London (HedgeNordic) – The general trend in credit is clearly yield compression. Investment grade corporate credit in Europe now has yields near to zero, with some issuers borrowing at negative rates; defaults are very rare. Even more leveraged companies, funded in Europe’s corporate bond markets are borrowing at historically low rates with an average yield of around 3%, which is close to the historical default rate.

But smaller and medium sized enterprises (SMEs), which may struggle to get funding from capital constrained banks, are often paying annualized interest rates of between 7% and 13%. And there can be substantial underwriting or other fees on top of this, where banks and brokers are involved. Direct lenders disintermediate the banks and so can be cheaper for borrowers, as well as offering competitive returns to investors. Scandinavian Credit Fund I AB (Kreditfonden) is one such lender. It has returned 6.64% in 2016, 8.13% 2017 and 7.02% 2018 which has helped it to win several HedgeNordic awards.

The Swedish Government is keen to encourage this activity: from March 2020, Sweden’s AP state pension funds will be able to get involved in direct lending as well, as part of a broader increase in their allocations to illiquid credit.

Criteria

Kreditfonden lends mainly to private companies. Co-founder, CIO and Partner Fredrik Sjostrand, estimates that, “10,000 to 20,000 of Sweden’s 250,000 SMEs could be potential candidates for borrowing between SEK 20 and SEK 400 million”.

The fund currently has 85 loans as it is selective and quite labour intensive to carry out research and due diligence on borrowers. Being local lets Kreditfonden carry out site visits. “We reject 99% of email applications we receive for loans and we typically originate between two and four loans per month”, he says.

“We reject 99% of email applications we receive for loans and we typically originate between two and four loans per month. We only lend against asset-backed collateral.”

“We only lend against asset-backed collateral”, says Sjostrand, who has previously spent nearly 30 years working in portfolio management, trading, analysis, risk management and capital raising at Handelsbanken, Bear Stearns, Straumur Investment Bank, Carnegie and Swedbank in Sweden, England and Luxembourg. “I have looked at every kind of financial risk over my career, and now I am focused on credit risk”, he says.

“I have looked at every kind of financial risk over my career, and now I am focused on credit risk.”

“Our loan to value ratios could range from 50-60% for limited companies, to 75% for commercial real estate and 90-95% for receivables. Whereas many issues of loans and bonds in the public markets are “covenant lite”, we insist on tight covenants, which include leverage, interest rate coverage, LTV (loan to value) and ongoing financial reporting from borrowers”, he says.

Though Kreditfonden is not lending against cashflows, does not want to lend more than 3 or 5 times companies’ EBITDA (earnings before interest, tax, depreciation and amortization), which is often close to various cashflow measures. “We look at reports from Bloomberg, credit ratings agencies such as S&P, and we have also developed our own tools”, he says.

Some of Kreditfonden’s loans pay cash coupons, others are PIK (Payment In Kind) loans that accumulate interest until the maturity of the loan, and others have partly cash and partly PIK coupons. He admits that PIK loans have some equity risk, so loan to value ratios are likely to be tighter.

Kreditfonden is sometimes the only lender. It also aims to be the most senior lender, where there are other lenders. For instance, it has recently “entered into financing agreements worth a total of SEK 131 million in an industry and engineering company with subsidiaries with an annual turnover of approximately SEK 200 million. All of the loans are senior and secured in shares in group companies”.

Non-Performing Loans

Sjostrand estimates that a small percentage of the fund is non-performing in October 2019, and the fund have god faith in returning both capital and interest rates after enforcing the collateral. The fund has only had two credit losses over the past four years. One in 2017 that had a minor impact on NAV, and one in 2019 that had a larger impact on NAV 2019.

The loss stems from fraud of the borrower and the case is tried in court right now. That is why the collateral didn’t fully cover the loan.

Otherwise lending at a discount to collateral values, allows the fund to recover the loan amount and even when borrowers default, says Sjostrand. For example one situation involved selling a private company, which took several months, and another will involve foreclosing on real estate. Some borrowers are asked to make personal guarantees on top of their corporate assets, so the fund may also have recourse to individuals’ assets in cases where corporate assets have lost value and are not worth enough to repay loans.

ESG

Kreditfonden’s ESG policy is based mainly on negative screening or exclusion. It does not invest in nine industry sectors: Cluster bombs, landmines, Chemical and biological weapons, Nuclear weapons, Alcohol, Tobacco, Pornography, Coal and oil, Uranium and Genetically modified organisms. The fund also avoids lending to companies that are involved “in violations of international norms and conventions on the environment, human rights, working conditions and business ethics”, the website says.

In common with most credit investors, Kreditfonden is not trying to engage with companies to change their behaviour in a positive way; it is more common for equity investors, who have voting rights, to do this type of “impact investing”.

Fund Structure

There is no secondary market for the Kreditfonden loans made, so they are “Level 3” assets, marked to a theoretical valuation model rather than being marked to market. IFRS accounting standards are applied by independent valuation agent KPMG and auditor PwC, and the accounting valuation does not perfectly match cashflows. Accounting valuations could be lower than cashflows where fees received up front are spread over the life of loans, or higher where PIK coupons are accrued before they are received.

Many direct lending funds have a private equity, closed end fund, style structure, often with capital drawn down as and when investments are found, and a three or five or seven year “lockup” meaning that investors cannot redeem before the end of the lockup. Kreditfonden is not a private equity fund: it very rarely takes equity stakes in borrowers, and is focused on credit risk. It is an open ended fund, and is unusual in offering monthly liquidity. As Kreditfonden’s loans are for between three and 48 months, there is potential for some mismatch between the fund liquidity terms and the asset liquidity. Kreditfonden also has a borrowing facility, mainly used for investments.

Some lending funds offer the option of regular income distributions to investors, which will often transfer most or all of the interest received from borrowers. Kreditfonden does not, so anyone seeking to generate a regular income from the fund would need to redeem some of their units.

Investors generally subscribe to, and redeem from, the fund in the primary market. “The vehicle is listed on the Nordic Growth Market (because this is a requirement for marketing to retail investors in Sweden) but in practice liquidity is limited and anyone wishing to sell the fund on NGM would probably have to accept a discount”, says Sjostrand.

“The vehicle is listed on the Nordic Growth Market (because this is a requirement for marketing to retail investors in Sweden) but in practice liquidity is limited and anyone wishing to sell the fund on NGM would probably have to accept a discount.”

The fund is denominated in SEK and is sold in Sweden, which contributes 95% of its c 7,000 investors, and Norway. The fund documents are only published in Swedish. Investors include insurance companies, smaller private companies and retail investors. Assets are SEK 4.4 billion. “The capacity target was set at SEK 5 billion, but will probably soon be increased to SEK 6 billion”, says Sjostrand.

This article featured in HedgeNordic’s Special Report on “Alternative Fixed Income.”