Jim Cass outlines the operational challenges involved in investing in leveraged loans - and why outsourcing could be the solution
Today’s climate of European banks deleveraging and scaling back their loan-financing commitments is causing significant dislocation in the capital markets.
Amid a rising tide of debt maturities, companies are faced with the reality that their key source of funding is evaporating like a Saharan rain puddle. A recent Reuters article noted that the volume of European-sponsored loans set to mature between now and 2014 stands at €264bn, yet the European Banking Authority has determined that banks need to raise €115bn in new capital.
Not that banks are bolting out of the stable to sell collateralised loan obligations (CLOs) - their bottom lines wouldn’t handle the losses. Rather, it is creating fertile ground for non-banking institutions - hedge funds, private equity firms, insurance companies - to step into the breach, particularly hedge funds that specialise in distressed debt. Today, the biggest global asset managers hold some $500bn in CLOs.
While CLO issuance in the US for 2011 was a respectable $12bn (€9.6bn), it pales compared with 2006, the height of the buyout boom, when $96bn in CLOs was issued.
“Listed loan funds could be the new version of CLOs for European investors,” Joseph Lynch, a Chicago-based managing director at Neuberger Berman Fixed Income LLC, told Bloomberg in October 2011. In fact, last year, Alcentra and Neuberger Berman successfully launched leveraged loan funds.
CLOs continued to be the single largest source of institutional loan demand in 2011, enjoying a 40% market share, according to the Loan Syndication & Trading Association (LSTA) in its annual 2012 Loan Market Chronicle. In the same report, 34% of respondents thought that banks would be the main source of leveraged loan financing in 2012.
That may be so, but banking regulation is undeniably moving the goalposts. Hedge funds are launching funds to capitalise on cheap valuations in the CLO secondary markets and the need for European banks to divest their debt holdings. Indeed, Avenue Capital Group has already raised $2.1bn for its latest distressed debt private equity fund.
Given the attractive yields on offer and the perniciously low interest rate environment, institutions appreciate the benefits of bank loan funds and are willing to commit capital for a number of years.
Last year, issuance in leveraged loans was $375bn and over $400bn was traded across 2,300 separate loans. US loan mutual funds attracted inflows of $16bn, while high yield bond funds netted another $12.6bn. Additionally, investment-grade lending in the US jumped to $845bn, double that seen in 2010 and setting an issuance record. Refinancing activity and a jump in merger-related bridge loans were the main catalysts.
As alternative investment managers become more active in this space, many are waking up to the reality of just how complex it is to manage leveraged loan assets. Valuations, accounting, data management and risk and investor reporting are some of the key challenges managers face, while communication with counterparties can be time-consuming and frustrating. Managers who build portfolios of leveraged loans often face difficulty calculating NAVs because the deals they enter into aren’t realised by agent banks until after the deals have settled. A lack of system automation can result in position inaccuracy for NAVs, forcing the back-office team to adjust the figures retroactively.
Today, investors increasingly expect managers to demonstrate institution-grade infrastructures. While a fixed-income manager that has decided to move into the leveraged loan sector might be able to manage other parts of the portfolio through spreadsheets, it is nearly impossible to create appropriate bank loan spreadsheets and report templates. The fact is that bank loans are complex and hard to value. The operational burden is often further accentuated by the fact that getting relevant loan-confirmation details from agent banks and custodians can itself take significant time and effort.
Perhaps unsurprisingly, managers are looking for outsourced solutions that can provide the operational expertise needed, while also giving them more time to focus on the investment process and avoiding the middle and back-office headaches. This is particularly important when considering data management and investor and risk reporting. Most managers’ internal systems are not set up to track and verify loan positions, making the generation of high-quality investor reports a real uphill challenge.
Primary and secondary sources of bank-loan information are needed to produce meaningful reports. Many of these sources, however, are disparate and require managers to incur the cost of using third-party data providers. Managers are reluctant to spend capital ramping up their operations teams when they know that outsourcing to specialist firms will likely solve the problem in a cost-efficient fashion.
Outsourcing as ‘firm arbitrage’
Another reason why managers are selecting to outsource is because it presents a form of ‘firm arbitrage’. In this niche area, finding the best investment talent is key, especially if it is a firm’s first foray into the bank loan business. However, it might not be worth it to hire specialised operational talent when outsourcers already have this dedicated expertise. Also, additional staff can put pressure on the firm’s profits, whereas outsourcing allows managers to charge many of the operational services to the fund, rather than incur them through the management company.
With extensive automated systems at the core of their business, outsource providers in the bank loan sector are providing managers with faster, accurate NAV production - up to 25% faster for some clients. Moreover, as positions are reconciled daily, it is a straightforward process to scrutinise individual positions in detail and flag potential errors or queries in the NAV. This offers a level of reliance that both managers and investors greatly appreciate and, indeed, are coming to expect.
Another way managers can benefit is when administrators have the capabilities to link their accounting engine to the firm’s portfolio management system. This is a key advantage given that multiple data sources create a heavy operational burden on managers that lack the necessary systems. This is particularly pertinent at a time when overall data aggregation is becoming more highly integrated in the industry.
Economies of scale
One economy-of-scale advantage that managers can enjoy relates to the already noted communication challenges of getting details on loan positions. As the administrator typically will already be servicing some of the syndicated loans that a manager buys for perhaps two or three other managers, they can benefit from that volume leverage and gain efficiencies. It is also more efficient for the manager to let its administrator deal with the various counterparties for record-keeping purposes than attempt to do this itself.
While this complex asset is gaining popularity and presents a compelling opportunity, it is not without its difficulties. Beyond having a clear idea of how a firm can add this to its investment expertise and package it for investor interest, it is critical that managers consider whether their operational environment can withstand the challenging nature of bank loans, or whether working with an administrator is the smarter approach. With a scalable, automated operating environment in place, managers will have one less thing to worry about and can, instead, focus on capitalising on the market momentum and gaining a competitive advantage.
Jim Cass is managing director in the investment manager services division at SEI