January 2022 – Anders Ellegaard, Head of Fixed Income, Industriens Pension

Anders, thank you for making time to join us on Private Capital Call.

Thank you for having me on the call and happy to share my thoughts.

1. Private Capital – Industriens Pensions is a Danish pension fund responsible for managing 415,000 employees of about 8000 industrial companies. How does private capital play a role in your investment objectives? 

Private capital is a core part of our strategic asset allocation and comprises of private credit, private equity and real assets, i.e. real estate and infrastructure. Our private capital started in private equity back in 2000 and we added infrastructure and real estate in 2002 and 2008. Private credit, which I am responsible for, was added as a strategic asset in 2014.

As such private capital has been part of our investment objectives for more than two decades and on a high level it has two main purposes. It provides expected superior long term risk adjusted returns, and it adds stability to offset the more volatile liquid equity and fixed income allocation. Especially in fixed income, I clearly see the expected return more attractive in the current low rate and search for yield environment. The flip side of private capital, for a pension fund like Industriens Pension, is that it locks up capital for multiple years and the typical private credit fund takes two to three years to get fully invested, which even for a labor market pension plan as Industriens Pension, limits the total allocation we can have toward private capital.

2. Inflation Sensitivity – You are in a unique position with so many member companies across a wide variety of industries in Denmark. Like the rest of Europe and the US inflation is rising. These costs, particularly labor-related, are not only impacting businesses, but could affect asset prices. How do you include this in your investment considerations?

Inflation and its effect on rates, and the combined effect on equities and real assets have been front and center since the beginning of the pandemic, and as such is included in every discussion. Is it inflationary due to expansionary monetary policy and retrenchment of global supply chains or deflationary due to increased debt burden and tech/Amazon-ization of everything? Currently the money is on inflationary, but the long-term jury is probably still out.

We use an inflation overlay to hedge our fixed income duration, which worked well in 2021. Currently we see some headwind to our US-denominated fixed income portfolio, but I see 2022 as well as the long-term post pandemic rate curve as very difficult to forecast.

The US and Europe are in two very different positions. Inflation is rising in both areas, as you say, both areas are experiencing supply chain bottlenecks and tighter labor markets, but Europe is a more open economy with a more controlled labor market. The US has significant excess saving and a strong economy; as such the ECB is in a trickier position without the strong consumer, a weaker economy and a potential unsustainable debt burden in the southern economies, if rates were to increase. Combine that with all the other moving parts; China, its common prosperity project, Hong Kong and Taiwan, and its Covid handling, Russian tension, new variants, talks of price control etc. and the elevated valuation across liquid assets. We expect 2022 to be a volatile year.

3. ESG Considerations – Anders, it seems as if Europeans have historically been a leader in ESG awareness. As an investor how do you bring ESG into your own performance metrics? Do you consider rewarding managers for their ESG related portfolio construction?

ESG and sustainable investment is a key area for Industriens Pension and as a fixed income professional, ESG has always been part of the investment thesis. I started my career doing credit ratings at S&P almost 20 years ago. The analysis always included an assessment of the governance, i.e. willingness to repay, reporting standards and board independence, as well as the risk of contingent liabilities from either environmental or social issues and long-term prospects for the business model. At that time, it was not called ESG and the focus was only to assess probability of default. Today ESG has evolved significantly and now embraces all aspects of being a responsible investor. But my point is that if a manager does not incorporate ESG into the investment analysis, decision making and as well as portfolio management, the manager is not doing its job. The same goes for myself, my team and the rest of Industriens Pension. We need to understand and incorporate ESG exposures into our investment decision and therefore also manager selection.

Our investment objective is to maximize risk adjusted real return to our members’ base while contributing to a sustainable societal development. This means that returns and capital preservation is our goal, but we want to do this in a responsible way, which we fundamentally believe offers great value and helps achieve our goal. As such we do not reward managers solely for their ESG approach, but is it a requirement to manage our members’ retirement funds.

5. Private Credit Terms – Middle market direct lenders (and their investors) enjoy the benefits of covenants. You know it’s also whether those financial tests have real teeth. Are you finding loan managers still observing these distinctions? In what other ways is private credit separating itself from more liquid asset classes?

It is a key question, along with the actual type of covenant and how they match the financial model and protect the lender. It does not matter if there are three covenants, but the one that matters is missing. And it is also an area that is difficult to assess in due diligence, similar to EBITDA adjustments and free baskets. The way we get comfortable with a manager is to understand the historical loans and whether the quality of those fits the story told in due diligence.

We view real covenants as the guardrail that protects when a company underperforms. In the liquid market, managers that are doing their job with an appropriate sized holding are able to divest their position at a minimum loss. In the private market, this is not possible and therefore the covenants are needed to force a conversation, when the company still has value. This said, covenants do not make weak companies strong.

I think there are multiple ways our managers in the direct lending space separate themselves from the liquid managers. One that gets less focus is the way they are able to solve underperformance in a sensible and constructive manner, thanks to a limited lender base with a common understanding. This is hard in the liquid market, as lending groups are often very large. If a manager is not able to sell prior to a correction, it may be difficult to avoid a loss, as some in the group may not be willing or able to hold a stressed asset.

5. Rate Outlook – Finally, as you think about central banks tightening, or raising the prospects of tightening, interest rates globally, how does that figure into your outlook for private credit in 2022?

I guess this goes back to the earlier inflation discussion and how the CB will react, and likely increased volatility.

I believe that as long as the economy is healthy or at least does not go into a prolonged recession due to longer term effects from Covid-19 or more likely a Fed policy mistake, the part of the private credit market we invest in is robust and should be fine.

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