“In both 2021 and 2022 our return drivers are the same – we find good credits, buy them cheap, and engage with companies to drive hard catalysts. Some of these are already starting to play out and the fund was up strongly in Q1 2022 despite the market volatility,” says Brantberg. Across both years, Lodbrok has been deploying capital into fresh opportunities in four main themes: underinvested energy situations; event driven convertibles; merger arbitrage in credit; and Covid re-opening trades. During 2022, a fifth theme area has emerged: a more discriminating refinancing market is generating both long and short opportunities. 

Lodbrok has been nominated for multiple awards, and following its strong 2021, the manager is also rolling out a new long only vehicle that can additionally invest in private debt and direct lending.

A new paradigm for pricing risk

“The market backdrop has moved from very benign to now much more uncertain. The paradigm has shifted from one of central banks underwriting the pricing of risk and flooding the markets with liquidity, to one of liquidity withdrawal and rising interest rates in response to heightened inflation. The Russia-Ukraine war has accelerated existing macro trends, with first and second order effects mainly observed through commodity prices: following many years of underinvestment, energy markets were always going to be facing a shortage of supply, wheat prices are contributing to food inflation, and supply chain problems have worsened,” says Brantberg.  

Other challenges for the high yield credit market include a technical supply and demand imbalance: fund redemptions and portfolio sales by banks, and structured credit vehicles, are adding to supply as are issuers anxious to refinance. “The primary window for borrowers has significantly repriced. Credit has gone from a benign refinancing environment to one with much more uncertainty over terms and pricing – and some issuers have not, and will not, be able to refinance,” says Brantberg.

All of this sets the stage for market turbulence, already manifested in equity market volatility and wider credit spreads. Though credit spreads have blown out somewhat they do not as yet discount the full risks of economic slowdown, recession, and rising defaults, according to Brantberg. “We find economic growth and default rate forecasts can be misleading as we do expect a meaningful slowdown – whether or not it is technically defined as a recession – and we are well above consensus for defaults. The initial widening of credit spreads can be seen as early warning shots during the calm before the storm.”

Lodbrok is positioned for this direction of travel. The fund is broadly market neutral most of the time, but is prepared to be opportunistically net long following a market dislocation.

Hedging, shorting, and timing opportunistic net long exposure 

Coming into the Covid crisis, the fund was fortunate in having a deliberate bias to investing in non-cyclical sectors on the long-side such as food and software. Some alpha shorts, including a cruise line operator, were also beneficial. After the Covid crisis initially hit, Lodbrok briefly and opportunistically moved to a net long stance, though looking back at the speed of central bank intervention, Brantberg admits he could have covered shorts faster and moved to net long earlier. He would also have been net long during times of meaningful dislocation, such as post-Lehman around late 2008 to early 2009, but in normal or frothy credit markets Lodbrok expects to be broadly market neutral measured in beta-adjusted terms. In fact, since inception of the flagship fund, returns have displayed an almost zero correlation to the European credit market – and in some periods such as the first quarter of 2022 this has been negative. “Our forecasted beta may be near zero most of the time, but our monthly net returns have had a negative realized beta. In the first quarter of 2022, for example, we were up 8% and the credit market was down 6%,” he clarifies.

A combination of owning lower beta event-driven situations, maintaining substantial shorts and hedging most of the time leads Brantberg to argue that most of the strategy’s volatility is caused by idiosyncratic events, rather than systemic financial or credit market risk. This name-specific volatility is partly mitigated through diversification across c.20 high conviction long positions and through a carefully crafted short book of asymmetric single names and hedges. “Single name longs can be “gappy” at times of volatility and the intention is to maintain a short book of single name shorts that exhibit similar gappiness,” explains Brantberg. 

Bolder single name shorts 

From 2019 to 2021 the single name short book targeted low running cost of shorts within a 1-2% range, in case European credit underwent a “Japanisation” with permanently low interest rates keeping “zombie” companies afloat. Now in April 2022 Lodbrok is prepared to incur more negative carry-on shorts in the expectation of larger capital gains should re-financings fail. “One example is a structurally and cyclically challenged UK retailer, which was able to refinance historically but might soon struggle to do so and may be required instead to restructure its debt. It is still possible to short the bonds at above 90 cents on the dollar, meaning losses of a few points plus the carry if it can refinance, and potentially significant profits if it cannot,” says Brantberg. Some patience is needed because failed re-financings may not trigger defaults until issuers get closer to maturity dates and deadlines whereas equities reprice more quickly. “With credit there is a trickle and then a flood when the primary market problems percolate into secondary markets,” observes Brantberg.

Macro and tail risk hedges

Lodbrok is also cognizant of the risk of Black Swan events, like Covid or Russia’s invasion of Ukraine. The portfolio has a variety of more macro, convex, option and swaption related, as well as tail risk-oriented hedges, which aim to protect the long portfolio in the event of a sharp risk off move in credit spreads, equity markets or other related markets. The most direct hedges include those on credit indices, while indirect ones can include out of the money call options on oil or put options on certain currencies that may be vulnerable to geopolitical events. “We add value as bottom-up fundamental pickers of credits, but we need to be macro aware. We do not take big macro long or short positions, but rather seek to be robust during periods of dislocation,” confirms Brantberg.

Inefficient European credit and the stressed sweet spot

Regardless of where markets are in the credit cycle, Brantberg judges the European sub-investment grade credit market to be structurally inefficient, mainly as a result of both its nascency (compared to the US) and rapid growth, having now more than quintupled in size since the GFC.

For much of 2018-2021 period, European corporate credit presented a paradox that Brantberg finds compelling. With credit spreads near historic tights, investors were pushed along the risk curve in search of yield whilst maintaining aversion to the many types of corporate complexity more often found in this part of the yield curve. These are the sorts of situations that Lodbrok specializes in. This resulted in both a large opportunity set and an outsized complexity premium for taking a view on specific corporate events such as mergers, restructurings, and spin-offs as well as simply capitalizing on fundamentally misunderstood business models.

Europe’s credit markets in April 2022 can still be characterized as something of a barbell. At one end, performing debt trades around or above par offering spreads that are relatively tight on a ten-year lookback, while at the other end, the supply of distressed debt is still quite small, especially relative to the wall of capital chasing such opportunities. In between these extremes lies a wide range of sometimes complex situations that can be categorized as “stressed” – this is where Lodbrok focuses.

Though average financial market volatility was low in 2021, it can spike up quite quickly as seen in the first four months of 2022, which arguably reflects the high levels of fragility and a somewhat binary investor mentality. “Investors will own a simple story at a very tight yield but rush to exit at a deep discount as soon as the situation gets messy. We get rewarded for price discovery, based on our deep fundamental research, in tackling messy and complex situations,” says Brantberg.

Incidentally, credit ratings are too slow moving to capture these dynamics in credit markets. 

Though credit ratings are traditionally used to define boundaries between and within performing, stressed, and distressed debt, neither official published ratings nor “shadow” ratings for unrated credits are useful for Lodbrok’s process. Brantberg is of the opinion that, “the ratings agencies are, by their nature, reactive and nearly always behind the curve by at least six months. The main benefit of credit ratings is that they can prompt technical selling from ratings driven investors, which can give attractive entry points for contrarian investors like us”.

Brantberg’s guiding rule is simple: “We seek to underwrite all our investments with the goal of achieving par at maturity no matter what”.

Deal flow sourcing and private equity style due diligence

Many of Lodbrok’s investments are somewhat off the radar for mainstream investors. Much of the deal flow is sourced off-market via the team’s network forged through their prior careers both in private equity and public credit with firms such as Bain Capital, Farallon, Och-Ziff (now Sculptor) and GSO Capital/Blackstone.

Lodbrok’s due diligence process is distinguished by its intensive private equity-style, which entails talking to management, former management, customers, suppliers, industrial advisors, potential M&A interests and others to build a deep understanding of the business, the complexity and what is likely to drive an accelerated pull-to-par. “This depth of research is not usually seen in credit markets,” says Brantberg.

Around one third of companies invested in are private equity owned, with another third publicly listed and the remaining third family owned. Different approaches to information gathering are applied to each type, and the process draws on the team’s experience of following these companies over time and through various incarnations often as public and private entities, and as either independent entities or parts of larger groups.

For instance, Brantberg has been following Europe’s largest home alarms firm for over a decade. “It was spun out of a global security firm Securitas, but the market misunderstood the business model which basically involves short term operational and capital spending to acquire customers who are then basically a 15-year annuity. This successfully sacrificed short term profit for the benefit of long-term franchise value. In the past we encouraged one of Europe’s largest private equity firms EQT to look at it and they took it private and went through numerous financing rounds. It was then sold to two other private equity firms.” Subsequently, the market volatility in 2020 provided the entry point for Lodbrok as the Covid crisis forced CLO managers to sell some of their better credits. “Knowing the group so well we were able to move quickly and confidently to acquire senior bank debt at 79 cents on the dollar and judged that this could be a good investment in any macro climate,” says Brantberg.

A focused high conviction book 

Given the focus on a concentrated portfolio and the time taken to research each investment, the manager considers that the strategy is capacity constrained at around USD 1.5 billion for the liquid credit strategy, including both the purely liquid fund and liquid sleeve of the new one (and leaving headroom for asset growth through performance). 

The deliberately lean team, designed to ensure optimal communication and connectivity among the investment group, aims to have around 20 active positions at any one time. Typically, no more than one position will be added or deleted each month. “We have the luxury of being highly selective. We want to be the deepest in the weeds and the thought leader on each position and we could not do this with 100 or 200 names. We believe that you can do something genuinely differentiated with a 20-name portfolio that you cannot do with a 200-name portfolio,” says Brantberg. 

Lodbrok has invested in a wide spread of industries, including “old economy” sectors such as pharmaceuticals, energy, and bakeries, as well as “new economy” areas such as software or food delivery but they share common qualities. They tend to be in relatively defensive sectors with low economic sensitivity. 

The common bottom-up quality of the companies invested in is their strategic business models, which could be attractive to acquirers; acquisitions are one way in which investments can be exited before maturity, at a higher return. “We seek higher quality businesses with a higher return on capital, with pricing power (especially in an inflationary climate) and with genuine reasons to exist so that we can identify multiple strategic buyers who would love to own them in both good times and bad,” says Brantberg.

Tailored to Northern European countries 

The firm’s specialist geographic focus is Northern Europe – which includes the UK, Benelux, Germany, Switzerland and Scandinavia as this is where the team have the most experience and strongest networks. Within Northern Europe, the approach needs to be tailored to each country. While the bankruptcy regimes may not be highly sophisticated in Northern Europe, they are reliable. This predictability in the rule of law allows Lodbrok the confidence to underwrite an investment, knowing that the country’s commerce relies on good governance should any form of court led restructuring be required. These markets all operate differently with different credit regimes providing a natural barrier to entry for those less accustomed to, or experienced in, these markets. 

“The way in which we seek to address corporate governance issues in the UK is quite different from that in Switzerland. And expert local counsel is used in each country, to complement Lodbrok’s internal legal resources. We know who to ask when we are digging deep into a German wind farm securitization or a UK software business,” says Brantberg.

Trade life cycles and complexity premia

The long book of the flagship strategy is invested in short duration liquid positions that have a market price or counterparty quotes. Between 5% and 15% of the book turns into cash each month and investments follow a distinct life cycle: “Phase one is where we start sizing into an investment that we consider to be mispriced due to some form of corporate complexity that the market is unable or unwilling to unbundle. When one does, one often unearths good strategic businesses with strong rationales to exist that are only being temporarily impacted and where, at worst, we can underwrite the instrument to contractual maturity.

“Phase two is where we generally increase the position as events and catalysts become tangible and we see a route to an accelerated pull to par. The higher cash price and lower duration gives us confidence to size up as we get closer to an event.

“Phase three is the post event trade. Here we are no longer being compensated for fundamental risk, as the business has been sold, or transaction risk, as the transaction has already occurred. Instead, we are compensated for a systemic bias whereby European institutions are willing to leave money on the table in order to clean up and move on from situations that have been messy and complicated in the past,” says Brantberg.

Energy: Oil services and renewables 

Net sector exposures normally max out at 25% but can fluctuate with the timing of long and short position entries, exits, and associated catalysts. Energy was the largest net exposure as of March 2022. This is a contrarian sector that has been starved of capital, which has arguably created the unintended consequence of an energy squeeze, seen for instance in record natural gas and electricity prices in Europe and Asia. Other investors are, in some cases, completely excluding or divesting from parts of the energy sector, but this is amongst many situations in multiple sectors where Lodbrok sees an opportunity to be part of the solution by driving outcomes, which can include not only generating high cashflows but also transitioning to lower carbon business models. Energy has been mainly geared to oil services which offer most gearing to the acute need for more capital spending on production and exploration. Lodbrok has sometimes invested alongside Norwegian billionaire, and veteran oil services investor, John Fredriksen, who recently invested in one of Lodbrok’s portfolio holdings, offshore driller Valaris.

Though constructive on the sector, Lodbrok has also identified some short hedge and single name alpha opportunities, including one recently exited in an Italian name; energy related hedges, such as out of the money puts on energy equity indices, were also especially helpful during the Covid shock in 2020. 

There is also exposure to renewable energy themes including solar power and silane gas. Lodbrok is one of the largest creditors of a polysilicon producer and supplier to the solar industry, which offers significant optionality under two scenarios. “A normalization of solar supply chains upon resolution of US/China trade disputes, or potential use of silane gas in electric vehicle batteries, could both be transformational,” says Brantberg. “The early 2022 selloff in growth equities is starting to make valuations more attractive in the renewable space,” he adds.

Playing mergers more asymmetrically in credit

Potential and actual mergers have provided some of Lodbrok’s most compelling trades. Lodbrok uses credit instruments to express views on corporate activity, both pre- and post-event, and can sometimes generate not only much higher absolute returns, but also much more asymmetric risk/reward than those available to investors who use equity to play the same or similar events. “Bank debt that could pay par (100) upon a merger deal closing can still be trading in the low 90s after the deal has gone effectively unconditional. Annualized spreads on a deal such as CSM Bakeries, which traded at 92 just three months before par was paid, could work out at over 30%, which is multiples of what the equity market would pay in unconditional merger arbitrage situations. European credit is simply much less efficient than European equity,” says Brantberg, who started out working in mergers and acquisitions at Goldman Sachs, before moving to event driven equity at Och-Ziff where he gained deep experience of merger arbitrage. He furthered this experience when moving to Farallon where he was focused on opportunities across the capital structure. This led him to find his niche in European corporate credit, which he believes is one of the most interesting areas of event-driven investing, providing a high-quality risk reward in an uncrowded and uncorrelated sector of the European investment landscape.

Event-driven convertibles and food delivery

As well as post-event trades, convertibles trading below par with certain nuances such as takeover ratchet clauses can generate big profits if takeovers occur and could still return par plus a normally healthy coupon income if no event materialises.

“We bought the convertibles of satellite operator Inmarsat at around par and received 154 upon a takeover but would still have clipped coupons around 4% per year if there had been no bid,” says Brantberg. Sometimes Lodbrok will even help to shape the features of convertibles. A listed German group focused on industrial and logistics properties provided an opportunity for Lodbrok to proactively structure a convertible, which contained a takeover ratchet. “We anchored the issue, buying at 97 and realizing 162 including coupons after a takeover occurred,” says Brantberg.

A contrarian bent is evident in name selection. The swoon in growth and technology equities has taken 20% off the Nasdaq 100 as of April 2022 but some smaller growth names have fallen by 50%, 75% or more and now have share prices that translate into interesting optionality for issuers’ convertible bonds. Currently Lodbrok is invested in the convertible debt of a food delivery business, Just Eat, viewed as highly strategic and attractive to acquirers. It previously received a hostile bid in 2019 from Prosus. An activist shareholder, Cat Rock, who argues that the stock is deeply discounted on a sum of the parts basis, is agitating for a spin-off or sale of its US unit, Grubhub, and Brantberg advocates this plan. “The convertibles trade below par but could pay well above par if a takeover happens at the right price,” says Brantberg. He recognizes that growth equity in general has been de-rated but therein lies a game changer for some of the stronger and more well-established food delivery firms: “New entrants with very low costs of capital had been destroying margins in many markets, but now that their costs of capital have repriced, incumbents have a better path to profitability. We have also taken more direct advantage of the repricing of capital, buying short dated convertibles issued by Delivery Hero, which could offer an equity like return if more rational industry pricing emerges”.

Contrarian Covid reopening trades 

While food delivery was an obvious beneficiary of the pandemic, sectors that clearly suffered from it are also interesting. Travel and leisure were not owned by Lodbrok on the long side before Covid, but in late 2021 Brantberg found bonds trading in the high 80s or low 90s could be very compelling because, “some businesses are emerging stronger from the pandemic”. News flow around new Covid variants and associated travel and other restrictions, as well as geopolitical shocks, have led to regular selloffs in travel and leisure names, though they are long term growth industries, growing faster than the economy. Within this theme, Lodbrok is exposed to intra-European travel, which has not been meaningfully impacted by the war, according to Brantberg.

Refinancing 

Lodbrok is typically priced out of the refinancing market. The current market turbulence and the absence of conventional sources of capital are, however, translating into opportunity in this area as well. A recent refinancing opportunity on the long side was a German chemicals company that needed to offer a low double-digit coupon for issuing new paper that would have most likely been priced to yield a mid-single digit return if done a few months ago. Lodbrok believes on the short side, the dynamic where the lowest quality companies were able to defer restructuring through refinancing is likely over.

Lumpy returns from unique events 

The long book return target is made up of running cash coupon yield of around 6-7%, which typically rises to c.11% if one includes the contractual pull to par assuming a par repayment at maturity. Lodbrok is deliberately targeting situations that are likely to be taken out prior to maturity through some form of corporate activity. If they are right about the timing of these events, then the expected returns are accelerated to high teens/low 20s. 

The average through the cycle return target is thus mid to high teens annualized, though, given the J-curve nature of the individual investments (a term more often used in private equity), in any given calendar year the portfolio can overshoot or undershoot. In 2021, Lodbrok attained more than double the target as some catalysts/events have materialized faster than expected and some corporate events delayed in the previous year came to fruition. “In 2022 we believe significant value in the current portfolio remains, with hard catalysts to realise this and we are now actively working on these situations,” says Brantberg. 

Lodbrok does not expect to achieve perfect timing and later, given the J-curve nature of these situations there can be opportunities for averaging in at better levels. Sometimes, the worst performers in a year have become the biggest winners in the next year. It can also be worth establishing a toehold or foothold in a position to start influencing the direction of travel.

Selective activism

Lodbrok aims to be the thought leader in every situation they get involved in, which Brantberg defines as, “Having the deepest fundamental understanding on the value of a business and what it should do. We will not necessarily be the largest creditor or own the fulcrum or controlling security, but we aim to have done the most work, which means we can help the company unlock value”.

Extracting value sometimes requires varying degrees of private or public activism, but this is not essential. “If events unfold as we like there is no point in being activist,” says Brantberg. However, Lodbrok becomes activist when intervention is needed to unlock value and/or enforce creditor rights.

In Swiss baker Aryzta (the largest profit contributor in 2021) Lodbrok had been a long-term holder of the debt but also took an equity position to be able to vote for governance (board) changes at the AGM. Their activist approach significantly influenced outcomes, with the whole board eventually being replaced. They successfully nominated two people to the board including Lodbrok’s former industrial adviser. As part of this process, Lodbrok spearheaded opposition to a bid from Elliott Advisors, arguing that this grossly undervalued the business: “We would not go public for the sake of it, though we do not shy away from being public if this is necessary to both maximise returns and ensure proper corporate governance. We try to be as engaged as possible and will cross over into a more public conversation in a minority of cases,” says Brantberg. In other cases, Lodbrok’s private and collegiate dialogue with companies can be pivotal: “We might have most ability to influence restructurings in a private company,” says Brantberg.

Occasional debt for equity swaps

If the original investment thesis does not pan out, Lodbrok might pursue value recovery through a debt for equity swap if this might lead to a better outcome. Lodbrok is prepared to step into a restructuring and Brantberg firmly believes that “investors in complex situations must be prepared to roll up their sleeves and get involved in messy situations if required”.

At the time of the interview, Lodbrok owned some US listed equities acquired through debt for equity swaps: Valaris and Skillsoft appear on its 13F regulatory filing.

The original plan for educational software and digital learning group, Skillsoft, was that a multitude of strategic transactions could make it a simple pull to par debt investment. However, the then PE owner did not choose to take any of the available options and, as a result, the firm needed to restructure. Brantberg considered that the original thesis in the value of the group remained intact and steered a re-org of the business through a Chapter 11 process. This ultimately led to Lodbrok negotiating a merger with a SPAC listed company, Churchill Capital Corporation II, including being instrumental in facilitating an investment from Europe’s largest consumer internet company, Prosus. “We wanted to realise the long-term fundamental value of the business and we think it is now a better business than when we first invested, even though the path to value has been longer than expected. We remain excited about the long-term story,” says Brantberg. Skillsoft has seen its share price halve in the first quarter of 2022 as the violent selloff in small cap US technology names has seen babies thrown out with the bath water. “This is despite it being a highly profitable company having returned to organic growth and leading industry consolidation through acquisitions. Additionally, Skillsoft itself could be attractive to financial or strategic buyers.”

In another example within the underinvested energy theme, Lodbrok was attracted to offshore drilling contractor, Valaris, by a rather complex structure that also created the potential for two avenues of recourse on a convertible bond should the company need to restructure. “An SPV issued a convertible guaranteed by the parent, and then lent back to the parent. This meant that if the firm became insolvent, we would be able to seek recovery from both the intra-group guarantee and the intra-group receivable, which gave us a clear path to par, regardless of the state of the market. The company did ultimately file for bankruptcy though Lodbrok mitigated much of the downside with energy related hedges such as out of the money puts on oil equity indices, etc. In the restructuring Lodbrok’s double claim was recognized by the court and they received twice the recovery of other creditors. Lodbrok was also prominent in the restructuring process and through active involvement could also benefit from underwriting an attractive new money facility while ensuring a strong re-emergence for the company. The firm refloated in June 2021 and the shares had appreciated by over 150% as of April 2022. Lodbrok remains excited about the value potential of the company given the more favorable macro environment as well as the self-help options available to the company.

However, Lodbrok will not always be so patient if they consider that a fundamental underwriting error has been made on their part. For example, if Lodbrok’s dialogue with companies falls on deaf ears, and concerns about corporate governance or other matters surface, then selling may be the only remaining option. “Thankfully, the largest realized loss thus far has been around 1% of the fund, on a German listed real estate manager that was not willing to heed Lodbrok’s views on corporate governance,” says Brantberg.

ESG

Activism is one facet of Lodbrok’s ESG approach, where the manager has engaged with companies to improve their governance, replacing boards, nominating directors, and changing control and ownership. The firm has also identified and raised social issues such as child labour, predatory lending, and environmental issues such as fish farming externalities.

ESG is very much integrated into the investment process. A key influence, Farallon founder Tom Steyer, is now characterized as an “eco-warrior” and has shaped Brantberg in terms of both investment and ESG. “Steyer identified the inefficiencies in the equity market around take-overs which resulted in merger arbitrage in the 1980s, similar to what we are seeing in European credit today, and he always took ESG into account in terms of underwriting, monitoring, and engaging,” says Brantberg.

Lodbrok’s primary objective is delivering high quality, uncorrelated returns to investors, and the process considers ESG factors for both longs and shorts: “We want to be long of good ESG and short of bad ESG businesses as part of our thesis,” says Brantberg.

The firm describes ESG considerations as a critical part of its investment process and they have been part of Lodbrok’s underwriting since its inception. Brantberg believes that there is a strong correlation between a company’s healthy ESG approach and good company management: “Understanding a business’ ESG related factors is essential in our early due diligence to help avoid positions in companies with poor long-term prospects”.

Whilst Lodbrok has no hard exclusion list as such it is less likely to invest in companies with what it considers low ESG ratings. If investors require special exclusions these can be accommodated through separately managed accounts or share classes. Some investors’ desire for ESG oriented customization involves reporting requirements, e.g., dedicated reporting on identification of ESG related issues, active engagements, and outcomes.

Look ahead

Looking ahead Lodbrok believes that the opportunity set for the strategy will not only remain strong but grow “as we are now entering a more uncertain economic climate in Europe and globally”. Uncertainty brings opportunity and as such they are in the process of adding to the investment team to ensure that they continue to take full advantage of the sizeable opportunity in the European corporate credit market.