LD utilizes banking regulations in new alternatives venture

In the pursuit of liquidity and high returns, Lønmodtagernes Dyrtidsfond (LD) has joined forces with an US manager which will invest DKK 1.1 billion in alternative credits on behalf of the Danish investor. This will fill a hole in the market left by banking regulations.
Claus Buchwald Christjansen, CIO at LD | Photo: PR/Lennart Søgård-Høyer
Claus Buchwald Christjansen, CIO at LD | Photo: PR/Lennart Søgård-Høyer

Lønmodtagernes Dyrtidsfond, better known as LD, has entered into cooperation with a US asset manager that will expand the Danish investor's alternative investment portfolio significantly.

The US manager, whose name LD cannot yet disclose because the last details of the investment are not yet in place, will place DKK 1.1 billion of LD's assets in alternative credits such as direct loans to companies.

The investment will increase the percentage of LD's total investments in alternatives from 4.5 percent to 7.3 percent. With that, LD nears its benchmark of 7.5 percent and the supervisory board's set ceiling on alternatives of 10 percent of the total investment portfolio.

According to Claus Buchwald Christjansen, Chief Investment Officer (CIO) at LD, the new initiative fits very well with the fund's objectives for investments.

"We think the returns are relatively high – we expect to be able to make at least 5 percent a year, preferably more. It's stable because much of it is coupon rate of interest. And it's relatively liquid because we can get out along the way because we built this profile," he tells FinansWatch.

Must be able to raise cash fast

The liquidity is crucial for LD, because the approx. 650,000 members could technically log into LD's site today and ask for their money paid out within eight days. Thus, it is a fortune of DKK 38.8 billion that has to be raised in ready money in one week, which is why it is vital for LD not to tie up its capital for too long of a time period.

"We can withstand tying a small part of our portfolio in something illiquid. But its duration must not be longer than five years. And in the meantime, we have to get a large part of our investment back in the form of interest rates and repayments," says Buchwald Christiansen, continuing:

"We have previously made private equity investments, and then after seven years the fund comes to us, saying that we are unfortunately in a recession, and the companies can't be sold, so they want to extend the loan period by a few years. We can't do that, because in seven years our fund will be half its current size because our members have withdrawn their money."

LD expects the fund's assets to have halved from about DKK 40 billion to DKK 20 billion in 2024.

The risk is there

With LD's new alternative credit investments, which include i.a. short-term consumer credits, direct business loans, and loans to companies with strained credit rating, the fund will, in a worst case scenario, get 50 percent of the portfolio paid back after four years, and 100 percent after five years. In this way, LD gets some investments that are illiquid over a number of years, which makes the returns higher, but they will be paid back to LD quickly.

How is the risk in this?

"It's there – of course there is a risk. Some of the assets that we will have in this portfolio don't carry much risk. Either because they are short-term, or because they are covered by a very large number of consumer credits. there are also things in this which are definitely risky. Such as loans to troubled companies. So it's a mix," says Buchwald Christjansen.

He explains that the risk in such a portfolio is mostly that the surrounding markets fall, and/or the economy entering a deep recession. The American manager that handles LD's new investment has made some model-based calculations which show that if the stock index S&P 500 falls by 30 percent, the value of the portfolio will fall by 7 percent. For comparison, American high yield bonds will fall by 17 percent in such a scenario.

"On top of that, we have created a hedging portfolio that reduces the expected losses in the scenario to 4.6 percent. We could add much more hedging and reduce the losses more, but it has its costs. So it's a balance," says the CIO.

Until 2010, LD had all its investments in daughter company LD Invest, which had about 100 employees who directly or indirectly managed the investments. But due to EU's public tender requirement, most of those investments have been outsourced to different managers. Presently, LD only has two employees handling investments: Kristoffer Fabricius Birch, Head of Equities, and Claus Buchwald Christjansen himself.

"We are a very small investment organization. We are two people managing. So we're not going to be making credit ratings. We're not going to keep an ongoing dialogue with a company that we are involved with. We need a competent organization between ourselves and the investment. And we have found that," says Buchwald Christjansen.

Utilizes regulation loopholes

Buchwald Christjansen gives an example of what an investment through the manager could look like: The banks are unwilling to grant loans on invoices at smaller companies, even though the service is granted to large AA-rated companies. Instead, the banks offer an overdraft facility for day-to-day operations with an interest rate of e.g. 12 percent. This is where LD enters the picture with the new American manager, offering to loan on the invoices with 10 percent interest. There is little risk of LD not getting the invested money back, because the large debtor companies are unlikely to go bankrupt.

"This is what led us to the new type of investments. The price setting of the assets in question has been distorted by the financial regulations of the past few years. We would like to help fill that hole," he says.

"What makes the difference from what other pension funds do is that we are willing to do it on assets with shorter loan periods. Maybe we have a little niche there. We believe that we have minimized the risks in this type of investment – process risk, credit rating risk, etc, which the Danish Financial Supervisory Agency (FSA) has paid very close attention to. Because we have managed to place it where the competence is," Buchwald Christjansen continues.

Why did you choose this specific manager?

"We have similar views on many things. After a long dialogue and getting to know each other, we are convinced that these are some of the most capable people in the field. They are simply the best fit for the job."

It costs – but the alternative is worse

In the Danish pension industry, the opinion is generally that it is too expensive have external managers on alternative investments. However, Buchwald Christjansen doesn't believe that LD is paying too much for the Americans to select the loans that go in LD's portfolio.

"I believe we have found a form of payment that everyone is satisfied with. It does, of course, cost in expenses, but the alternative is that we don't do it at all. I don't believe in that option, because our members are bright enough to see that if we weren't able provide the same returns as comparable pension funds in the coming years, more people would currently be abandoning ship" he says, pondering:

"We could also go find some other managers and cobble together a portfolio. The problem is that these people are much more competent, and they are innovative in regard to controlling this liquidity and hedging. We could never do that alone."

He is not willing to reveal exactly how the pay system between LD and the American manager works.

"But we have made a pay system where I believe they are interested in working for us. It works so that they get something out of providing good results. On the other hand, I think the expenses that we pay along the way compare adequately to what we can expect in returns," says Buchwald Christjansen, adding:

"But naturally, it will be more expensive than a manager on an equity portfolio."

LD manages about DKK 38.8 billion on behalf of just under 650,000 members. The assets come from a remittance from the Danish state to LD in 1980, made up of the frozen cost-of-living allowances from 1977 to 1979. The assets diminished in 2015, when LD paid in about DKK 10 billion to the Danish state. It was part of an effort to secure members a lowering of taxes by advancing payment of the rates, which would previously not have been due until down payment.

English Edit: Marie Honoré

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