Stockholm (HedgeNordic) – Investing in private credit has grown increasingly appealing to many institutional investors seeking alternative avenues beyond traditional fixed-income assets. The potential for higher yields, especially in the once-dominant low-interest-rate environment, along with its diversification benefits, has driven interest in this asset class. Ericsson Pensionsstiftelse, the pension fund covering the employees of Swedish telecoms company Ericsson, has recognized private credit as a core component of its asset allocation.

“We have been investing in private credit since 2011 and see it as a core component in our asset allocation…”

“We have been investing in private credit since 2011 and see it as a core component in our asset allocation, representing roughly 12 percent of our total assets under management,” says portfolio manager Michael Levén. Private credit provides investors with opportunities to access a wide range of credit strategies, spanning from senior direct lending to mezzanine and non-performing credit. This diversity offers flexibility and the potential for attractive risk-adjusted returns. Ericsson Pensionsstiftelse’s private credit portfolio, which accounts for more than one-tenth of its SEK 30 billion portfolio, includes a blend of direct lending, junior debt, and stressed credits.

Benefits Beyond the Yields

Beyond the allure of higher yields, private credit offers several advantages over public debt, including more flexibility, greater downside protection, and protection against inflation. “We expect to get improved risk-adjusted return compared to public debt through yield pickup and downside protection,” explains Levén. “The low duration risk and inflation protection due to its floating rate nature are also positives as long as the underlying portfolio companies are able to tackle higher interest costs.”

“We expect to get improved risk-adjusted return compared to public debt through yield pickup and downside protection.”

Private credit, typically comprised of floating interest rates that adjust in tandem with benchmark rates, has become even more attractive in a higher interest rate environment. “We believe private credit generally is very attractive in today’s market and that the relative attractiveness compared to private equity, for example, has increased given the rapid increase in base rates in addition to slightly increased margins and fees, coupled with lower levels of leverage,” says Levén. The portfolio management team at Ericsson Pensionsstiftelse usually targets net internal rates of returns (IRRs) in low to mid-teens for junior debt and stressed credits, compared with a net IRR of 6-9 percent in local currency (USD or EUR) in direct lending. “Given the rapid increase in base rates seen over the last year and a half, our expectations are currently somewhat higher than those figures,” argues Levén.

The Protective Armor of Private Credit

Private credit can prove to be an appealing option for investors in a rising rate environment, provided that issuers can withstand higher financing costs. “While higher interest rates are advantageous for private debt as long as the companies can service the interest, we believe it will pose problems for many companies going forward,” warns Levén. With Ericsson Pensionsstiftelse accessing this asset class through external fund managers, Levén underscores the importance of investing with “managers that have solid skills in fundamental company analysis and credit underwriting in order to be able to minimize downside by investing in less cyclical sectors and companies.”

“While higher interest rates are advantageous for private debt as long as the companies can service the interest, we believe it will pose problems for many companies going forward.”

Private credit deals are often structured to include security features such as collateral, covenants, and priority repayment rights, offering added protection for investors. Compared to the syndicated loan market, private debt enjoys the advantage of often being a bilateral negotiation between the lender and the company owner, providing more flexibility and protection for investors. Levén argues that “it is also critical for us that the managers we invest with have the resources and expertise to handle difficult situations such as workouts and restructurings when they arise.” While Levén does not adhere to strict criteria on the length regarding the length of a manager’s track record, if possible, his team prefers to see how managers have performed in more demanding market environments.

ESG: An Investor’s Compass

Many allocators, including Ericsson Pensionsstiftelse, often favor private credit with an ESG (Environmental, Social, Governance) approach that aligns with responsible investment principles. While private credit investments can promote ESG principles, private equity often has a more significant impact in driving ESG initiatives due to its active ownership and ability to influence portfolio companies directly. “Private debt funds generally have less influence than private equity managers on a company’s ESG agenda,” says Levén. “Since they do not control the companies, the requirements we have on our private debt managers differ a bit from private equity.”

“Private debt funds generally have less influence than private equity managers on a company’s ESG agenda.”

Nevertheless, Ericsson Pensionsstiftelse has developed its own ESG due diligence process and an ESG ranking system, where the team rates managers on a scale from 1 to 5, requiring a minimum score of 3 to invest. “There is both an overall ESG score from 1 to 5 and scores from 1 to 5 for each underlying subsection,” explains Levén. “Managers generally need to have a minimum overall ESG score of 3 for us to invest in them. If they fall short, we sometimes suggest the manager to make improvements after which we will make a new evaluation,” he elaborates.

In certain cases, Ericsson Pensionsstiftelse has declined to invest in managers who did not meet their ESG standards. “Even though these are numerical scores, the assessment is rather qualitative,” Levén points out. “Rather than imposing hard requirements, managers need to have ESG policies and frameworks in place, along with organizational resources to support them and report on ESG.”

Limits to Allocation Despite Attractiveness

Ericsson Pensionsstiftelse has been investing in private credit since 2011 and intends to continue doing so in the future. “We have been investing in private credit for more than ten years and it has been a large part and a core component of our portfolio for many years and will likely continue to be so going forward,” concludes Levén. “But given that private credit constitutes 12 percent of our total assets under management, we will probably not grow that proportion significantly, even though we see private credit as a very attractive asset class in today’s environment.”