The 2007 guide to Leveraged finance
Alcentra is the largest manager of leveraged loans in Europe with over 8 billion under management across 16 investment vehicles.
David Forbes-Nixon established the European side of the business in 2002, with funding from Alchemy to buy out the CDO operation of Barclays Capital. Since then, the firm has grown and after a part sale in 2005, is now majority owned 80% by Bank of New York Mellon. The remaining 20% is still owned by the management and employees, fostering a unique, long-term culture at the firm, which has seen only one member of staff (a junior analyst) leave in the past two years.
Chart 1: Institutional loan investor group and vehicle
Although Alcentra is the largest CLO manager in Europe, the platform has been expanded prudently in line with growth in the LBO market since 2000. In fact, Alcentra has turned away many opportunities to raise more funds, where it did not believe this would be in the best interests of investors or the firm. The management aims to maintain a market share of around 5% of the institutional loan market. At this level, Alcentra can lever off its size to ensure it continues to have good access to collateral. As the largest manager, the firm is right at the top of the thinking for private equity and arranging banks when it comes to making allocations. However, the funds are not so large that they have to buy the market to keep the cash at work and therefore compromise on credit. Alcentra has run with an approval rate of less than 35% in the past 18 months. This is not expected to increase during 2007.
Secrets of success
Successful CDO managers like Alcentra focus on three main areas: deal sourcing, credit analysis skills and active portfolio management.
In the current market, characterized by insatiable demand for loans, hyper liquidity and a swathe of new entrants, deal sourcing is the toughest of these three criteria. All managers claim to have excellent access to collateral, but investors can test a managers claims in this respect. The speed of ramp-up of new funds (to a point where they are fully invested) is probably the best indicator of a managers access to loans in the market. Alcentras average ramp up speed is around four months, clearly demonstrating its superior position in gaining good allocations in the top loans.
Chart 2: Key factors for CDO management success
Further proof of Alcentras capabilities in this area are its low cash balances, which average around 2-3%. This contrasts very favourably with Moodys studies showing most CLO managers in 2006 holding around 10% cash, because they were unable to source loans to fill their funds. Typical CLO funds usually come with mezzanine or subordinated debt buckets of up to 20% but, again, many managers have difficulty filling these. Alcentras CLOs are nearly all at their targeted mezzanine levels, with consequent benefits to the equity investors from the enhanced spread on these loans.
This comes not only from the size of ticket Alcentra can write (potential funding capabilities of 250 million in senior debt and EUR150 million in mezzanine making it equivalent to a mid-sized bank), but also from the length and strength of managements relationships with the private equity sponsors and the banks. Private equity sponsors have become increasingly proactive in the allocation process: in addition to favouring friends and family, they are also blocking other funds they deem undesirable from the syndication. For example, several European sponsors are known to make strenuous efforts to keep the more aggressive hedge funds out of their deals. In practice, policing this is difficult for a sponsor to achieve, except at the outset and on any subsequent refinancings, when the existing syndicate becomes clear.
Clearly, there is a balance between filling up a fund quickly with collateral on the one hand, and simply buying the market with no regard to the credit quality of what you are putting into the funds. A rigorous credit selection process is therefore crucial to avoid defaults and losses to the fund. Alcentra tends to participate in the larger end of the market: with a combined experience in leveraged loans of over 100 years, Alcentras credit committee have learned that it is often the smaller deals which create credit issues, whereas larger companies attract better management teams and have the ability to sell non-core assets or operations in stressed periods, thereby keeping the loan current. Such is the extent of demand at the moment that many managers, particularly the newer entrants, are moving down the credit curve to look at the smaller end of the spectrum, with obvious implications for credit quality and liquidity. Bank syndication teams relate that many new players in the market carry out little or no credit work, especially where they do not expect to be given a large allocation.
Constant monitoring of the loan portfolio is, however, important since one of the toughest areas to get right is deciding when to sell a credit. Alcentra has a large credit team of 14 professionals, giving it strong capacity to cover the whole portfolio thoroughly, and to monitor the loans on a monthly basis. In any one year, a typical CLO portfolio will see around a third of its loans prepaid, but Alcentra also trades a further 10% or so of the portfolio every year, on the basis of credit quality, removing the weaker names and reinvesting in better credits. Trading for CLOs is also governed by strict tests under the terms of the fund. Furthermore, CLOs are not usually mark-to-market funds, so there is no pressure to buy or sell when the rest of the market is going through a period of volatility. However, Alcentra has a well established credit opportunities fund, one of the first from a European manager. This is a market value fund and has far fewer restrictions on trading than the CLOs.
As already mentioned, Alcentra has one of the largest credit teams in the European CLO space, with 11 analysts and three portfolio managers. The team is split on industry sector lines so that each analyst develops specialist knowledge of his or her sector. Not only is the team very wide in terms of coverage, but it is also very deep in terms of experience, with the average experience of each analyst standing at over 10 years. This contrasts with many of the newer players in leverage loan management, which have small teams of analysts often with little or no experience beyond the past two years of what has been a bull market. Staffing has been a major constraint for new entrants to the market. At a time when the arranging banks are looking for extra resources for their leveraged loan and syndication teams, it has proven very difficult for some teams to attract experienced people.
Chart 3: Corporate default and recovery rates, 19762006
Testament to Alcentras credit selection process is its market-leading default rate which, with just two defaults in seven years, equates to less than 0.25% pa as an annualized rate. In the current market, most managers will have had very low default rates over the past two years there simply havent been any defaults. Since some of the newer participants in the market have no experience of a downturn or of what can happen when things go wrong, this scenario is likely to change. Apart from the work-out and recovery experience of the senior members of the team and the PMs, Alcentra also has a dedicated specialist covering the stressed and distressed debt market, who has considerable experience in restructurings in several European jurisdictions. Credit, as everyone knows, is cyclical and, while the current upwave has gone on for much longer than anyone thought possible, at some point, the market will turn. Alcentras management do not believe "its different this time", which is why they have remained very selective, even if it sometimes means leaving money on the table.