Issuers: Credit-arbitrage vehicles
Amount: more than $ 8 billion in 1997
For a niche of the market that contains only three genuine participants, credit-arbitrage vehicles provide plenty of intrigue and acrimony. They also provide a hefty volume of deals: last year over $8 billion worth of Euro-MTNs. In September, the life of the first such vehicle, Alpha Finance Corporation, will come to an end. In the decade since its launch many have tried and failed to duplicate its success. And those that have succeeded have not always seen eye-to-eye.
The logic behind the vehicles is straightforward. Raise initial equity capital and leverage it by issuing triple-A rated debt, mainly MTNS and CP. Invest the proceeds in a portfolio of investment-grade assets, and give the equity investors a Libor-plus return from the credit spread between the company’s assets and liabilities.
The difficulty arises in getting, and maintaining, the triple-A rating. Fiona Gregan, a director at Standard & Poor’s in London, says that over the past year she has had over a dozen enquiries from people looking to set up such a vehicle, and points out: “Many of those haven’t come to fruition.”
The role of the rating agencies has come under scrutiny with the departure of a senior member of Moody’s structured-finance team. Having had access to proprietary information he is now believed to be developing a similar vehicle for Nesbitt Burns. Stephen Partridge-Hicks, one of the founders of Gordian Knot which manages the Sigma Finance companies, thinks it challenges the credibility of the agencies, saying: “If you can’t trust a rating agency, and be open and direct with them, then it completely undermines their business mission.”
However, Partridge-Hicks is quick to point out that setting up a business is one thing, but the real challenge lies in managing it well. Very few people have got to that stage. The last credit arbitrage company to be assigned a rating was Centauri in 1996, managed by Citibank Credit Structures (CCS) who also run the Alpha and Beta companies.
That is set to change. Dresdner Kleinwort Benson has a vehicle set for launch in the second quarter, with an MTN programme of around $6 billion. Its designer is Alan Harley, previously of CCS: “It will take off from where we left Centauri,” he says.
Centauri itself marked a significant advance over CCS’s previous vehicles. Whereas the equity in Alpha is only leveraged five times, Beta has 10 times leverage, but Centauri could go as high as 25 times the equity capital. “We have made huge advances in terms of risk management, so we can now measure risks more accurately and free up capital as a result,” says Charles Covell, managing director at CCS. “It allows us to remain in the market in a way we are comfortable with.”
This is increasingly important in a market that has experienced dramatic spread compression since Beta was launched in 1993. As a benchmark, CCS regards Libor plus 2% as a good return for equity investors. Beta still achieves that mark because it bought the majority of its assets before most of the spread convergence happened. If it was launched today, CCS would expect earnings on the same risk to be halved. To meet the benchmark, a similar company would therefore need to take more risk on the asset side of its balance sheet.
Centauri avoids this extra risk because its more sophisticated structure provides double the leverage possible with Beta. This improved capital efficiency allows it to remain invested in blue-chip credits.
These are vehicles that live or die by the fluctations in credit markets. The credit crunch precipitated by Asia was potentially disastrous. “If any of these companies had Korea in their portfolios, then it was certainly going to have an impact,” says Gregan at Standard and Poor’s. As a double-A credit, Korea would have been a legitimate investment. However, Covell didn’t buy into the logic: “Investment banks continually pressured us to buy Korea and Asia, but we resolutely refused. It’s not our business,” he says. Others may not have been as conservative, but as Gregan points out: “They have all weathered the storm, and are all still triple-A.”
Despite the Asian crisis, returns on Beta held up well last year, says Tim Greatorex, director at CCS: “We help maintain our position by ploughing back all disposal or MTN buy-back profits into yields.” The profits are put into a pot and then paid to investors pro rata over the remaining life of the vehicle. Beta has around $30 million in the pot, which contributes 20% of the current yield.
While the new-issue Eurobond market has been stifled by spread widening in the wake of Asia’s turmoil, Greatorex says that the MTN market has remained far more resilient, pointing out that “the river of money has to find an outlet somewhere”. He says that the CCS vehicles will fund themselves through MTNs wherever possible, and that “rather bizarrely, it works out to be cheaper than CP”. He feels that in the CP market you rarely pull off an exceptional trade, it is more about single-point arbitrage available on a daily basis.
A greater concentration on MTNs also helps to extend the companies’ maturity spectrum and to dilute liquidity risk. “It’s very easy to talk about credit risk, but in reality it is relatively modest given the quality of assets that we invest in,” says Greatorex. (Approximately 60% of the companies’ assets are triple-A rated, with the rest split evenly between double-A and single-A.) “Liquidity risk is more important as the debt is rolled over more frequently than the assets themselves.”
CCS has been the nursery of the market. Dresdner’s Harley is a former employee, so are Partridge-Hicks and his partner at Gordian Knot, Nick Sossidis. They lay claim to being the originators of the idea for Alpha, although Covell alludes to “a senior Italian banker” at Citibank.
Partridge-Hicks refuses to call the Sigma companies credit arbitrage vehicles: “If you borrow and lend you take credit risk. We’re involved in a business, not a transaction, and that business is essentially spread banking.”
In contrast to Harley, the Guardian Knot founders’ split with CCS was acrimonious. The bad blood resurfaced when CCS was looking to name Centauri. Harley recalls that an oversight by the company’s lawyers meant the reservation of the name with Delaware authorities lapsed before CCS was able to register the company. This came to the attention of Gordian Knot, which acted promptly to register the name itself. CCS sought to retrieve the name, but baulked at the sum Gordian Knot was demanding. As a result, what is known as Centauri elsewhere in world, goes under the name of CCUSA Inc in the US.
Sossidis and Partridge-Hicks dispute this account, saying that they had registered certain names in Delaware at the time of launching Alpha in 1988. They say that the issue was more concerning the Greek alphabet, than Centauri.
Dresdner’s new vehicle has the working title of NewCo, and Harley has no intention of revealing its intended monicker before the launch date. But he’ll be steering clear of Greek.
