Stockholm (HedgeNordic) – Institutional investors, including those from the Nordic region, have steadily increased their allocations to private market asset classes such as private equity, private debt, real estate, and infrastructure. Despite a general weakening in appetite for alternative investments in a higher interest rate environment, pension and institutional clients continue to explore private assets. This interest is driven not only by the long-term outperformance of private assets compared to public equivalents but also by the broader investable universe they offer, as noted by Christoph Junge, Head of Alternatives at Danish pension provider Velliv.
Approximately ten percent of Velliv’s €45 billion investment portfolio is allocated to alternative investments, including private equity, private credit, liquid alternatives such as trend-following CTAs and commodities, as well as infrastructure and timberland. Led by Christoph Junge, Velliv’s alternatives team manages about €4.5 billion in these assets, excluding real estate, which is handled by a different team. “Private equity remains the largest building block of our alternatives allocation and has been so for a long time,” says Junge. The second-largest component is illiquid credit, categorized into two segments: low-risk and high-risk illiquid credit.
“Private equity remains the largest building block of our alternatives allocation and has been so for a long time.”
“Illiquid credit with low risk typically includes credits such as commercial real estate debt, infrastructure debt, and asset-backed securities that are very senior in the capital structure with minimal risk,” explains Junge. “In contrast, high-risk illiquid credit can include anything from senior direct lending and mezzanine, all the way to CLO equity,” elaborates Velliv’s Head of Alternatives. Together, these two buckets form the second largest building block of Velliv’s alternatives allocation. The third largest portion of the alternatives portfolio consists of liquid alternatives, including CTAs and long-only commodities. This allocation has seen significant growth over the course of the past two years. Real assets such as infrastructure and timberland make up a smaller allocation, followed by an impact allocation.
Roles of Private Asset Classes in a Portfolio
Every asset class, including those in private markets, plays a distinct and defining role in the broader portfolio. “Each of these asset classes has its own distinct role in our portfolio allocation,” reiterates Junge. The primary role of both private equity and private credit in Velliv’s portfolio is to outperform their liquid counterparts. “In private equity, our goal is to achieve the highest possible returns and outperform listed markets over the long run,” explains Junge. Velliv targets a performance that exceeds listed markets by at least three percentage points per annum throughout a complete cycle. “Similarly, private credit also seeks to outperform the returns of liquid credit markets,” he adds. Low-risk illiquid credit aims to outperform investment-grade credit, while high-risk illiquid credit aims to pick up additional spread and illiquidity premium compared to their listed counterparts.
“In private equity, our goal is to achieve the highest possible returns and outperform listed markets over the long run. Similarly, private credit also seeks to outperform the returns of liquid credit markets.”
“Private credit is still credit, and private equity is still equity,” emphasizes Junge. “Both private and public markets are influenced by the same macroeconomic factors.” While diversification is not the primary objective of Velliv’s investments in private equity and private credit, “there is a bit of diversification to be had given that only a minor part of the global economy is publicly listed.” Private equity and credit offer a much wider investable universe. “We get a bit of diversification by gaining exposure to a broader range of companies that would otherwise be off-limits.”
Investing in real assets serves a distinct purpose. “With infrastructure and timberland investments, we are aiming for stable returns and inflation protection,” points out Junge. Real assets expose investors to a different set of risk premiums. “Timberland, for instance, grows each year; trees don’t stop growing just because the world is in a recession,” explains Junge. “Investors get more timber on the stump year after year, which is an attractive feature of timberland as an asset class.” In addition, there is no immediate need to harvest the trees if market prices are unfavorable. “Crucially, our own analysis and broader research show a strong positive correlation between timberland investments and the consumer price index, offering effective inflation protection,” Junge adds.
“With infrastructure and timberland investments, we are aiming for stable returns and inflation protection.”
“The same can hold true for infrastructure investments, but depends on the underlying investments and their structuring, so devil is in the details,” emphasizes Junge, adding that Velliv “deliberately chose to go for the core and core-plus segments, which are the lowest-risk areas.” While timberland and infrastructure are among the lowest-risk building blocks in the portfolio, “certain parts of private credit and private equity represent the more ‘high-octane’ building blocks.”
The Effects of Higher Interest Rates
The era of low interest rates in the decade post-financial crisis led to a surge of investment capital flowing into private markets. However, the recent shift towards a higher interest rate environment has dampened fundraising activities in this universe and has manifested varying effects on the appeal of different alternative asset classes. “There are some asset classes that should suffer from higher interest rates, with private equity being a prime example,” says Christoph Junge.
“There are some asset classes that should suffer from higher interest rates, with private equity being a prime example.”
He explains that with current interest rates significantly higher than before, the expected return from private equity could have declined from around 20 percent during the low-rate environment to approximately 15-16 percent today – all else equal. Junge suggests that leverage, a traditional driver of returns in private equity, will become less influential. “The focus has shifted to operational improvements,” he asserts. “In the future, the general partners who will survive and fare best are those who are masters of operational improvements. It’s not about financial engineering anymore.”
Junge draws a comparison to the 1980s, when interest rates were above ten percent and private equity still delivered solid returns despite relying heavily on financial engineering. “However, you cannot compare today’s private equity landscape to that of the 1980s, because markets were much more immature back then,” he observes. Despite this, Junge anticipates the higher interest rate environment to slightly reduce expected returns in private equity and the attractiveness of private equity as an asset class. “The same might hold true for some real assets, such as timber and infrastructure,” he adds, though the link is not as clear. “The discount rate is just one component of the equation.”
Private Credit: The Preferred Choice in Today’s Market
Private credit, on the other hand, has benefited from the rise in interest rates. “With its floating rate nature, the base rate has gone up from zero to 500 basis points, so we are currently earning 9, 10, or even 11 percent after fees on senior direct lending,” explains Junge. “This makes private credit more attractive than private equity,” he asserts. Junge questions the value of opting for equity when senior lending offers returns in the teens. “If private equity offers 15 percent returns and private credit yields 10 percent, is it worth taking on the additional risk in the capital structure for that extra return?”
As a result, Velliv is maintaining its current allocation to private equity while expanding its investment in private credit. “We are not halting our investments in private equity, we still make commitments due to the runoff in the existing portfolio,” says Junge. He notes that Velliv’s private equity portfolio would be worth only half its current value in five years without new investments. “We are focusing on maintenance commitments.”
“If private equity offers 15 percent returns and private credit yields 10 percent, is it worth taking on the additional risk in the capital structure for that extra return?”
Junge observes significant optimism surrounding private credit. “There is certainly a trend of widespread bullishness on private credit at the moment,” he notes. While this enthusiasm often makes him cautious, he acknowledges the reasons behind its attractiveness. “I always consider if there are any overlooked risks that may bring down the bullishness, but it’s understandable why private credit is seen as attractive currently,” he continues. Nevertheless, he emphasizes that “the fun only lasts as long as borrowers can pay the debt and can sustain substantially higher interest rates.”
Junge and his team at Velliv are carefully monitoring borrowers’ ability to meet interest payments and maintain adequate coverage ratios. However, he notes that if “we are concerned about companies not being able to pay the interest rates as debt investors, we should be more concerned about equity positions due to their subordinate status in the capital structure.” Everyone is bullish on private credit, says Junge, and “I can fully understand why everyone is bullish.” Junge finds private credit to be relatively more compelling than private equity at the moment.
This article is part of HedgeNordic’s upcoming “Private Markets” publication. The interview with Christoph Junge took place in mid-May 2024.
