Leveraged loans: How can investors get access?

Guest comment by Mathias Neidert, bfinance

As investors look towards leveraged loans for floating rate protection in a climate of rising interest rates, they are faced with an increasingly complex set of choices. Is an open-end strategy more suitable than a fund with a five-year lock-up? Are trading-orientated strategies preferable to ‘buy-and-hold’? Is the intention to target widely syndicated loans versus those that are thinly syndicated or structured by the lender themselves?

The leveraged loan manager universe is remarkably diverse. In part, this stems from the very different parentage of the strategies. Fixed income houses, private credit managers and collateralised loan obligation specialists have all got in on the act with different capabilities and resources.

For traditional fixed income houses – many of which use leveraged loans within broader multi-asset credit or leveraged finance strategies – dedicated vehicles offer a more explicit route to access the same capabilities. Portfolio managers in this space tend to have a more ‘trading-orientated’ mindset, seeing this activity as a key source of alpha generation, and use widely syndicated loans (with deeper secondary market liquidity) to facilitate that trading.

Private debt managers, on the other hand, have broached the leveraged loan space from entirely the opposite direction. These managers often voice a philosophical preference for closed-end fund structures – commonly a five-year lock-up with a one-year ramp-up. Unlike their more traditional manager counterparts, they tend to take a ‘buy-and-hold’ approach, featuring a higher proportion of less liquid loans. More recently, however, we are seeing a growing number of these firms offering open-end strategies and pitching them as a liquidity management solution for investors in their private debt funds, enabling ‘committed capital’ to become fee-generative.

Collateralised loan obligation managers also tend to be more ‘buy-and-hold’ orientated, with strong capabilities in structuring securities and managing them for the first two or three years of their life, but with a tendency to take a more hands-off approach as the loans mature. Many of these managers do not offer open-end pooled fund vehicles.

Importantly, investors should not assume that the underlying strategy is well-suited to the wrapper that carries it. Nor should we assume that a manager will be equally capable in all parts of the leveraged loan asset class. The manager’s choice of vehicle type is likely to be based on additional factors besides their investment approach and capability, such as ease of fundraising and benefits to the broader business.

Jump in a pool?

Another key decision that investors must make is whether to use a pooled fund, a separately managed account or a fund-of-one. Not all managers, of course, offer all of these options. Although pooled funds may offer speedy deployment, liquidity and minimal paperwork, they often do not suit investors’ needs on points such as ESG and credit quality, while cash drag and transaction costs can hamper performance.

Segregated mandates, now offered by most managers, enable more flexibility but require a hefty minimum ticket size ($75 million-$100 million). They can also create complex administrative burdens, exacerbated by the fact that many custodians are not well equipped to provide appropriate support. Lastly, funds-of-one are more time consuming to set up than segregated accounts, and slightly more expensive (5-10 basis points of additional cost) but eliminate much of the administrative burden associated with funds-of-one since the loans are not held directly on the investor’s balance sheet.

Ultimately, no one should be deterred by the wide variety of approaches available in this asset class. Instead, investors should embrace diversity and consider the widest possible range of strategies that might suit objectives.

Mathias Neidert is a managing director at bfinance, the business consultancy