative and private credit. NordicInvestor interviewed Jimmy Lundby, Chief Portfolio Manager for Private Credit Investments, to hear about the priorities and focus are for 2023.

Pensam seeks attractive risk adjusted returns from alternative credit, including a higher return than more standardized asset classes. “The floating rate nature of loans is another advantage in a rising interest rate climate. If EURIBOR goes up our rates go up,” says Lundby. The broader liability matching is handled by another unit within Pensam.

Asset backing and structuring are other attractions. “There is a strong focus on collateral, asset-backed lending and senior infrastructure, where we think risks are fairly low,” says Lundby.

Structuring can also mitigate risks in private credit, through strong covenants, and the private equity style due diligence that managers carry out on their borrowers. “Our managers have a focus on strong businesses and lend to companies and markets with a strong focus on stable earnings and cashflows. As a fixed income investor, upside is limited, so we try to protect the downside,” points out Lundby.

There is also scope for diversification within the private credit allocation.“It is a very broad asset class. We use different building blocks to construct a portfolio with higher, medium and lower risk elements. The lower risk part is mainly about yield and the higher risk opportunistic part also seeks capital appreciation. We do not want to be too concentrated in one issue, deal, sector, country or geography”.

Cautious, selective and opportunistic allocations

Whether Pensam adds or reduces sub-sectors of credit depends on their relative value in terms of risk reward. “We are only in a sector or part of the universe if there is a reason to be there. Broadly, wider credit spreads make high yield more interesting and given the pricing we are likely to invest more in that space. However, it is also important to analyse counterparties and stay away from more cyclical businesses that may not survive,” explains Lundby.

The portfolio is balanced between a relatively conservative core holdings and some more adventurous allocations. At the lower risk end of the spectrum, Pensam has both infrastructure debt and real estate credit investments, but there is also some appetite to take more risk at certain points of the cycle: “we have a foundation of senior high-quality assets offering stable returns without hiccups, but when the time is right, we also want to be more opportunistic and add some extra risk to take advantage of forced sellers of loans, and buy assets at a discounted price if the quality is right. A recession looks likely, which is a good time for the distressed segment,” expects Lundby.

Private lending could also be attractive as lenders may now be in a strong bargaining position: “With public markets pretty much closed, there are opportunities for private debt managers to do deals at attractive pricing. Companies may need capital and not be able to find any other lenders,” says Lundby.

Target returns and pickups

The return target is based on a liquid benchmark hedged back to Euro or DKK. “A target of 7-10% includes some illiquidity premium. The exact yield target will vary with the size and risk of the underlying business,” says Lundby.

Beyond illiquidity premia, there can also be premiums for structuring, complexity and deal certainty as direct lenders can deliver faster.

It is not always straightforward to measure the yield pickup on a fair basis: “spread per turn of leverage measures have some value, but you also need to consider that stronger businesses with more stable income can hold more debt than more cyclical businesses. A more holistic, ratings- based view can factor in all risks and mitigants, including cashflows, earnings, forecasts,” argues Lundby.

Outlook and risks

Pensam expects that a recession would further widen out yields on both public and private debt. So far as of October 2022 private debt yields have not risen as much as on public debt, but the comparison is not like for like. Private lenders are able to dictate stricter terms whereas public yields partly reflect much higher legacy levels of leverage and cov-lite structuring. “We are seeing more conservative, lender-friendly capital structures and documentation. Pricing in secondary public markets in contrast is based on older structures with more debt and weaker terms,” explains Lundby.

Recession and defaults are the top two fears:“we also look at whether borrowers can pass on higher interest costs. Oil, gas and shipping prices are other more specific concerns. Recession risk makes us more cautious, but could also throw up opportunities: some credit managers took advantage of forced sellers in the Covid crisis,” points out Lundby.

ESG data, rating and activism challenges

ESG data is always a challenge, but some EU guidelines have helped. “Initial due diligence includes ESG screening, scoring and rating with Sustainalytics, based on a questionnaire. A dedicated ESG team are working with managers and counterparties to get better data, and have specific goals. It can more difficult to achieve change in credit compared with equity, because we cannot control the board”.

Cash management and liquidity

Overall liquidity management is handled by the liquidity portfolio manager. Cash management is handled at the overall pension fund level not for the alternative credit allocation. “We have looked at trade finance but did not allocate yet. We tend to stay with asset classes we are familiar with, such as ABL, infrastructure and corporate lending,” says Lundby.

Fund terms range from monthly and quarterly, to some multi-year lockups on closed end funds.

Secondaries have been used in the past but are not currently being used actively, though that may change in future. Coinvestments could be considered.

Pensam is not currently exposed to shorter duration strategies such as trade finance.

Manage selection and due diligence

Due diligence takes at least 6 months for a new manager, and might be 3 months for a new fund from an existing manager.

Seminars and conferences; cap intro teams; industry colleagues; third party marketers; online databases; investment advisors; media and existing relationships and networks can all contributed to idea generation. “There is also a database of internal notes on managers. We also compare notes with Danish peers,” says Lundby.

External advisers, including local law and accounting firms, are used for tax and legal aspects. Operational due diligence could also be outsourced for managers located far away.

The DD process does deep dives into managers’ individual investments: “we look at case studies of investments, and talk to other investors in the space. We want to understand business models: are managers competing on the basis of lower pricing and higher leverage, or different business models,” points out Lundby.

There are 50-100 manager meetings a year of which half are with new managers. “We like to keep abreast of the marketplace, meet people and be aware of what is happening. Technology such as zoom calls helps us to do more meetings,” says Lundby. “A high bar is set for investing in new funds and we are unlikely to invest in first time funds, though we might invest in a new fund from an existing manager,” he adds.

Pensam invests both through comingled funds and separately managed accounts. European domiciles are generally preferred as US domiciles can be more complicated for tax. “We do not want to invest in funds using aggressive tax structuring,” he stresses.