Stockholm (HedgeNordic) – Direct lending fund Scandinavian Credit Fund I has experienced a couple of years of sub-target returns either due to forced selling caused by investors’ flight-to-safety amid the Covid-19 outbreak or due to specific issuer-related problems. Even in the worst of times, Scandinavian Credit Fund I continues to deliver positive single-digit returns to investors for a sixth consecutive year, with an annualized return of 4.4 percent over the three years ending 2021 and an annualized return of 5.8 percent since launching in January 2016.
“Unless we face any serious credit events, our portfolio will be yielding around 5.5-6 percent net-of-fees to investors,” says Fredrik Sjöstrand, the CIO of Scandinavian Credit Fund I. The direct lending fund delivered an annual return of 5.8 percent in 2019, followed by 4.3 percent in 2020 and 3.2 percent last year. “It doesn’t look that great when looking at the trend, but we don’t expect any more issues that will hold back the portfolio’s current yield of 5.5-6 percent after fees.” Increasingly underwriting floating-rate loans due to the rising interest rate environment, Scandinavian Credit Fund I continues on its objective to fill the void created by banks’ reluctance to issue and hold loans to smaller companies due to tougher banking regulations.
“Unless we face any serious credit events, our portfolio will be yielding around 5.5-6 percent net-of-fees to investors.”
“Alternative lending is experiencing a continuation of what we have seen over the last ten years,” Sjöstrand says about the current state of the direct lending market. “The banks have been deleveraging due to capital requirements, and the upcoming Basel IV standards will put even more strain on corporate lending,” he elaborates. The Basel IV standards, due for implementation in January of next year, will further increase global bank capital requirements. “There are different players that are entering the market trying to take a chunk out of the banking sector’s corporate lending business.”
“Alternative lending is experiencing a continuation of what we have seen over the last ten years.”
Scandinavian Credit Fund I has been focusing on a less-competitive segment of the market in the Nordics, providing loans of between SEK 20 million and SEK 200 million to smaller and mid-sized companies in the Scandinavian region. The low-interest rate environment of the past decade has forced direct lending players such as Scandinavian Credit Fund I to accept lower rates from borrowers. Signs are pointing to change. “We have been forced to lend at lower rates in the narrowing spread environment,” Sjöstrand explains the impact of the low-rate environment on direct lending. “As spreads are widening, we can start lending at higher rates,” he emphasizes. “It’s great to see spreads return to normalcy, which, of course, will lead to a higher expected return of our direct lending portfolio.”
“As spreads are widening, we can start lending at higher rates. It’s great to see spreads return to normalcy, which, of course, will lead to a higher expected return of our direct lending portfolio.”
The team running Scandinavian Credit Fund I mostly opted for giving out fixed-rate loans during the fund’s first few years of operations. With inflation and interest rates on the rise, the team led by Sjöstrand has increasingly been opting for floating-rate loan agreements with borrowers. “When we are doing new loans in this environment, as we have been doing over the past year, we are increasingly swapping into floating-rate notes,” says Sjöstrand. The direct lending fund may well be back on its track to deliver between six to eight percent per year. “That is something that will hopefully materialize during 2022.”
Strategy Risks and Investor-Perceived Risks
Direct lending offers investors the opportunity to achieve attractive returns with less downside risk and market-to-market volatility. These benefits, however, come at a cost: illiquidity. “Credit risk is the main risk associated with direct lending strategies,” says Sjöstrand. “That is what we are eating and sleeping with,” he adds. “But for investors who do not understand the mechanics of direct lending, the liquidity risk becomes the main issue when too many investors try to redeem their investments too early all at once.” That is what hurt Scandinavian Credit Fund I in the first quarter of 2020, when the fund decided to impose redemption “gates” to deal with the mismatch between the illiquidity of its investments and the sudden liquidity preference of investors.
“Credit risk is the main risk associated with direct lending strategies. That is what we are eating and sleeping with.”
But as long as the team behind Scandinavian Credit Fund I performs proper due diligence on borrowers to avoid credit events and investors do not head for the exits at the wrong time, Sjöstrand’s direct lending fund can deliver on its promise to return uncorrelated high single-digit returns. “The main risk our investors face is that we do not do our homework in a proper way when it comes to credit analysis,” highlights Sjöstrand. The team seeks to address credit risk by “conducting a thorough research on borrowers before entering the loan and then carefully monitoring loan performance.”
The business of direct lending can handle credit risk through risk-mitigating discussions enabled by better and quicker access to management. “The coronavirus pandemic, for instance, has forced us into much tighter relationships with corporates,” says Sjöstrand. With one group of borrowers that Sjöstrand refers to as “focused credits,” the team running Scandinavian Credit Fund I maintains a continuous relationship “where we constantly look into the numbers, talk to the management, and so on.” Superior risk control may be achieved due to better access to information and management.
“The coronavirus pandemic, for instance, has forced us into much tighter relationships with corporates.”
With inflation on the rise and ongoing supply chain issues – exacerbated by Russia’s invasion of Ukraine – and many other problems, it remains difficult to assess the vulnerability of borrowers amid a difficult economic environment. “We are trying to factor all issues and challenges into our credit decision-making process,” says Sjöstrand. “The things that we had to factor in two years ago may be different from what we are factoring in today, but we always have a forward-looking assessment into each borrower.”
Investor Expectations, Place in a Portfolio
Scandinavian Credit Fund I delivered a return of 4.3 percent in 2020 after being forced to sell its liquidity position at a loss during the liquidity squeeze triggered by the Covid-19 outbreak. At the end of last year, Scandinavian Credit Fund I experienced an investment write-down to one of its positions. Despite these struggles, the direct lending fund has enjoyed six consecutive years of positive returns to deliver an annualized return of 5.8 percent since launching in early 2016.
“We will never give a return of 10 or 20 percent per year,” says Sjöstrand. “But even if we had a very poor year by our standards as in 2021, we still manage to achieve strong returns relative to other alternative fixed-income funds,” he continues. “If an investor wants to have a cushion in the portfolio, Scandinavian Credit Fund I has proved its ability to do just that.”
“We will never give a return of 10 or 20 percent per year. But even if we had a very poor year by our standards as in 2021, we still manage to achieve strong returns relative to other alternative fixed-income funds.”
Having approached only Nordic investors so far, the team at Kreditfonden now plans to roll out Scandinavian Credit Fund I beyond the Nordic borders. “We are channeling our efforts towards growing our investor base, targeting continental Europe,” says Sjöstrand. “As Swedish investors are more equity-oriented, they may not appreciate a six or seven percent return despite the low downside risk,” argues the CIO of Scandinavian Credit Fund I. “Direct lending appears more accepted outside the Nordic region, which we are trying to change, but it does no harm to broaden our investor base by targeting the southwest part of Europe.”
This article features in HedgeNordic’s “Nordic Hedge Fund Industry Report.”