On the record: Private credit
As the valuations of traditional credit assets look stretched, we asked two Danish institutions how they invest in alternative credit markets
The market has aged, but is still attractive
PFA invests in various types of private credit, including corporate credit, real estate, asset-backed and infrastructure debt. We invest in a combination of formats, directly or through funds, but we are also open to risk-sharing opportunities or loan book transactions. That said, we are predominantly direct investors. The total portfolio of alternative credit is €2bn, which is about 3% of our total assets. Our direct private credit investments are €1.6bn, or 2.3% of total assets.
We originate investments through various channels. One channel is our private equity and infrastructure relationships, where we pitch ourselves as credit investors to sponsors. We try to stay close to the credit funds we invest in, to take advantage of opportunities that may be too large for the funds themselves. We also have direct relationships with corporates, but our main source is private equity sponsors.
When we invest directly, our due diligence process mirrors that of a private equity situation. We follow a structured and rigorous due diligence process, as if we were investing. This involves engaging with external advisers on finance, tax, commercial and technical aspects.
Being rigorous and structured in the way we approach financing opportunities means we need to go after the larger cap deals. It is hard for us to justify putting the machine to work if we only deploy a minor amount.
It is not ideal to be presented with a private placement opportunity and being given a few days to decide on participation. We prefer to come in early and take the necessary time to conduct proper due diligence.
We have seen some market compression, both in terms of yield and loan documentation. However, we think that the yield and documentation packages are still attractive compared with liquid credit assets.
The private market has matured, as European debt funds or sophisticated investors like ourselves have become more active. Private debt funds are more active in the mid-market segment, but recently we have seen more in the bespoke, junior financing markets.
That said, we still see value in private credit and will continue to deploy assets. Recently, PFA has passed a significant milestone, as our portfolio of alternative assets reached DKK100bn. Credit is important in this context. One area where we no longer see value is the infrastructure senior debt market.
Look for protection in adverse scenarios
We define alternative credit as investments and strategies that are illiquid by nature, either in terms of the assets or structure. Private credit is a building block of our alternative investment strategy. Our private credit investments include fund financings, direct lending, special situations and mezzanine credit. We invest both through funds and directly, with a focus on Europe and the US.
Danica Pension has about DKK500bn (€67bn) in assets under management and 10% is currently invested in alternative investments. Private credit represents a sizable portion of this allocation.
As a pension fund, we manage capital at various levels of risk, with different requirements in terms of overall liquidity. Our private credit investments are spread across both our high, medium and low risk portfolios and the allocations depends on the individual investment schemes.
The overall selection and due diligence process is consistent across our private market investment activities. The process always includes financial, commercial, legal and ESG due diligence. Our focus areas can however shift with the nature of the investment.
In credit, it is key to understand the true downside protection properties of the investment and the avenues for unlocking that protection in adverse scenarios. That ultimately enables us to make a well-informed risk/reward analysis.
Private credit is a good way for us to expand our exposure to the broader economy, compared with what the public credit markets offer. However, it is always imperative that private opportunities offer a yield premium over assets with comparable risk levels in the public market.
As investors in private credit, we believe that publicly traded assets such as bank loans or high yield bonds, are not necessarily of better quality than private market assets.
The origination process differs profoundly between public and private markets. Banks act as intermediaries in public markets, whereas in private credit markets, such as middle market secured direct lending, the investors are often the originators and will hold the assets to maturity. For this reason, investors in these markets often conduct private equity style due diligence. This means that a lot of information is exchanged between investee companies and investors prior to a deal. Counter intuitively, there may be more information available in private markets than in public ones.
At the same time, theoretically, default probability should be higher in private credit markets, because the businesses are smaller and the ratings are lower. This is why credit selection skills as well as the ability to take credits through times of distress, to preserve value through restructurings, is particularly important.
As more and more investors enter the private credit markets, overall competition on the terms for deploying capital is naturally intensifies. For the time being, there seems to be both stability in terms of spreads and discipline when it comes to maintaining sound credit documentation. Obviously, we are monitoring these developments closely.
Interviews by Carlo Svaluto Moreolo