Stockholm (HedgeNordic) – Following a change in legislation, the four Swedish national pension buffer funds, AP1-AP4, were granted the opportunity to invest in private debt starting in 2021 to capitalize on the illiquidity premium in this asset class and generate returns amid a low-interest-rate environment for traditional fixed income. In late 2020, AP2’s board decided to make a strategic allocation of two percent of its then SEK 386 billion portfolio to private debt.

Patrik Jonsson, who had been with AP2 since 2015 as Head of Manager Selection for Public Assets, was entrusted with the responsibility of building AP2’s private debt allocation. “At the time we had the legislative change allowing for investments in illiquid private debt, we were in a near-zero percent interest rate environment, and we thought this might be an interesting addition to our portfolio,” recalls Jonsson. He faced the challenge of initiating this allocation during the Covid pandemic when travel restrictions were in place and in-person meetings were impossible. “Was I supposed to do a huge allocation with managers I had never met?” Jonsson recalls asking himself at the time.

Jonsson started the process by engaging with existing managers in AP2’s portfolio who were involved in listed alternative credit, including high-yield bonds, leveraged bonds, CLOs, and structured credit. “That alternative credit allocation was managed by five external managers, which provided a starting point for building the private debt allocation during the pandemic,” says Jonsson. “It was easier to start the allocation process by working with managers with whom we had prior relationships,” he claims. The resumption of travel to the United States towards the end of 2021 made the allocation and selection process much more feasible.

“Allocation changes to this asset class take years and years to execute regardless of how much time you spend on this internally.”

Despite the relatively modest allocation target of two percent, AP2’s large portfolio size required deploying about SEK 8 billion into private debt. Jonsson emphasizes that building an allocation in the private debt space is a time-consuming process, unlike more liquid asset classes where changes can be made swiftly. “One thing that we have learned over the past years is that it takes time to build an allocation like this,” acknowledges Jonsson. “In the private debt space, even if I wanted to deploy that money tomorrow, that just cannot be done for practical purposes,” he says. “Allocation changes to this asset class take years and years to execute regardless of how much time you spend on this internally. We are working on finding ways to accelerate the ramp-up of our current portfolio.”

Illiquidity Premium – the Perfect Match

Liquidity is typically perceived as valuable and highly desirable for most investors. However, liquidity often comes at a cost. For long-term investors such as AP2, this lack of liquidity translates into an additional compensation known as the illiquidity premium. “In theory, there should be a premium for investing in illiquid instruments compared to liquid investments and there is definitely an illiquidity premium in private credit,” says Patrik Jonsson. 

“In theory, there should be a premium for investing in illiquid instruments compared to liquid investments and there is definitely an illiquidity premium in private credit.”

“As an AP fund, this illiquidity premium is a really good match for us.” In comparison to many other asset owners, AP2 has the luxury of being able to foresee its inflows and outflows for years, if not decades. “That is a competitive advantage,” considers Jonsson. “The ability to accept illiquidity for the premium is something that we should try to exploit.”

Private Credit as an Alternative to Equities?

Private credit has served as a powerful complement to traditional fixed income, particularly in a low-interest-rate environment. “We were operating in a zero-interest-rate environment when we started allocating to private debt, so we thought this asset class might offer a good pick-up compared to listed credit,” recalls Jonsson. Yields on these private debt investments – which are largely based on floating-rate loans – have gone into double digits. “We find ourselves in a different situation all of a sudden,” says Jonsson.

“My opinion is that private debt currently could be viewed as a very good alternative to equities.”

“With the base rate in the U.S. above five percent and adding the spread on top of that, we are looking at expected returns that can compete with the expected returns from the equity market,” he elaborates. “Private debt as an asset class has undergone significant changes over the last three years since we started allocating and much of that has occurred in the last twelve months,” explains Jonsson. “My opinion is that private debt currently could be viewed as a very good alternative to equities.”

Diversification

AP2 started out building the allocation to private debt with plain-vanilla investments, such as senior direct lending in the United States and Europe. Jonsson has also left some room for an allocation to private debt in other regions of the world, but that is not particularly appealing in an environment with attractive opportunities in the U.S. and Europe. “There is no real need to go to other markets at this stage, as that would add more complexity to the portfolio.”

Private debt includes a wide range of strategies from senior direct lending and mezzanine strategies to higher risk-return non-performing credit strategies. Having so far mostly invested in senior direct lending, AP2 has considered diversifying the portfolio across more types of credits. “In the current interest rate environment, I don’t see the point of pursuing junior, mezzanine, or second-lien investments when the senior part is providing us with such great returns,” emphasizes Jonsson. “A senior loan in the U.S. right now yields about 12 percent, why would we be stretching out to try to get 15 or 20 percent.”

“In the current interest rate environment, I don’t see the point of pursuing junior, mezzanine, or second-lien investments when the senior part is providing us with such great returns.”

Jonsson does not see any reason to climb the risk spectrum in pursuit of higher returns. With a contracted return of 12 percent from senior debt investments, he notes that it is important to question how much return is actually needed to fulfill obligations. “If you cannot really fulfill your needs by achieving 12 percent, you have an asset-liability mismatch.” For Jonsson, “there is no need to stretch further. This environment is as good as it gets.”

Default Expectations

With higher interest rates and a slowing economy, there is a greater likelihood that the companies behind these securities may default on their loans. While the possibility of defaults is a valid concern for investors venturing into the private debt space, it shouldn’t dominate their perspective. “Could there be defaults? That’s a valid question to ask,” says Jonsson. “And yes, there will be defaults.”

“Could there be defaults? Yes, there will be defaults. Yet, if you are generating a 12 percent income, you can afford some haircuts on that and still perform well.”

According to Jonsson, the primary factor that could unsettle this market is substantial credit losses. However, scrutinizing historical loss rates is insufficient for meaningful insights, as they have essentially been at zero since the inception of this asset class. “But it’s unlikely they will remain at zero going forward. Yet, if you are generating a 12 percent income, you can afford some haircuts on that and still perform well.”

Should credit losses become the catalyst that tips this market over, “that would imply that private equity had been losing money hand over fist,” explains Jonsson. Given that private equity continues to support a considerable number of these companies, and the loan-to-value rations are typically well below 50 percent, “seriously contemplating the prospect of substantial credit losses within private credit should give one pause before committing another dollar to private equity.”