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Stipulations in some fund limited partner bylaws dictating strict due diligence could pose a challenge for asset managers, sources say.

“Many investors have historically had rules regarding on-premise operational due diligence in their bylaws, where someone on their team needs to do an in-person meeting,” says one direct lender.

With social distancing measures making these meetings difficult, firms are considering whether to defer fundraising in the hope that social distancing will be relaxed, or whether they should now look to amend the internal rules.

Fund managers have yet to face any material impact on fundraising — particularly involving long-standing relationships.

While managers and investors can’t meet face to face, virtual onsites are being carried out over Zoom to satisfy operational due diligence and transparency is being maintained through screen sharing, says one investment consultant. “It’s not ideal, but we are able to complete a high level of diligence.”

GSO chief executive officer Steve Schwarzman also spoke about the subject on the firm’s quarterly earnings call on 23 April: “We had one fund that we were supposed to have a big due diligence meeting with involving 150 attendees, and it was done on Zoom. Much like the way we’re all working now, everybody was cool about it.”

However, fundraising for first-time or new firms is anticipated to take much longer than expected, unless the newcomers have owners with deep pockets and an outstanding track record.

Prophet Capital is winding down its $500 million-plus CLO and structured credit hedge fund. The firm cites poor liquidity and uncertain valuations as the biggest factors behind its decision.

“Investing in a quarterly liquidity hedge fund does not really work for CLOs anymore,” says New York-based David Rosenblum, a managing partner at the firm. He says that liquidity in CLO junior debt and equity tranches has become particularly tight over the past few years, even before covid-19 struck.

In addition to shrinking dealer balance sheets, buy and hold investors are taking up greater market share, which further hurts liquidity among the counterparties wanting to trade.

Prophet is contemplating launching long lock-up vehicles through which to invest in both CLO and mortgage strategies. However, the current fund is intentionally not being restructured in a way that forces investors to stay.

“We’ve got too much respect for our investors to do that. They’ve signed up to a quarterly liquidity strategy, so we will not force them into a different liquidity profile,” says Rosenblum.

The Prophet hedge fund had no leverage heading into the covid-19 crisis, which means its voluntary liquidation can proceed at its own pace.

Fear of missing out is one reason institutional investors are allocating to private credit, but market partici­pants say that investors should err on the side of caution, despite the number of attractive opportunities.

Tim Atkinson, a director at investment consultant Meketa, says his clients were not overweight or heavily emphasising direct lending over the past few years because of tight spreads and deteriorating underwriting standards. “We were deliberately slow to make commitments, thinking that when pricing and risk changed we would want to have dry powder,” he says.

Atkinson adds that there is a fear of missing out from some investors — and fund general partners are trying to raise funds quickly to take advantage of this.

“Though spreads have already compressed several hundred basis points in many credit sectors, we are cautious as we don’t know when economic activity will resume in a meaningful way,” he says.

Private credit valuations are more attractive for buyers than six months ago, but their private nature can make the asset class difficult to trade in the secondary market. Prospective investors also face difficulties timing their entry into private credit as there is a risk that valuations will be hit again.

March fund returns submitted to Creditflux in April (see pages 18-21) were poor, but one manager distinguished itself in the covid-19 dislocation using a synthetic strategy rarely seen since the 2008 financial crisis.

Hellebore Credit Arbitrage, launched in February 2014, returned 2.02% in March, its best monthly return since January 2019. The fund seeks opportunities to trade the skew between single name CDS and indices, using fluctuations in this basis as a credit neutral synthetic asset to generate alpha. It targets a 12% net return with 6% annual volatility.

“The CDS market suffered a quantum leap repricing of all of its risk premia: curves, relative values and credit index bases,” says Paris-based Frank Bielikoff, founding partner at Hellebore. “Some credit index bases flashed in Hellebore systems at their most distressed levels since the global financial crisis.”

Skew trades were popular before the 2008 market crash, but became much harder to place in its aftermath as market makers fell away and single name CDS liquidity evaporated. Trading volumes surged in March, however.

Playing the basis was still difficult for most indices given wide bid-offer spreads, says Bielikoff, but Hellebore found tradeable mismatches in US investment grade index CDX IG and emerging market sovereign index CDX EM.

“The CDX IG index was indicated 3% richer than its fair value,” he says. “The index spread was two-thirds tighter than its fair value. For investors, it was close to impossible to hedge effectively and books had to be light to avoid draw-downs.”

The Hellebore Credit Multi-Strategy fund, launched in April 2019, also showed a positive 0.6% return in March.

Deal flow is streaming in for European direct lenders who, despite monitoring portfolios for covid-19 related issues, have one eye on the primary market. “It’s interesting to see the speed at which direct lenders are straight back to looking at new deals,” says Ben Davis, partner at Proskauer.

“We did a survey of private credit funds and 86% said they were open to looking at new deals. We have seen a lot of new term sheets for new financings and not necessarily at a slower rate than before.”

New deals are becoming more lender friendly — both in pricing and terms — as they reflect increased risk.

“The tightening of terms is something that is under review for a lot of these deals,” says Davis. “Perhaps the most obvious of these is adjustments to ebitda.”

He says it seems ebitda cures are being removed, while in other deals’ terms more aggressive language is being reduced, such as on debt incurrence or opening leverage.

“You could probably get another 150-200bp on deals now,” one direct lender told Creditflux.

Secondary opportunities and the ability to provide additional financing to other direct lenders for their portfolio companies will also lead to new deal flow in the last quarter of this year and Q1 2021, sources say.

The market-distorting power of government and central bank interventions has been easily observable in bond/CDS differentials during the covid-19 crisis — as noted in various Creditflux articles this past month. But an even more extreme reaction appeared in CDX index tranches on 9 April, when base correlation measures plummeted following the US Federal Reserve’s unveiling of a $2.3 trillion aid package.

CDX HY tranches in particular warped beyond recognition with base correlation numbers quoted by IHS Markit for a short time looking like a singularity.

Senior mezzanine 25-35% tranche base correlation, which had been 16 basis points more than 15-25% junior mezzanine, dropped over 40bp on the day to be quoted lower than 0-15% equity.

IHS Markit did not comment on the moves by time of press. Kinks in correlation of this kind are typically caused by a dramatic widening of a few single names, says one index tranche investor. Yet in this case the feature arose because the bulk of the US credit universe suddenly looked to have a government backstop, leaving the idiosyncratic risk of the remaining few in stark focus.

Lockdown orders across the world have forced the loan and CLO markets to modernise certain industry practices at speed, leading to speculation that some of the emergency measures adopted could become permanent, according to market participants.

One CLO manager told Creditflux that their productivity has improved due to an extra two hours of sleep every night: “Because of how well working from home has gone, how do you go back?”

Speaking on a virtual panel hosted by the Information Management Network (IMN) in April, the Loan Syndications & Trading Association’s executive director Lee Shaiman said the transition to remote working had been “pretty amazing”.

“We had historic volumes in the last two weeks of March. Our industry is always written about in the press as still settling trades on faxes with physical signatures — that’s not true and we proved it.”

However, the transition hasn’t been entirely without problems. One CLO investor said that their internet connection had slowed as a result of multiple family members simultaneously using it for work and school.

Speaking on the IMN panel, AGL Credit Investors’ chief operations officer Wynne Comer said: “Working from home is more effective than I think people would have thought, but anyone with nine-year-old kids is going to be so happy to be back in the office.”

Comer added: “I don’t think more managers will be adopting a work from home policy just because it’s better than people expected.”

Recent years have laid the groundwork for social distancing, with the market producing numerous electronic trading platforms, such as CitiVelocity and KopenTech.