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CVC offers twin turbo returns

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Yield products are hard to come by today, what with investment grade corporate credit spreads tightening and government bonds offering precious little chance of generating any meaningful income. James Williams explores another solution…

The CVC Credit Partners European Opportunities Fund offers a unique proposition, aimed at a wide range of investors who are seeking an income as well as the opportunity to generate capital gains; a twin-engine source of returns.

With yields having collapsed close to zero in the lower risk areas of the market, CVC Credit Partners provides an alternative source of income by buying up senior secured loans across the first lien of the capital structure.

“The Fund provides investors with exposure to a strong income stream by investing in floating rate senior secured investments across large liquid capital structures that offer a target 5 per cent income per annum. This is a similar dividend yield achieved in many large-cap stocks, the difference being you are not investing in the senior secured part of the capital structure, but rather the equity, meaning you are in the highest and most secure part of the risk spectrum. 

“In addition, through the strategy, we are also seeking to generate circa 3 to 5 per cent in capital gains by opportunistically purchasing debt instruments at a discount to its redemption value prior to maturity. In short, we are actively acquiring a pool of collateral that is not only delivering a stable cash income but also capital gains to deliver a target return range of 8 to 10 per cent over the medium to long term, with an average 50 per cent loan to value,” explains Andrew Davies, Senior Managing Director and Portfolio Manager, CVC Credit Partners. 

Davies and his team look at two segments in the portfolio. One is performing credit, which is the cash income component, and the second is what Davies refers to as “opportunistic investments”. These are stressed and distressed investments identified by the team whereby a future event such as refinancing will positively impact the value of those investments. 

The fund, which launched on 25 June 2013 and operates as a Jersey closed-ended investment company limited by shares, holds around 50 per cent in performing credit and 50 per cent in opportunistic credit focusing, as the name implies, on the European corporate credit market. The reason for this, says Davies, is that because the strategy has been designed to deliver income (the 5 per cent dividend that it pays out) it needs access to a stable source of income, which comes from the performing part of the portfolio. 

Although some of the opportunistic credit positions also pay cash, this happens on a less frequent basis. 

“The portfolio’s composition is characterised by a proportion of the portfolio delivering high cash income from low volatile secured assets across a performing book and a segment of the portfolio seeking to generate income and additional capital upside from the more volatile opportunistic part of the book. Put together, we aim to deliver a stable 5 per cent cash return and 3 to 5 per cent capital growth,” says Davies.

“The majority of what we do in the performing portfolio is in the broadly syndicated institutional market. These are large new issue primary deals that are coming into the marketplace. We also trade assets in the secondary market.”

The opportunistic, non-performing credit positions in the portfolio are purchased in the secondary market.

For funds like CVC Credit Partners European Opportunities, the regulatory changes that are underway make for a once in a lifetime opportunity set as European banks are having to reduce their balance sheet capacity to risk-weighted assets. Corporate credit, and loans in particular, of levered businesses, fall squarely in the cross hairs. 

“In the past, European banks would hold performing corporate credit loans – they used to represent almost three quarters of the buying universe,” explains Davies. “That legacy is now being reduced as banks take these assets off their balance sheet and price them into the institutional market. There continues to be a shift of bank held assets into the European institutional market, similar to what was seen in the US institutional market 15 years ago.

“In our view, these assets are mispriced because it was relationship-led lending. A bank would typically lend to a corporate in such a way as to generate additional fees deriving from M&A events, other financing events, revolving ancillary lines of credit, etc. So the debt was often priced lower than institutions would want to hold it at.”

On the opportunistic side, it is even more prominent that there is a regulatory-driven push to divest non-performing corporate assets: anything from shipping, car loans, credit cards. Prior to the financial crash, banks built huge amounts of such assets that are still sitting on their balance sheets and continue to underperform. 

These impose a significant amount of risk-weighted capital requirements on banks’ balance sheets. 

The amount of capital they need to hold is very high and, if it is trading at a discounted value, it impairs the amount of capital that banks can generate, so they are disposing these assets into the institutional market. 

“The two opportunities are being driven primarily by the same regulation that applies to risk-weighted assets. In our view, the performing credit market is going to grow because the banks are no longer going to participate as they once did, and on the opportunistic side the volume of assets is also growing as the banks are forced to deal with capital requirements and raise capital,” comments Davies. 

With respect to where CVC Credit Partners are seeking out these opportunities – 85 per cent of which are floating rate instruments providing an effective inflation hedge – they would appear to be legion. This is because the banks are no longer thematically disposing of single industries or single corporates. Historically, a distressed name would occur in a single region or industry and that would be the focus of the entire market. 

Now, because it is a regulatory push, banks are being forced to divest across all geographies and industries they have exposure to. 

“In our view, this creates a more favourable portfolio proposition because we don’t just have to focus on single industries or sectors. We haven’t had to over-expose ourselves to any single sector because the flow of assets today is cutting across a wide number of industries. Over the last 12 to 18 months the flow of assets from bank portfolios have included asset-heavy portfolios: infrastructure-led financing where the growth model (i.e. toll roads in Spain) has not been realised. We’ve seen a lot of these long-term assets coming into the market in the last few years. 

“This strategy does not trade in infrastructure assets – but the flow of disposals have included these type of investments.

“Over the past decade, we’ve been tracking all European corporate issuers and watching how the product mix has evolved. We are monitoring more than EUR60 billion of corporate balance sheets. So the opportunity set is significant. It’s just a case of deciding when we want to engage and timing the opportunistic part of the strategy in such a way that we achieve the capital appreciation,” explains Davies. 

During Q3 this year, total loan volume was EUR18.4 billion, up 10 per cent on the previous quarter of EUR16.7 billion. This has put 2016’s YTD total loan volume ahead of the same period last year, at EUR49.0 billion versus EUR48.7 billion. This comeback in annual new issue volume was largely due to a surge in opportunistic transactions, with refinancings and dividend recaps up by 99 per cent and 115 per cent respectively on Q2 2016.

“The debt market is continuing to grow as corporates look for non-bank financing. I don’t think European banks will retreat to the same extent as in the US, but regulation is pushing them to reduce the amount of risk they carry on their balance sheets. It’s not often you can take advantage of a regulatory push for performing and non-performing credit,” remarks Davies.

The Fund invests just over half (57 per cent) of the portfolio in single B-rated credit. The lifecycle of most of these corporate credits is five to seven years. In the performing part of the portfolio there are no refinancing concerns. These are companies that can easily facilitate financing on their balance sheet. However, in the opportunistic part of the portfolio, “the view is we would like these corporates to refinance either through creating liquidity or because we believe by doing so it will improve the performance of the debt before it reaches its maturity date,” says Davies.

Another path to unlock value could be for a corporate to go through a restructuring event, where CVC would seek to influence an outcome to the benefit of its position within the capital structure.

“A possible outcome here is for a restructuring to position a corporate so that it can return to profitability and as such try and grow its way out of its problems by putting the balance sheet into a better financing capacity,” continues Davies. “The cash flows they generate are used to service debt which is too high and therefore prevents the company from growing. They go to the bond holder or the loan holders like CVC who would agree to convert a proportion of their debt into equity to help operating liquidity for a period of time. Another option could be to extend the maturity of the loan, and if certain milestones are not met during that extended period, then we would take control and seek to recover our investment.

“There are many ways a restructuring can assist a corporate’s balance sheet.”

The principal of being able to allocate to both performing and non-performing credit is that it allows the investor to get exposure to upside from CVC’s credit picking expertise. Where investment grade corporate and government bond yields are today, if there is any stress within the markets they can’t really go much tighter. If anything they will go wider (when rates rise). 

“That ability for us to price the yield profile of the opportunistic segment of the market, whose yields are not moved by general market sentiment, allows us to add downside protection in the portfolio as well,” emphasises Davies. He offers the following concluding thought: “Every corporate issuer now is in full refinancing mode given where European credit spreads are today. They want to refinance as much as they can to reduce their cost of capital. In the high yield market we are seeing 7-year and 10-year deals yielding 4 to 7 per cent. The downside risk in fixed income and high yield today is that if and when yields widen out, an investor’s mark-to-market will be material.”

A fund that is able to generate two unique drivers of returns across the most secure part of a corporate’s capital structure could provide a welcome solution to investors that are worried about how to protect parts of their fixed income portfolio from future rate moves.

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