By James Williams – Alcentra is one of the world’s leading asset managers. With a focus on sub investment-grade corporate credit it has built a strong 11-year track record in secured loan investing. It has USD16billion in assets under management, including some USD9billion in European assets.
Whereas historically European asset managers would gain access to loans by raising capital and creating a CLO, in recent times the use of fund structures has become more common. Certainly, CLOs are still used – last November saw Alcentra close its USD406.5million Shackleton II CLO, bringing the total number of CLOs on its US platform to 15. But as the banks remain wary of lending, leveraged loan funds are gaining prominence.
Last year saw Neuberger Berman launch the NB Global Floating Rate Income Fund. Alcentra did likewise with the introduction of its LSE-listed Alcentra European Floating Rate Income Fund, which invests in the secured loans and high yield debt of primarily European corporates. This emergence of listed loan funds even prompted Joseph Lynch, a Chicago-based managing director at Neuberger Berman Fixed Income LLC, to say that they “could be the new version of CLOs for European investors”.
Today, Alcentra is becoming increasingly active, not just in secured loans, but other areas of fixed income including CLO funds, stressed/distressed debt and direct lending.
“In 2009, it was very hard for companies to re-finance in the loan market because the banks were being very conservative, CLOs were less active in the market. All the liquidity was in the high yield bond market so people tended to go down that path.
“The senior secured loan market, however, has caught up. Loans have some attractive characteristics relative to bonds: they have strong covenant structures, low default rates, high recovery rates. Particularly now, when the high yield bond market has had such a tremendous run over the last 18 months, we think the relative value is in the loan market,” explains Simon Perry, Head of Business Development, EMEA, at Alcentra.
To tap in to increased investor appetite for loan funds, the firm has built a range of solutions as a function of investors’ tolerance for liquidity.
“We are raising more new capital from pension funds and insurance companies in to unlevered vehicles: either segregated managed accounts, open-ended funds which trade at a net asset value, or in the case of the LSE-listed European Floating Rate Income Fund, a closed-ended fund that issues shares on the stock exchange,” adds Perry.
The open-ended fund is 80 per cent weighted towards senior secured debt with the other 20 per cent in cherry picked subordinated (junior) debt. The portfolio is comprised of 60 individual loan positions held in companies across 26 market sectors. The average yield to maturity is more attractive for loans in Europe compared to the US – around 7.15 per cent versus 5.60 per cent – but Perry notes that there are good arguments for both markets:
“The US loan market is deeper and more actively traded. Essentially, the US is good in terms of corporate backdrop, not so good for returns, while in Europe potential returns are higher but you’ve got to be more selective about where you’re investing.
“We think there’s a strong argument for being active in both markets and keeping a close eye on relative value between the two.”
Investors should expect to earn returns of between 7 and 10 per cent over a three-year timeframe, but Alcentra’s flagship European Loan fund – an open-ended monthly liquidity loan vehicle – went beyond that for 2012, returning just over 12 per cent.
The only problem is that growing popularity could make loan funds unwitting victims of their own success. With significant money coming in, says Perry, it puts pressure on new issue spreads, and, potentially deal terms. “In the US we’ve seen that translate into a tightening of spreads and an increase in the prevalence of covenant-light deals.”
CLO funds produce significant returns
This has prompted Alcentra to cast its net into other exciting areas of the fixed income market. And if one considers raw performance alone, 2012 proved particularly fruitful for the firm’s secondary CLO funds, both of which are open-ended structures. As Perry mentions: “The stand out success story of 2012 is what happened in the structured credit space.
“We focus purely on CLOs and currently have two funds: one of which focuses on the mezzanine part of the capital structure, the other which focuses on first-loss tranches. Both of those funds generated around 40 per cent returns for 2012, which was quite phenomenal.”
That may not necessarily translate into 2013 with Perry estimating a 20 per cent return opportunity. The benefit of investing in a first-loss equity tranche of a CLO is that most of the return comes from current income on the underlying asset, and this, according to Perry, “is a little more sustainable. Having said that the strategy is more sensitive to any upticks in default rates or downgrades.”
Direct Lending and stressed/distressed debt
Due to the issue of tightening spreads in primary loan issuance, Alcentra is also looking at investment opportunities in direct lending and stressed/distressed debt.
One of the key advantages of the direct lending market is that the volume of investor demand is much less: after all, these are not broadly syndicated transactions but private deals. It’s a much smaller universe, allowing managers like Alcentra to maintain yields and deal terms more effectively.
The flipside to this is that because only one or a handful of lenders are involved in loan origination, there isn’t any secondary market liquidity. Such strategies therefore favour investors who are less constrained from a liquidity perspective.
“This is an area where middle market companies are starved of access to finance because of the way banks are pulling back on the back of increasing regulatory capital constraints. As this is a less liquid market you have to access it through longer lock-up fund structures (e.g. closed-ended GP/LP fund structures), so it really only suits investors with a longer investment horizon.”
To illustrate Alcentra’s growing interest in direct lending, at the end of 2012 it was one of four managers selected by HM Treasury to manage direct lending funds under the Business Finance Partnership.
“We launched and closed a GBP200million fund at the end of 2012. That fund is aimed at lending to middle market corporates across the UK. We are currently raising funds for a second fund that will be more European-focused.”
As for stressed/distressed debt situations, this is a potentially interesting opportunity over the near-term in light of the fact that there are a number of companies, who, because of more challenged businesses or leveraged balance sheets, have failed to secure refinancing in the capital markets. These companies face a maturity wall in 2014-2015 and this should create attractive pricing in the secondary market from distressed sellers.
“We are targeting returns of 10 to 15 per cent in that strategy. There are opportunities to find debt trading at 70 to 80 cents on the dollar. You may be buying something on a yield of 12 per cent but if there is an opportunity of an earlier exit through refinancing that yield could potentially be boosted to a 15 or 17 per cent return,” suggests Perry.
Given the variety of investment opportunities that Alcentra is pursuing in fixed income, the administrative burden when it comes to managing loan fund portfolios can be substantial. Segregated managed accounts require granular reporting on every loan position, while the firm’s LSE-listed fund requires a daily NAV: these are far from simple exercises.
According to Stuart Medlen, Executive Director and Global Head of Transaction Management at Alcentra, there are three separate areas that need to be considered when administrating loan funds: pricing, loan settlement, and general loan administration.
That market vendors such as Markit and Thomson Reuters have, over the last five years, been growing the number of dealer quotes they receive for their pricing services has, says Medlen, allowed managers to price their loan portfolios more efficiently.
“That’s been a clear development in Europe and has allowed for a lot more visibility within the loan asset class,” says Medlen, who illustrates the point by adding: “Historically, the CLO market did not have a pricing element needed in loans as there is today. It then evolved with the introduction of managed account structures which had a mark to market element and perhaps monthly NAVs. Now, at the end of the scale you have vehicles like the Alcentra European Floating Rate Income Fund that prices the NAV on a daily basis.”
This pricing function played a key part in the fund’s board deciding to choose BNP Paribas as its administrator.
“We viewed them as the best-equipped administrator to cope with what is a new type of vehicle. The fact that BNP Paribas can produce a daily NAV that is published on the LSE is the most important thing for us. It sounds simple, but there are a lot of administrators that struggle to provide this. Most provide a T+10 turnaround so moving to a fund with daily pricing is quite a big leap.”
Another challenge is loan settlement. This is particularly true of Europe which has a lot of idiosyncratic jurisdictional complexities. Alcentra has a strong in-house settlement team to ensure that loans are settled quickly and efficiently. Even though loan settlement has decreased steadily over the last few years to around 30 days it’s still nowhere near as fast as the bond market.
Having said that, the process in the US is a lot smoother because its market is homogenous.
Says Medlen: “At the moment the US market is looking to move to a straight-through processing model. Once a loan looks more like a bond from a settlement time and efficiency perspective that would be a clear advantage to attract new investors to the asset class. Hopefully, in the not too distant future, the majority of US loans should begin settling STP and some European loans should follow suit thereafter.”
The third challenge is general loan administration. Unlike bonds, which have a defined interest, collection period, and investors know exactly what income flows they’re going to get, that’s not the case for loans. Contracts roll over, they can be monthly, quarterly and are typically linked to Libor (floating rate loans). Factor in potential defaults, Payment in Kind (PIK) interest and there are a lot of unique areas within loan administration.
“It was important for us that they had a dedicated loan administration system that could help us do our daily reconciliation quickly,” says Medlen, who added that having a partner within the same time zone was also vital.
“Finally, the corporate secretarial part of the BNP Paribas offering is something we found attractive. Being a Guernsey vehicle and a London-listed fund means that there are a lot of reporting requirements. We wanted an administrator that had done this before and was well aware of all the LSE’s reporting requirements. It’s quite unusual for a loan fund to be listed, after all.”