Structured finance has been growing rapidly over recent years, with predictions from S&P Global Ratings that we could see $1 trillion of issuance worldwide in 2018 in this part of the credit space, and CLOs set for $110 billion of global new issuance during the year. S&P also notes that refinancing and reset volume from CLOs is likely to reach a similar total in 2018.
It’s clearly a buoyant market, boosted by the search for yield among investors at the capital supply end and the need for borrowers to capitalise on solid economic growth at the capital demand end of the chain. Nevertheless, structured credit remains the preserve of a smaller number of specialist managers than the wider private debt market, making it an area where it’s still possible to find attractive niches away from the competition. PDI spoke to Hiram Hamilton, global head of structured credit at Alcentra, based in New York, and Cathy Bevan, portfolio manager for Alcentra’s structured credit funds based in London, to explore developing opportunities.
Q To what extent do you see structured credit as a type of distressed debt?
Hiram Hamilton: We don’t necessarily see structured credit in those terms, although there can be some overlap. For us, structured credit is a particular type of debt finance that involves the securitisation of pools of credit – the extent to which these are distressed really depends on the assets that are in those pools. So in 2009, for example, securitized pools of mortgage debt generally contained the most distressed assets.Yet if you looked at securitized pools of corporate loans where the assets were solid, such as leveraged loan portfolios, you saw mis-priced or mis-underestood debt not so much distressed debt.
Cathy Bevan: Yes, back in 2009, there was an opportunity to acquire mezzanine pools at a steep discount, for example – if these returned to par, you could generate highly attractive returns. There are fewer of these opportunities now. Today, you must focus on particular areas – smaller opportunities or specific niches that are difficult to invest in and where there are fewer players looking.
Q What kinds of niches are available in today’s market?
HH: One thing I’d start by saying is that the amount of capital available to invest in structured credit is a shadow of what’s available for the wider debt market, where you have asset managers, hedge funds, banks and private equity houses all jostling for deals. There are far fewer players in structured credit, which means it’s much less efficient – there are delays in pricing or mispricing at times. That means experienced and specialist players can take advantage of investment opportunities that others don’t see. That said, there is more competition than there used to be, which means we do increasingly need to look at niches.
CB: One area in which we have been particularly active over the last few years, where others were to a lesser extent, is in building control positions in pre-crisis CLOs – the CLO 1.0. These are obviously older and trickier to invest in because there will be loans in these pools that have been restructured and the more solid names will have been able to pre-pay – that usually leaves you with the more complex situations.
Q How do you evaluate this kind of deal, given the difficult nature of some of the credits?
HH: You need a large team, that can price each name in the portfolio individually and come up with a specific view on each. There aren’t many managers that can do this – most tend to look at default stress generically and take a more macro, top-down view. Our bottom-up approach means we can price these pools effectively. It’s also important to take a control position – that means you can effect a call of these CLOs and force liquidity in the portfolio through loan sales. This has been a good opportunity for us in the last three to five years – last year, we called more than ten CLOs, the same the previous year.
Q Presumably that means it’s an opportunity that will eventually wane as more are called?
HH: Yes, these obviously won’t last forever and they will become a smaller part of the opportunity set. Over recent times, we’ve also been looking at another niche – CLO warehouse capital. Through these deals, we provide some of the upfront capital required by managers before they issue their CLO to investors. Managers need to purchase half of the loans in advance which is accomplished using warehouse financing and the manager’s own capital, which is transferred when the CLO issues. And in Europe, there is the added complexity that managers need to have 5 percent risk retention capital in place, and that can be a big cheque for them to fund. We can fund the junior part of the CLO warehouse to access a levered pool of assets at no fee – it gives us attractive returns on short duration investment.
Q How competitive is this market?
CB: There are other funds investing in CLO warehousing but it’s definitely a more niche area. One of the attractive features is that it is a heavily negotiated trade – you have to work through the terms and the potential triggers for the banks, ensuring that you put in place adequate protections for the position. The other point about this is that the high velocity, short-term nature of the financing means that you need to have a pipeline of new deals ready to go – as one rolls off, you want to have more to invest in. You also need a significant amount of capital behind you, as managers usually prefer to work with one funder as opposed to having to negotiate with several parties.
Q The US and European markets are quite different. How are opportunities shaping up in these two regions?
CB: We are quite unusual in that we cover both markets and have a large team of analysts who can help us gain a perspective on what each of the two markets is doing – we can identify relative value across the two.
HH: The underlying credit markets are different between the US and Europe, and the sectors are different, too. One area we’ve seen this disconnect is in energy. Energy is a big sector for the US and it lead a large sell-off in 2016. Europe, by contrast, is a net energy importer, which means that the underlying exposure to oil and gas in collateral pools is low, yet European credit also traded down in 2016 – we can see this distinction, and it has been a good opportunity for us.
Overall, the two markets have different rate environments and different financing costs, so if you can find pricing that’s similar across the two markets, that can present good investment opportunities, but you have to have the capability to assess each company within the pool to understand what you’re taking on and build a default view based on individual names in the portfolio. We are of the view that you shouldn’t buy a tranche unless you have an edge on the underlying.
This article is sponsored by Alcentra