Global credit funds & CLO's
September 2020
| Issue 227
Published in London & New York.
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News in brief
September 2020 | Issue 227
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CLO funds top rankings, but still have ground to make up
CLO funds top rankings, but still have ground to make up CLOs may have taken a hammering in March but, for the fourth consecutive month, funds that invest in these assets dominate our ranking of the top performing credit funds.

Two funds managed by Lupus Alpha gained more than 9% in July, while a pair of CIFC CLO funds were up 7% and 5.6% to occupy the top four spots in a dataset of 159 credit funds.

However, CLO funds have a lot of ground to recover with the best performing CLO funds in recent months still in negative territory.

A fifth of funds have positive 2020 figures, led by Orchard Liquid Credit Fund, which is up 14%. Read "Fund performance"
Guernsey puts Highland wrangles out to pasture
A royal court’s dismissal of proceedings in Guernsey could spell the beginning of the end in Highland Capital Management’s legal action against former employee Josh Terry.
The decision has wide implications. If Highland had got the case heard, the way may have been opened for other asset managers with offices on the island to sue employees there regardless of where they work.
Highland’s battle with Acis Capital Management president Terry has run for four years. But the decision leaves Highland with little place to take it except back to the US — where it has already failed to find favour.
Moreover, as detailed in Highland Capital Management LP’s chapter 11 bankruptcy filing in October, a $425,000 settlement with Terry and his wife expressly hinges on Highland defendants not using “one of their thousands of entities, funds, or affiliates to sue, directly or indirectly, Mr or Mrs Terry”. The accord did not release Highland CLO Funding Ltd’s claims in Guernsey, nor claims by Acis, but suggests further Highland action against Terry would be in breach.
Sir Richard Collas, Guernsey’s outgoing lieutenant bailiff, found Highland’s strongest argument rested on a claim Terry owed fiduciary duties to the company that went beyond contractual obligations.
But in Collas’s judgment, Highland’s submissions failed partly because the two directors of the company (Jim Dondero and Mark Okada) stressed that they had ultimate responsibility, “thereby denying any suggestion that Terry was a shadow or de facto director”.
Highland’s original case ended in October 2017 with Acis being asked to pay nearly $8 million to Terry.
Direct lenders turn to attractive non-sponsored deals
Non-sponsored deal flow has increased in August and lenders are grabbing the opportunity. These deals typically exhibit a premium to sponsored deals, but with plenty of cash chasing middle market M&A, lenders have previously found quality deals tough to find.
“Now is an interesting time to find attractive risk-adjusted returns in the market,” says Carey Davidson, managing director and head of capital markets at Monroe Capital.
“Monroe now has a meaningfully larger amount of non-sponsored deals in its pipeline. While it may not be an appropriate time for business owners to launch an M&A process, it is a great time to turn to the private credit market and find capital to finance an acquisition or growth,” she says.

Non-sponsored lending is generally perceived as riskier because sponsored companies may have additional sources of capital to help bridge any gaps, where a non-sponsored company would not. But Davidson says this is a myth.
“Sometimes a sponsor’s behaviour is not perfectly aligned with the lenders preferred direction for a company. Sponsor decisions can be driven by other factors, including fund performance, fund life, etc, which means that they may not necessarily be rushing to infuse capital,” says Davidson.
Owners of non-sponsored companies are also more likely to take aggressive measures to support a business, given it could be their family’s heritage, which is a different type of decision-driver to any a sponsor would have.
Would-be CLO managers change tack to distressed
Institutional investors are allocating to distressed debt at a record rate, leading some first-time CLO managers to adjust their business plans.
Robert Marinaro, head of credit at AllVue Systems, says that small CLO managers are less likely to have a distressed business than larger firms, a significant number of which have some kind of distressed offering.
Some start-ups that aimed to start with a CLO are now launching a distressed or dislocation fund first, says Marinaro. “That’s where more of the debt is and it’s going to be easier to fundraise for,” he says.
Firms hope their distressed funds can later be used as anchors to start building CLOs. They will also enable the manager to buy lower quality assets.
Marinaro predicts the coronavirus pandemic will blow up the size of the distressed debt market from $70-100 billion to $350-450 billion, while low interest rates will increase its attractiveness.
After years of new managers establishing fresh CLO platforms, the pipeline has dried up. No first-time managers have debuted in the US since March.
CLOs given workout flexibility as ‘safe harbour’ now viable
From October CLOs will be permitted to hold equity securities resulting from workout situations, say lawyers at Cadwalader, Wickersham & Taft.
The ability of CLOs to hold non-loan assets came to the fore following marketing firm Acosta filing for bankruptcy in late 2019, but has become more important as the coronavirus pandemic leads to an increase in defaults.
“The initial restructuring of the debt in the Acosta case was done in a way that limited the ability of CLOs to participate in the restructuring plan,” says Cadwalader partner Nathan Spanheimer. “Some of the value in the restructured company was put into a new equity class requiring a new capital investment from debtholders, and the loan securitisation exemption limited the ability of CLOs to make this new investment.”
Historically banks were not permitted to invest in CLOs that were not structured as loan-only vehicles because of the triple A investor’s ability to remove the manager, which was classified as an ownership interest. The amended rule allows the triple A investor to rely on a ‘safe harbour’ exemption.
Cadwalader partner Gregg Jubin says a CLO with a triple A investor that goes down the safe harbour route would be allowed to hold any asset, with few restrictions under Volcker. “The 5% bond bucket could be a 50% bond bucket and it wouldn’t matter,” he says. “So the question you’re going to have after Volcker goes away is are you going to rely on the LSE [loan securitisation exemption] at all, or do you just rely on the safe harbour and the change to the ownership interest definition? We’ve been recommending that people ditch the LSE altogether.”
HY rallies as curve steepening picks up
Credit spreads may have normalised since the March/April peaks of the coronavirus sell-off, but relative value investors are still finding a wide array of trading dislocations beneath the headline numbers.
Prime targets for relative value arbitrage lie in an ever-shifting basis gap between bonds and CDS, as well as the reshaping of index curves and discrepancies between CDS index values and the average spread of their underlying constituents.
According to investors and strategists, these opportunities arise from geographical differences in bond issuance, fluctuating fund inflows and outflows, and the impact of central bank bond buying programmes.
CDX HY vs HYG bond ETF (bp)
The impact of central banks on investment grade bond spreads has been widely flagged. But a startling change in relative value is also apparent in the past month’s performance of US index CDX HY versus the HYG iShares iBoxx US dollar cash bond ETF. CDX HY has been on a rally since the last week of July, while HYG has finished where it started.
This dynamic is underpinned by high yield fund flows, which have been a tale of two domiciles. US-focused funds have lagged over August and recorded outflows, according to Bank of America strategists.
By contrast, Europe and globally-focused funds have enjoyed inflows of similar size, which mid-month translated into the first net inflow to high yield in three weeks.
Sponsors leave lenders holding equity-like risk, claims Zwirn
Loan investors are being coerced by private equity sponsors and are assuming equity risk without compensation.
Sponsors tend to favour asset lite, high cash flow generating, service-oriented businesses, says Daniel Zwirn, chief executive officer of distressed debt firm Arena Investors, but there is a fundamental misalignment.
“On the downside, lenders and sponsors will both get a zero, but on the upside the lender gets 9% while the sponsor gets 3-4 times — a huge misalignment.” New York-based Zwirn says this is exacerbated by the fact that the lenders themselves have financing (one-two times debt to equity) at around Libor plus 300 basis points with tight covenants.
“Pre-covid we had a loan to an enterprise software maker, owned by a sponsor, badly executed and cash flow was down, but it was an interesting business. We made 11%, but we could have been paid 3-5 times for the equity risk we assumed while the company was in distress,” says Zwirn.
In this environment, disregarding what a bankruptcy process would look like, lenders should foreclose and take control of these enterprises, Zwirn claims.
“The issue is weak covenants and weak businesses that are asset lite and can’t handle the turbulence of restructuring processes — as a lender you effectively have a gun to your head,” he adds.
Financial CDS move points to relative value boost
The credit derivatives market could take an important step towards greater versatility with the 21 September roll, as participants again consider whether to begin including financial names in the CDX IG investment grade index.
Adding swap dealers to CDX IG, as index administrator IHS Markit has proposed, would replicate the senior financial CDS component of European counterpart iTraxx Europe. This raises the prospect of investors being able to make standardised relative value trading bets on US investment grade corporate CDS performance versus that of the financial sector, or US versus European financial borrower divergence. It could even point the way to senior versus subordinated CDS trading in the US, as is possible in Europe.
IHS Markit had floated the change ahead of the March index roll, but committee members rejected the idea, citing “a potential negative cost impact of inclusion”.
In the event, coronavirus-led volatility rocked CDS, moving it much faster than cash bonds as the sell-off began. CDX NA IG gapped out from 44bp in mid-February to 151bp on 20 March. Going into September it is back to around 66bp.
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