Operating a liquid senior secured debt strategy alongside a private debt mandate is one way of overcoming relatively long ramp-up times for a private debt portfolio by giving investors immediate access to the market and the ability to earn yield from day one.
One firm with such an approach is London-based asset manager Intermediate Capital Group. Head of Direct Lending, Max Mitchell and Head of Credit Fund Management, Zak Summerscale were asked for their thoughts.
Is having a liquid senior secured debt strategy alongside a private debt mandate a common approach now?
MM: We have been managing client money in private debt for more than 25 years and in liquid senior secured debt strategies for more than 15 years, however, we really only started to actively package them together in the last five years. Initially it started off being a solution in response to a specific client need but now it is becoming an increasingly common approach as it helps to address a number of common issues impacting pension schemes.
ZS: In the last 24 months we have definitely seen an increased demand for more holistic approaches to credit, with clients wanting multi-asset strategies combining different features to match their needs.
Why would investors want to combine liquid and illiquid versions of senior debt into a single mandate?
MM: Our first experience in 2012 was a €200 million mandate for a Nordic client that wanted exposure to private debt but they needed us to help manage liquidity for them during the expected two-year ramp up phase for the private debt portfolio. We devised a “parking strategy” whereby we immediately deployed part of their commitments into liquid senior secured loans and rotated out of these liquid loans to fund their deployment in private debt as required. The benefits to the client were not only did we manage liquidity for them but at the same time we were able to avoid cash drag and generate yield from day one.
ZS: Managing liquidity is a common investor rationale for these multi-asset strategies. The other key reasons that we see are to increase asset diversification, generate yield while maintaining liquidity, and take advantage of market dislocations.
What are the challenges and downsides of offering these combined strategies?
ZS: Some investors have similar issues to a lot of fund managers in that they have different people responsible for liquid and illiquid strategies, so it’s two different decision-making processes. It is clearly easier to set up if the client has a single team managing the asset allocations and the ongoing relationship with the manager. Consultants are increasingly encouraging the combined liquid/illiquid approach as they realise that it helps investors with their asset liability issues.
MM: In my opinion there are limited downsides to these multi-asset strategies. Clearly the allocation between the liquid and illiquid assets needs to be agreed up front and managed properly.
Presumably a lot of active management is required to run a liquid secured debt strategy effectively?
ZS: The liquid senior secured debt market is more cyclical than private debt with assets flowing in and out all the time so yes, there is a great deal of active management required. To give you a sense, the European liquid senior secured loan market comprises several hundred billion of assets across several hundred companies; we actively follow the vast majority of this market although we are typically invested in less than half the issuers at any point in time.
It’s a market that is still dominated by collateralised loan obligations (CLOs). There is a lot of secondary market inefficiency in pricing, which is driven by the technical documentation within CLOs rather than the actual value of the credit.
When CLOs are in full flow, as they are at the moment, it’s natural to be a seller of paper as the CLOs are a natural home. But when CLO market demand is down, the same pieces of paper are harder to place. This gives significant opportunities for active managers to take advantage of the market technicals caused by CLOs.
How big a resource is needed to support that active management?
ZS: You need to fundamentally understand every single credit, which does require some resource. There are also huge economies of scale and you need to be of a certain size to take advantage of mispricing. On the flipside, you need to be nimble enough to trade in the secondary market. At ICG, we have five portfolio managers and ten credit analysts on the liquid side, providing the right balance for us to be effective.
Importantly, we look at everything based on our view of the credit and not the view of the rating agency.
How liquid is the “liquid senior secured loan” market? Is there an optimum size of company when it comes to the ability to easily trade in and out?
ZS: It’s not always about the size of the company. It’s important to look at the make-up of the syndication and decide what you’re comfortable with. €500 million-plus of debt is pretty liquid these days but, with less than that, knowing about the syndication is crucial. You’ve got to be able to sell at the right price at the right time. As an active manager you need to be on top of liquidity and what investors’ needs are.
Why do you view the private debt and liquid senior secured debt strategies as being so complementary?
MM: The overlap between the private debt and liquid senior secured markets is relatively low because the issuers are generally different. Companies tend to issue in the private debt market or the public debt market, not both simultaneously. Private debt tends to focus on mid-market companies where debt issuance is €350 million and lower, whereas the liquid senior secured debt market focuses on issuances of €350 million and upwards. From time to time, private debt will compete with the debt capital markets in upper mid-market deals but this is opportunistic and generally when the liquid market is shut. Therefore, by investing in both strategies, you are getting complementary exposure across the full range of corporate debt issuers.
What do you think the outlook for liquid senior secured debt will be in 2017?
ZS: There is significant demand for senior secured loans currently given investors are waking up to the attraction of high current income and low volatility. However, we have several important elections in Europe in 2017 which will add volatility as well as details around Trump’s economic plans. This is likely to create opportunities for active managers to thrive. When there is demand for yield it is important to be discriminating in picking assets. There is risk in the asset class so understanding the fundamentals through a large research team is critical to long-term success.
How are the proposed ECB leverage guidelines likely to impact the market?
ZS: It depends on how they end up being implemented. If you use a blunt tool in terms of debt to EBITDA it punishes capital-light businesses. It may push more business to the direct lending side rather than the liquid side. The proposed wording “except in exceptional cases” is similar to the language that was used in the US and it took some time for the US regulator to demonstrate what that meant. I suspect a similar dynamic will occur in Europe.
Max Mitchell joined ICG in 2001, initially based in London before moving to Hong Kong in 2005 where he helped to run the Asia-Pacific mezzanine investment business. In 2009 he moved to Sydney to head up ICG’s business in Australia before returning to London in 2012 to set up and run ICG’s direct lending business.
Zak Summerscale joined ICG in June 2016 to head up the firm’s Credit Fund Management business for Europe and Asia Pacific. He has 20 years’ experience in managing secured loan, high yield and illiquid credit strategies and was previously at Babson Capital.
This article is sponsored by Intermediate Capital Group. It appeared in the March 2017 issue of Private Debt Investor