Stockholm (NordSIP) – Following NordSIP’s review of the performance of international public equity and fixed-income funds, we approached a range of international and Nordic private debt and private equity article 9 funds to hear about their experiences during the first half of 2023.
Our survey covered seven private market funds. Five Article 9 private debt funds replied to our inquiries: the ACTIAM Financial Inclusion Fund, the resonsAbility SICAV (Lux) Agriculture Fund, the responsAbility SICAV (LUX) Micro and SME Finance Debt Fund, the Trill Impact DWM SDG Credit Fund and the SEB Microfinance fund. Their replies were complemented by feedback from the portfolio managers of two article 9 SFDR private equity funds: the Kempen Global Impact Pool and the Kempen SDG Farmland Fund.
The feedback suggests that global interest rates and inflation were the most relevant factor in determining fund performance and expectations of future returns. While some private equity funds struggled in this environment, private debt markets thrived and expect to continue to benefit from it, while also offering insights into how to avoid predatory lending practices. Agriculture also featured prominently among private equity replies.
Rising to the Top with Interest Rates
Portfolio managers tended to focus on the effect of the Ukraine war on inflation and the subsequent interest rate rises. Given that the rates at which they lend are inextricably tied to global monetary policy rates, private debt portfolio managers seem to have naturally benefited from this environment.
“Interest rates remain an important factor for the portfolio yield and performance relative to the risk-free rates. In 1H 2023, the fund delivered a positive performance of 3.05% in USD (I2U share class), which is equivalent to ca. 150bp above the risk-free rate. It is below our mid-term target of Secured Overnight Financing Rate (SOFR)+300-350bp, mostly due to the rapid rise in interest rates, which affects the yield of our loan portfolio with a 6 to 12 months lag. That said, the fund outperformed its peers on the period thanks to the resilience of its investment portfolio and a low provisioning rate,” said Jaskirat Chadha, manager of the responsAbility (SICAV (LUX) Micro and SME Finance Debt Fund.
Viktor Andersson, Head of Microfinance at Trill Impact, agreed. However, the superior performance of the fund in SEK (8.01%) also suggests that exchange rate dynamics were important (4.42% in US Dollar and 2.01% in Euro). The depreciation of the Swedish krona did indeed not go unnoticed by asset managers. “The yield of the underlying loans was the most important driver of the fund, but in addition, the unhedged local currency basket also contributed positively,” said Camilla Löwenhielm, co-investment manager of the SEB Microfinance Fund.
However, increases in policy rates and exchange rate differentials were not everything. “This biggest impact on the performance during H1 2023 – besides the increasing yield of the portfolio – has been the global coffee market’s price volatility which caused increasing provisions on investees in Africa as well as Latam,” adds Csaba Révész, manager of the resonsAbility SICAV (Lux) Agriculture Fund.
“The Fund has been outperforming the [FTSE Small Cap Index] SMX index y-o-y since its inception in 2014. The fund has been able to perform better than the index and its peers due to its conservative risk management approach that results in limited realized loss rates (14bps p.a. since inception), broad portfolio diversification with focus on productive underlying loans, cost-effectiveness and effective hedging policy,” Sinisa Vukic, Senior Portfolio Manager of the ACTIAM Financial Inclusion Fund, added.
A Tougher Environment for PEs
Among private equity (PE) funds, the increase in interest rates appears to have forced companies to accelerate their path to profitability. As the last decade saw some of the lowest interest rates in history, private equity models, which rely on leverage, were able to exploit this environment to slowly explore new growth paths and business models. Now that the cost of funding is increasing this approach is no longer feasible, it seems. Nevertheless, Kempen’s agriculture-focused fund seems to have done well.
“Exposure to Venture Capital and Growth Private Equity was a drag on performance, as markets were challenged by rising rates, high inflation, soaring energy prices and the war in the Ukraine. The uncertainty that came with these challenges resulted in a difficult fundraising environment, putting new financing rounds under pressure while effectively shutting down the IPO market. Across the portfolio we see that our investment partners are increasingly focusing on fast-tracking a path to profitability, often at the expense of high growth,” says Ralph Engelchore, manager of the Kempen Global Impact Pool fund. “This fast-tracking to profitability prepares a company better for an exit but has resulted in lower valuations across the portfolio. Underlying fundamentals are still developing favorably, as persisting revenue growth indicates that portfolio companies are providing essential services.
The Kempen Global Impact Pool fund aims to make investments that positively contribute to solving global problems around the food, water and climate nexus and five Sustainable Development Goals (SDGs). This approach exposes the fund to the infrastructure sector, which was a net positive contributor to what the manager describes as a flat performance during the first half of 2023.
“Exposure to private markets categories, most notably Private Equity and Private Infrastructure [was a positive contributor to the fund’s performance]. In particular, our impact lens directs us to the higher growth parts of these markets, as this is where positive impact opportunities tend to concentrate (innovation and scale-ups, greenfield renewables & storage infrastructure,” Engelchore adds.“Exposure to Private Infrastructure provided a natural hedge against inflation and rising energy prices. Some of the greenfield renewables infrastructure investments in our portfolio were developed and reached operational status. Becoming an operational assets typically goes hand in hand with a valuation uplift, as underlying income streams (from selling electricity)values the asset at a higher level. On top of this, some operational assets were sold to strategic buyers at a premium,” Engelchore continues.
Transformative Farming and High-Intensity Olive Orchards
The agricultural focus of the Kempen SDG Farmland fund provides a welcome respite from a pure focus on monetary dynamics. According to Portfolio Manager Richard Jacobs, transforming depleted land into productive soil has proven a successful strategy for the fund.
“Last year we saw a significant increase in the valuation of row crops farmland, soybeans and maize, by 20-30% globally. As a result, one of the drivers of our returns last quarter was the increase in value of our Australian row crops. Our innovative approach, the ’Transforming Strategy’ allows us to turn depleted land into fertile farmland. In Australia, we successfully transformed a piece of land formerly owned by a coal mining company into farmland. Now we are planting it sustainably and creating habitats for native animals like koalas. A special passageway is also being built so that the animals can cross the site safely,” Jacobs explained.
Considering the path ahead, Jacobs‘ focus was on developments in “We are looking forward to the second half of the year, because then the second harvest is due on our olive plantations in Portugal. By buying smaller, unproductive plots from more than fifteen individual sellers, we were able to create a high intensity orchards. When underwriting the investment two years ago, we originally expected to receive about two and a half euros per kilogramme of olive oil. Last year’s harvest sold at four euros per kilogramme, exceeding our original expectation. This year, olive oil prices are expected to reach six to seven euros per kilogramme because of lower than expected yields due to the lack of sunflower oil from Ukraine, heat waves in southern Europe and the lack of rainfall in Spain, Italy and Portugal. Despite the extremely dry and hot year, our sufficient water supply and good irrigation have largely mitigated the negative impact,” Jacobs said regarding the second half of the year.
Continued Momentum and Possible Threats
Returning to private debt markets, most portfolio managers agree that a continued rise in interest rates will be favourable. “Continuing increasing interest rates [will be a significant driver of performance in the second half of 2023]. It will increase performance in the fund since we will be able to negotiate up the pricing on the new loans from the fund,” said Trill Impact’s Andersson.
However, certain changes could unsettle this momentum. “Sustained levels of high volatility in USD and global interest rates would have an impact on our performance relative to the risk-free rate. However, at this point of the hiking cycle, we expect the yield of our loan portfolio to continue to catch-up with interest rates and the fund performance to get closer to our mid-term target of SOFR + 300-350bp,” responsAbility’s Chadha explains.
“The demand for loans and the credit quality of our portfolio’s end borrowers (i.e. micro and SME end-borrowers) and consequently of our investment portfolio, show little historical correlation to the interest rate cycles. A sharp contraction in global growth may impact our markets and would increase the chance of credit losses in excess of our long-term average of 0.8%. However, the current economic growth outlook for 2023 is stable and supportive for our operating environment,” Chadha continues. According to the IMF, emerging market GDP which grew at a 3.7% rate, is expected to stay Constance in 2023. In contrast, the IMF projects a contraction in developed markets.
However, not all investors agreed with the IMF. “We anticipate economic growth in EM to decline slightly in 2023, as Central Banks may raise interest rate to fight inflation. The impact of tighter monetary policy is expected to, over time, push financial inclusion institutions to pass on the higher funding costs to end-user borrowers which is expected to reduce the credit demand. However, we expect this process to take some time and manifest itself closer to late 2023 due to the relative longer duration of liabilities as compared to assets at microfinance lenders. Overall, we anticipate that 2H 2023 will provide similar result as the first half of the year,” ACTIAM’s Vukic argued.
Avoiding Bad Lending Practices
Microfinance funds are keenly aware of the predatory lending risks that an environment characterised by rising rates may entail. Addressing this concern must be at the forefront of their approach, according to Trill Impact’s Andersson.
“We keep track of lending rates and margins in the MFIs the fund lends to, and too high rates are a cause for the fund to not lend to a MFI. All the MFIs the fund lends to adhere to the Client Protection Principles, and have a responsible approach in general to lending. They would not all of a sudden change their mission and start applying predatory lending because international interest rates start increasing. We wouldn’t work with them in the first place if they had such inclinations, that’s part of the due diligence,” Andersson explains.
“Some MFIs may pass on increased funding costs to their clients (in the same way that it happens here), or accept decreasing margins. We are not talking very high numbers in any case though; if we get 2% extra for a loan to a MFI, that doesn’t translate to much for the microentrepreneur since they tend to have very high-profit margins (the smaller the company, the higher the margins in relative terms). And the pricing has over the years fluctuated in these countries anyway since they all traditionally are in high inflation and high interest rate environments,” Andersson concludes.