Structured credit debate: The leveraged loan revolution
A huge influx of liquidity has made the collateralized loan obligation almost standard fare for Europe’s institutional investors. But as they snap up CLO equity and new credit opportunity funds, they need to choose carefully.
DR, Indicus There has been more than $73 billion of issuance in the leveraged loan marketplace across 148 deals this year so far. At that rate issuance will far surpass 2005. What is driving this explosive growth?
DFN, Alcentra This has been a watershed year for leveraged loans. As you say, there has been huge growth in volumes and it has been fuelled by private equity capital. About 50% of the market is now funds provided by institutional investors, be they CLOs, hedge funds, credit funds or prime rate funds. An arranging bank looking at selling down an underwriting position at the beginning of 2004 could probably raise €400 million from European-based institutions in the European market. Today it’s more than €2 billion. That means that institutional investors can now drive transactions. And that’s also had a big impact on secondary market liquidity. One dealer estimated that there would be $75 billion of trading of leveraged loans in Europe this year. That’s up from $50 billion in 2005 and $25 billion in 2004. And now a loan CDS market is developing, making it easier for portfolio managers to manage their risk.
TB, Bank of America In Europe, the institutional bid for loans has historically referred to CLOs. Today, there remains a large bank investor component to the market. However some are noticeably selling out of loans via portfolio transactions, sometimes looking to earn CLO fees. More importantly, we are now seeing a wider variety of non-bank institutional investors in addition to CLOs, including hedge funds and non-rated structured funds.
IH, Babson I agree with David that the big driver is the influence of private equity funds. With the vast majority of our assets still sourced in primary syndication, we need to keep close to the private equity houses and the arranging banks.
DR, Indicus In the four or five years since the beginning of this institutionalization in the market, how has the investor base changed?
TB, Bank of America Two or three years ago the institutional bid for loans in the market was roughly 30%, and 95% of that was typical cashflow CLO vehicles. Today the institutional bid in the loan market is something like 50%, but only two-thirds of that are cashflow vehicles. So, one-third of an increased share is represented by multi-strategy credit hedge funds or alternative structures set up by CLO managers.
DFN, Alcentra The market’s a lot more global now for investors in CLOs. At the start, there was a lot of liquidity out of Germany and Scandinavia, but Asia has opened up significantly this year. Also, of the four funds we’ve raised this year, we haven’t done the usual equity roadshow. They’ve all been reverse enquiry. Now, one of the biggest issues we have is equity allocations on our deals, whereas that used to be the hardest tranche to sell.
LB, Euromoney So the increase in demand is right across the capital structure?
SP, UBS Yes. First there was huge demand for triple-A debt from investors who saw structured credit as an alternative to the traditional way of taking a credit view. For triple-A risk, they got a wider spread. Over the last two years, as they’ve got more familiar with the structured credit product, they’ve moved down the debt structure. We’ve also seen the pioneering buyers of the equity use their experience to bring other, less experienced investors into pooled funds. Investors now understand the positive aspects of the loan market and that’s fuelled this huge increase in demand across the capital structure.
SP, UBS There’s much greater understanding of how CLO structures work. People are going down the spectrum not so much to chase yield, but because they’re more comfortable with the structures, and so they’re comfortable taking the opportunity of that yield.
AK, Harbourmaster Yes. There are more dealers willing to trade in CLO equity, because the market is becoming more transparent. It is trading, and if an investor wants a bid, there are a number of banks that will provide a bid for that equity.
AH, Alegra But there’s a handful of people in the market you can approach who can give you a price, and people should be aware that bid-offers are sometimes wide. A lot is being sold on the basis of Intex modelling assumptions. What may be the investors’ benefit today may become a double-edged sword because someone on the other side may become disappointed. And bad news always travels. That’s why, when you talk to your potential investors, you want to make sure that they understand the mid- to long-term investment horizon of such investments.
TB, Bank of America Arrangers of CLOs are starting to see some differentiation in pricing throughout the capital structure between well-established managers and newer entrants. In the market we see triple-As pricing at 26, 27 basis points over Euribor for some inexperienced managers, and 22, 21 bp for experienced managers. At the equity level, we are told by our investors that some deals involving inexperienced managers are getting done only by agreeing significant discounts. So investors are starting to employ greater scrutiny over deals as the flow continues to increase.
LF, Calyon To a certain extent that reflects the marketization of loans, that is, loans products (including CLOs or low-levered funds) increasingly being included in the portfolio allocations of large pension funds and insurance companies: when these institutional investors shift some of their previous alternative investment allocation to the loan asset class, they obviously understand that buying a classic equity CLO is different from buying a deleveraged fund like a zero to 40%. These investors generally need size: low levered structures usually rely on a larger asset pool and that implicitly means they can be allocated a larger size compared with a classic CLO product.
DR, Indicus That’s what the banks have seen. What about you on the buy side?
SP, UBS From the investor side, there have been two interesting developments. One is the manager of managers concept. When we started out selling we were looking for individual investors who understood and liked the story. It wasn’t the insurance companies or the pension funds – it was some insurance companies and some pension funds. As some of those people have evolved into managers of managers, they have brought more people into the asset class. The other thing is that a lot of people were held back from the market early on, just because the market wasn’t big enough. You have to devote a lot of resources to understanding how a CLO works, and if you can only buy 10 issues a year, why bother? The huge increase in liquidity and diversity in the market helps bring more investors in.
IH, Babson And selling the idea has become an awful lot easier. We now have a track record, so it’s much easier to get investors interested. We’re getting significant reverse enquiry interest but performance is the key to future fundraising.
Rise of hedge funds
LB, Euromoney What has been the impact of the increase in hedge-fund activity in the sector?
AK, Harbourmaster We’ve already seen hedge funds pull back. In 2005 many were faced with redemptions and sold off their loans. It taught us that hedge fund money flows in and out. We saw further large sales of loans by hedge funds recently. But it is important that there are more than just CLO vehicles in this market, because managers have different motivations, different investment strategies, and you can take advantage of that in secondary.
DFN, Alcentra, We generally focus on the larger end of the market, the likes of TDC or Ineos. And, like Harbourmaster and Babson, we can put large amounts of capital on the table on day one, so we get invited into primary. Secondary is expensive, and some of these new entrants only have access to the market through secondary, which is not attractive from a portfolio management and relative value perspective right now.
TB, Bank of America Many CLO managers are setting up alternative funds that are market-value based, have redemption features and look more like quasi-hedge funds. That is partly because there is investor demand, but partly because well-established managers with long, good track records want more freedom in how they manage the loan asset class. They are limited in many ways in a typical cash-flow structure. They seek to have greater flexibility in order to be able to do what they do best–manage credit. Investors are interested in this type of product only to the extent the manager’s credibility speaks for itself.
Competition for assets
DR, Indicus Standard & Poor’s says that there are 76 European-based institutional investors active in the marketplace, up from 33 a year-and-a-half ago, compared with 236 US managers active in structured credit and leveraged finance. The majority of new managers in Europe have been existing managers in the US. Ian and David, can you give us your perspective on that?
IH, Babson Babson Capital was already a large US manager when we were acquired in 2004, and they took the view that buying established credit expertise was their preferred route. That credit philosophy is still very much core to our structure. Our business operates pretty well autonomously and the rest of Babson is strongly focused on US dollar-denominated assets. We’re mostly euro- and sterling-denominated. If you’re setting your stall out to be an expert credit manager, you have to have convincing resources directed at the market you say you understand.
DFN, Alcentra A lot of the new US entrants have found it very tough in Europe. Hiring the right talent is challenging and with only 10% to 15% of loans publicly rated, you need credit analysts who’ve been through cycles. The European market is still predominantly private-equity driven. Of those leveraged loans done in Europe, over 90% are sponsor-driven LBOs. In the US market, 50% of issuance is corporates levering up their balance sheet. We’re starting to see more of that, but it’s not common yet in Europe. I think some of the big hedge fund players have been quite surprised that they can’t just turn up at an arranging bank with a large chequebook. They also need to foster and develop good relationships with the private equity firms. What’s more, each jurisdiction in Europe has a different bankruptcy regime, a different culture, different ways of doing business, and hiring locals is a quicker way of getting to grips with that.
LF, Calyon Asian and Middle Eastern investors are increasingly considering European loans. It is true that they tend to be attracted to the larger US asset-managers who have set up European offices, as they have usually bought US loan deals before from the same brand. That could sometimes be a misleading analysis: the US firms may have long track records managing US assets, but their understanding of the European market heavily depends on whom they’ve hired and how they are set up.
TB, Bank of America There are over 200 managers in the US with reduced prospects for growth domestically. Many have set their sights on Europe. Some have bought very large and well-established businesses, others have bought teams, others have taken a more incremental approach. The strategies differ and no one strategy is superior. The key is to have a strategic approach with long-term goals that is capable of convincing investors that the manager can effectively manage the product in Europe over the longer term.
IH, Babson That gets your first deal off the ground, but the story then has to develop based on performance. You have to get funds fully invested, keep them fully invested, not buy your assets at big premia, and make sure poor credit selection doesn’t turn round and bite you.
AK, Harbourmaster We larger managers are getting very good allocations, in terms of collateral, in terms of getting the equity done on CLO transactions, and we’re seeing reverse enquiry for separate accounts and CLO transactions. I see the most intense competition for assets being between the US entrants and the smaller European managers.
DR, Indicus So you believe that investors should look harder at the size of the managers because of your access to deals and to all elements of the capital structure?
AK, Harbourmaster Size definitely matters in this market. The big buyers who are regularly active in the market see lots of deals, we have lots of choice, and can turn down loans while keeping our transactions well invested. With pure size comes negotiation power with arrangers, who will make concessions for large tickets.
LB, Euromoney That’s the arrangers, but isn’t it the relationship with the sponsor that really matters?
AK, Harbourmaster If the sponsor doesn’t want you in the deal, then you’re not in the deal, so sponsor relationships are important to us, and we are well known as a responsible lender. However, we’re investing in the senior secured loan only, not in the mezz or second lien, and for the senior secured, the arrangers are also important in deciding whom they want to propose for the invitation list and the suggested allocation which is approved by the sponsor. The sponsor involvement at that stage is generally not as important as at mezzanine levels.
SP, UBS Early on in the development of the market, the relationship with the sponsor was key to getting assets, but with more managers now seemingly able to get assets, have the sponsors given up on trying to keep control of their bank syndicates?
IH, Babson No, far from it. They’re very keen on seeing and vetting the names which go into the subordinated tranches of their deals. They are pretty ruthless on deciding who gets the mezz.
DFN, Alcentra European sponsors are also focused on who’s in the senior syndicate as well. CVC and Permira are developing a core group of strategic investors who support their deals, and they quite often show them new issues early. They want a rational set of investors who can write big tickets, and do the right thing if there is a problem. A number of the bigger European private equity firms will approach a core group first, maybe at the same time as the co-arranger part of the syndication. We've had situations this year where we’ve put €150-€200 million on the table in large market-leading companies, and got allocated pretty much what we’ve asked for. That is a significant competitive advantage. I’ve seen that less with the US sponsor community who are more driven towards the cheapest possible financing. So Alan is right, if you’re choosing a manager, size does matter.
SP, UBS We’re seeing definite delineation between managers. There are those with access to mezzanine, tending to do deals that have 15% mezzanine buckets in them, and then there’s another group going down the senior-only route, who don’t have such strong access to mezzanine assets. Managers go down different paths, depending on the strength of their sponsor relationship.
AH, Alegra There are disadvantages with size though. With your size, Alan, surely you must be buying the market because we at Alegra compare the size and growth of the European leveraged-loan market with the growth of larger managers such as Harbourmaster. The question is obvious: if you’re not buying the market then aren’t you assuming large cluster risks across all your vehicles and a considerable overlap within your CLOs?
AK, Harbourmaster In common with the other large managers, we get access. Out of more than 200 leveraged buy-outs done in Europe last year, we did around 40, and we did 20% of new issues. That is not buying the market. Our track record, during 2002/03 in particular, illustrates that we have outperformed the market.
MH, Prytania And large managers may be immune from some of the other pressures faced by smaller or new managers. A lot of managers have commented that liquidity and pressure from new entrants have led to less time for due diligence. Whereas previously with their relationships they had at least three to four weeks to do the work properly, now that can be compressed to two weeks – as it is in the US. They find there is less disclosure and less access to management.
Fundamental analysis matters
DFN, Alcentra At Alcentra we’ve got nine dedicated industry-focused analysts who each cover no more than, say, 20 names and three industries. I think there will be a correction in the next year or two and the guys who’ve done the fundamental credit work are going to be at a huge advantage. They’ll be the liquidity providers and be able to buy fundamentally attractive paper at cheap prices, and we have positioned ourselves to do that. We’ve also just hired a distressed-debt analyst to work on credits that are perhaps slightly underperforming, maybe 12 months ahead of needing him. Our view is always to have extra capacity in your credit team. That’s where the new entrants are going to have a tough time when the cycle turns. You need a deep bench of talent to run a CLO business, and you can’t spread these guys too thinly.
AH, Alegra As a provocative statement, David: if the market is liquid, then all you need is someone on a desk understanding credit. When you give that person tight trading parameters, he doesn’t need all that talent. At the end of the day, as an investor, the only thing we look at is, ‘What is this deal (and its assets) worth?’ Because if one day the market liquidity dries up you cannot trade out of your assets any more, but neither can anyone else.
DFN, Alcentra There’s enough liquidity today, but when the market turns, if you don’t know what you own, you’re dead. You can’t manage your deals by numbers. In Europe, only about 10% to 15% of new issues have a public rating, the rest 85% to 90% have a private rating. So if you don’t have a team doing the credit work, meeting management, modelling the numbers and understanding the key risks, you’ll be found out.
AK, Harbourmaster If you’re running a portfolio of senior secured loans on the basis that you can buy the market and you can trade out of the market if credit goes down, you will lose money.
AH, Alegra From the investor’s point of view, when the downward cycle hits you, isn’t it merely a question of how much one asset manager is hit versus another? You still have depressed pricing, whatever credits you’ve selected.
DFN, Alcentra But with CLOs you’ve got 16-year term finance, and the likely life of the deal is eight or nine years. Loans have one or two points of upside and they’ve got 30 or 40 points of downside. So if you buy the wrong loan you’re in trouble. If you have too many low-recovery rate loans, then the impact on your equity returns is going to be significant.
DR, Indicus Both Babson and Alcentra are launching mezz funds. Is that driven by investor demand given what we’ve heard about the attractions of both senior and equity?
DFN, Alcentra We raised a dedicated mezz fund because we saw a number of opportunities which we thought were attractive from a risk-adjusted return perspective and that didn’t fit our natural CLO platform. Five years ago, banks focused more on arranging senior debt, and there were some dedicated mezzanine boutiques, such as ICG, Mezz Management and so on. That has changed irreversibly in our view. Today, the private equity firms want to go to one arranging bank to underwrite the senior and mezzanine debt, and consequently we can leverage off our dominant position in the senior loan market and our strong relationships with private equity houses to get decent allocations in the mezzanine market. The number of deals we do compared with the number of deals we look at is significantly lower for mezz. We probably buy 40% of the deals we look at in the senior space compared with one in four mezzanine deals. The sort of investors that are attracted to that fund are the sort of limited partnership investors that also invest in private equity.
IH, Babson Our mezz fund is closed and is a limited partnership fund. We believe mezz fits in CLOs comfortably in limited amounts, but you need to have enough room to be able to ride the mezz through defaults over an extended period of time if necessary. In order to do larger mezz pieces, you need a more flexible, less leveraged structure. We’ve gone for a traditional limited partnership structure, one unleveraged pool and one one-to-one leveraged pool, so it’s a very limited scale of leverage compared with the 10 times leveraged models that CLOs work on. The best way to maximize value in mezz is to concentrate your efforts and make sure that you do the right things at the right time even if patience is needed. That requires manpower and a deep understanding of deal dynamics and value over a wide range of outcomes. We could take up to €50 million mezz within the Almack mezz fund and could comfortably write €100 million of mezz across all our capacity. However we would not wish to maximize our position in every deal, because however skilful and diligent you are, mezzanine financing is more risky and excessive exposure to single names is undesirable.
AK, Harbourmaster We have taken the view that there is more compelling value within the context of a CLO transaction in the senior secured loan, not only from lower default rates but because of the high recovery rates. In 2000, we came under a lot of pressure from CLO and CDO arrangers to have a 30% mezz or high-yield bond bucket, in order to get a supposedly good IRR target. But uniquely we focused on the senior secured, because it’s a cash-pay asset, which pays regularly. Across our nine funds, you see steady quarter-on-quarter distributions, with low volatility, and a lot of investors like that steady cash return. In our view you can lever a more stable asset class slightly more highly than you can something more volatile, like mezz or second lien, to generate very good IRR returns for our equity investors. Our first CLO transaction was called this year by the equity holders and realized 17% IRR, which is the highest realized IRR of any European CLO which has been called to date.
LB, Euromoney We are starting to see some new structures. Let’s start with Harbourmaster and Bank of America’s pro rata deal.
AK, Harbourmaster We’ve added €1.5 billion in pro rata loan capacity. Pro rata loans allow CDO managers to participate in strips across the full capital structure of an LBO including amortizing term A loans, revolvers and capex facilities, as well as the bullet B and C loans. Given the nature of the market, given the high prepayment rates on some assets, combined with our size and scale, we were able to access some pro rata pieces, get very good fees and generate an arbitrage comparable to institutional loans in a number of primary transactions. We’re very much an investor in institutional loans, but we do see value in some situations that are more market timing driven. The transactions with Bear Stearns and Bank of America have achieved tight pricing on the liabilities, and that drives the arbitrage on the institutional loan side, and on the pro rata side. It means that we have now locked in term finance very cheaply to take advantage of any pro rata opportunities, now and in the future.
AH, Alegra When the market is this hot, you hardly get any price advantage from taking As, Bs and Cs together, as opposed to just Bs and Cs. Looking at the risk/reward you may be right on the revolver, but the reward on the As is 200 to 225bp. So in this market I don’t see much differentiation.
TB, Bank of America Price differentiation is a secondary argument. When we approached this as arranger, we intentionally created a different structure from the deals that had been done in the US. In the US, a pro rata deal meant investing in revolvers and term A, full-stop. Our approach in Europe included revolvers, term A, term B and term C. Flexibility is the key to the structure, not reliance on pro rata economics. The financing is structured so that you can produce a competitive equity return notwithstanding a significant component of revolvers in the transaction. So with 25% revolvers you still get a 15% equity return on a 35% drawn basis for the revolvers. The manager is not forced to buy revolving loans or term A and the portfolio can be rebalanced over time to be institutional tranches only, for instance if the economics for the revolving component of the transaction no longer make sense. In this case the result would be further upside for equity investors.
DFN, Alcentra I take my hat off to Alan and Tosh for getting pro rata deals done. Any innovation is a good thing for the market. But will the pro rata deal go the same way in Europe as the US market? In the US there was great fanfare over providing liquidity in the bit that nobody wanted and thereby getting cheap revolver pieces. And that premise proved to be false, because the revolver traded up significantly and the equity returns in those deals were quite poor. It is helpful to be able to buy revolvers, but we haven’t done it yet in our CLOs (although we have bought transactions with some delayed draw B/Cs or mezz such as Elior, France’s largest catering group). Because of our size, we’ve never had a position where we wouldn’t get taken care of anyway in the B/Cs. We prefer generally to play revolvers in the credit opportunities fund, where you’re doing more technical trades, blending good fundamental credit analysis with buying credits cheaply.
AK, Harbourmaster Our rationale for pro rata is arbitrage, not access to collateral. Also, the US pro rata deals were different structures, done at a different stage in the cycle. Importantly, and unlike the US pro rata transactions done previously, we have full flexibility to invest in the B&C term loans and quickly migrate the transaction to an institutional CLO, if the arbitrage disappears. We’ve bought a lot of revolvers very cheaply, and when those revolvers trade up that represents gains for our equity investors.
SP, UBS I think the reason pro rata hasn’t happened until recently is that people felt they could get access to the Bs and Cs. Now, with pressure on assets, the banks that are leveraged finance houses and CLO arrangers are looking for ways to help CLOs hold a broader range of assets. Banks are well placed to take on some of the complexities of funding multicurrency revolvers, so this is a natural area to explore. It’s only recently, with the huge influx of new managers, that there has been this focus on getting access to assets.
AK, Harbourmaster I disagree. It’s all about scale – being able to write €100 to €150 million tickets. If you’re doing pro rata pieces to get allocations, you have to look at every single deal, which doesn’t make sense. Our motivation is not about access to collateral because fundamentally we’re arbitrage players.
New funds and opportunities
DR, Indicus Alan mentioned credit opportunity funds and that’s the biggest new development in hedge funds. Of 8,000 hedge funds, as of six months ago, 1,000 were fixed-income focused. A year or so ago two or three hundred were credit op, and that has doubled or tripled since then. What experience have you had investing in these funds or being able to attract that type of capital for more total return focused funds?
TB, Bank of America What is meant by the term “credit opportunities fund” varies. The relevant fund to this discussion is focused on loan product and is either a stand-alone product or a sub-fund of a master fund product. Some of the current loan funds that we are seeing in the market in Europe are focusing on taking advantage of stressed asset buying opportunities when the market softens. Other funds are multi-strategy and include significant exposure to high-yield bonds and structured finance securities. No two funds are the same; some are rated structures, others unrated. Many are being tailor-made for certain investors who buy relatively large tickets in comparison to your average CLO investor.
DFN, Alcentra Credit ops funds cover a multitude of sins, but they are certainly more flexible than CLOs, depending on the financing you use. We have a credit ops fund, the Alcentra European Credit Fund in which we use total return swaps, which aren’t rating agency-driven. We’ve found that beneficial in terms of accessing the market and obtaining value. I agree with Tosh that when you’re venturing into stressed and distressed you’ve got to reduce the leverage on that part of the portfolio and/or you’ve got to have locked up investor capital and term finance matching that. You need to have enough time to see the investment thesis played out and hopefully the recovery in the credit you bought at discounted levels manifest itself.
LF, Calyon Leveraged credit portfolio managers primarily look at credit opportunity funds as the right format for releasing their alpha-generation capability which is highly constrained by the rating agencies diversification criteria in a classic CLO. In a classic CLO, the loan asset manager is to some extent required to buy a bit in each sector to please the diversification criteria. If the managers are released from these requirements, they can pick more specific opportunities, which results in portfolio that may be more bucketed and so able to generate more alpha. So a credit ops fund manager is saying: “let me do what I want, give me more flexibility, I’ll show you a better return.’’ At the same time, the asset manager will most likely charge higher fees in a credit ops fund compared with a CDO.
TB, Bank of America Yes. Credit opportunities funds are only successful to the extent that investors believe that the manager can create alpha via a trading-based approach to credit. However, most investors will demand that a total return approach be based in sound credit analysis. They will examine the assumptions regarding the alpha that can be generated, but will normally also look at the base case return assuming it’s a 100% par loan strategy. If the manager chooses a more conservative strategy over time, this investment may still be attractive because at five or six times leverage there is a very flat curve in terms of sensitivity to defaults.
SP, UBS With the classic CLO, you’re primarily selling the asset class and the arbitrage that you generate through the leverage, whereas with a credit opportunities fund, you’re selling the manager and very little else. Most of the increase in return comes through what the manager’s going to do, not through the structure. So a credit opportunities fund is more like a hedge fund, the CLO is more like capital markets arbitrage. I don’t see traditional CLO equity investors looking to get into credit arbitrage funds. They’re two different pools of investor.
MH, Prytania There’s a cross-over though in that, whether it’s a market value structure with loans as the largest component or even securitization leverage, you are selling to investors the same story which is essentially: ‘‘this is a CLO – it’s a loan vehicle.’’ You not only access the investor pool, but, more importantly, you’re accessing the tightest prices that you can get in any type of vehicle. You are thereby minimizing the excess interest you have to pay away in order to get into the credit opportunities area by disguising the characteristics of the fund that you’re doing. The market is suffering from excess liquidity and we’ve also had the longest upswing in the credit cycle we’ve ever seen. The combination means more and more flexibility is given to managers at a very limited cost. By and large there’s incredibly tight pricing and therefore a very attractive arbitrage. It will be one year perhaps into the downswing of the cycle before investors reassess and decide they’re happy with their conventional boring CLO manager because they don’t want that additional volatility.
LF, Calyon The crossover between CLO and credit opportunity investors is in my view relatively limited. Maybe at some point in a tough cycle investors may indeed go back to what you called “the boring managers with the boring constraints of the CLO format”, but as far as credit opportunity funds are concerned, we tap into a much wider (unlimited) pool of money to be invested, for example pensions and retail money in general. The loan market is now entering the fund of funds market. One of Calyon’s current deals is a multi-managed loan deal called Confluents, where five asset-managers each focus on a specific part of the market, with a fund-of-fund manager on top, and market value features added to it. Leveraged loans are a low-volatility asset class. Through this product, you find a combination of managers that will add the diversity the investor wants but also the market-value stability the investor wants.This type of products suits retail money very well, as this is a stable product that is going to pay something like four points over Libor on two to three times type of leverage. Pension and retail money are in my opinion the main growth levers for credit opportunity fund today.
Permanent capital vehicles
DR, Indicus Who are the investors in permanent capital vehicles, and what challenges do they face?
SP, UBS The permanent capital vehicle is another opportunity to cultivate a new investor base for the asset class. The idea is to take the vehicles that we’re all familiar with, but to list them as shares on the stock market. They are then eligible to go into equity income funds as well as increase their appeal to a much broader universe of investors who currently do not look at CLO equity.
There are a lot of funds that like the liquidity and accessibility of the underlying equity market, but it’s very hard to generate attractive yield opportunities there. In structured credit, a CLO vehicle can generate comfortably 10% to 13% returns over a fairly consistent range of outcomes.
That’s a very high level of return for an equity income fund, so there’s an opportunity to take this technology and transplant it into more of an equity-like vehicle. We’ve seen a huge increase in the education of capital markets investors over the last few years. But with this product we’re going back to the beginning. We need to explain to equity investors not just how a CLO works, but how the debt markets work.
IH, Babson So what are the merits of that as a public vehicle, say, compared with a pooled high-net-worth vehicle through a private bank?
SP, UBS There are a lot of investors who are well set up to invest in publicly listed vehicles, so you’ve got one vehicle that can access a very wide universe of clients. To put together enough money to invest in a pooled fund you need to have relatively broad distribution. By structuring the product as a listed share you maximize the universe of investors who might have interest in it.
LF, Calyon The other advantage is the potential size if you do it through the public market. You can grow your overall size by tapping into the retail market. Arranging banks carrying a large retail presence will increasingly become the dominant players in this market.
AH, Alegra But when you put something on the stock exchange in share format, which has restricted tradability, without daily bid-offer spread, you will simply then have a stock with a limited liquidity. If you don’t have the liquidity in the underlying CLO equity, it’s like you’re doubling up the illiquidity with such an instrument. We have seen these types of vehicles in the private equity industry.We have recently seen Doughty Hanson, a British private equity firm, abandoning its plans to launch a listed fund after failing to attract interest from investors. Doughty Hanson even said that there were concerns over the trading performance of such investment vehicles which trade at discounts of up to 15% compared with the flotation price.
SP, UBS The first deals need to be very clear about what they’re targeting, who they’re targeting and how that story is represented to those people, because there is enormous opportunity for misinterpretation of the objectives of these funds, and the potential for some nasty surprises.
LF, Calyon They will need a track record. But if they work well, it could potentially be the most attractive development of the market over the next few years. The first ones to buy may be the kind of funds that have equity buckets and will know what they are buying – not fully liquid stock, but something with market-makers providing secondary liquidity. Through the secondary market, any one of us can buy or sell, as you just need to give the right share ticker to your banker.
LB, Euromoney And what do you all think of the most recent innovation, the LCDS [loan credit default swap] market?
TB, Bank of America The managers I’ve spoken to think the LCDS market is a bit of a non-event in Europe thus far. Everyone in the market wants to go long loans today, and LCDS is trading inside the cash product, which essentially means it’s a negative basis trade. But that’s a finite market. Perhaps LCDS will become a more interesting means for transferring risk when the market softens, when a more robust two-way market can be established.
AK, Harbourmaster The CDS dealers see the real opportunity in a loan index. Then the correlation traders can get involved, and that will spur growth in LCDS. It’s not going to come yet from the CLO loan portfolio managers, such as ourselves, because there are a number of issues around the documentation, namely that any multi-currency obligation can be delivered, and that it’s the cheapest to deliver obligation. That’s an issue at the rating agencies as well, because they have to do rating agency currency stresses on LCDS. So whilst we do have the ability in all of our transactions to sell protection on LCDS because we built it in from the very beginning, we’re not doing that, and we’re not likely to do it in the near future. But there is a huge push to get this product established.
LF, Calyon The main difference between Europe and US is that in the US, restructuring isn’t a credit event, but in the practitioners’ meetings in Europe, that’s where we start. The second thing is that in the US, LCDS trade on a Reference Entity rather than a Reference Obligation basis, while in the current European draft template the trade refers to a Reference Obligation only. That type of divergence will be a big hurdle to potential liquidity of the market.
AK, Harbourmaster Absolutely! The credit events are different. The type of CDS contract is different. In the US it’s very similar to the corporate CDS rather than a specific LCDS that has been designed for Europe. And the nature of the market means that banks need modified restructuring as a credit event to get regulatory relief. That’s going to be a difficult hurdle to overcome.
DFN, Alcentra It’ll take a long time to get the standardization and the liquidity and enough dealers quoting two-way markets and enough names to make it interesting, but it will happen. The ability of banks and investors to buy and sell protection on loan positions means that restructurings are going to be far more complex, because some banks who’ve bought protection on names, and hedged some of the names in their portfolio, will want a credit event. Having said that, anything that increases liquidity in the market, thereby potentially increasing the flexibility of managing portfolios, has got to be a good thing.
LF, Calyon As all the developments we have discussed mean that the demand for structured loan product is increasing dramatically, we will quickly come to a point where this market is outgrowing the underlying market. We’ve reached that point in other asset classes. We have increasing demand for structured loan assets and the synthetic market will be there. My view is that the US standard will drive it, at least in the short term. Unfortunately that will leave Europe behind in terms of size and opportunities.
DR, Indicus Thank you all very much. That is all the time we have.
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