Credit: Real yields for real money
Martin Steward speaks to Babson Capital Europe, which argues that the time has come for European pension funds to allocate seriously to the loans market
In a way you might say that Babson Capital Europe has been preparing for today's loan market since 2005, when it began to see an opportunity to raise capital from real money investors for non-leveraged loan products.
"It was not so much that we saw the collapse in the new issuance of structured debt coming," recalls CEO Ian Hazelton. "We just wanted to be more than a one-trick pony when it came to capital raising. For a time in the market, structured vehicles were the most efficient way to raise capital; we don't think they are now."
Established in 2000 as part of the Duke Street Capital group, Duke Street Capital Debt Management spent its first five years constructing five CDOs and CLOs bearing the ‘Duchess' brand and investing in European senior secured loans, mezzanine and LBO-sourced high yield bonds.
Acquired and renamed by Babson Capital Management in 2004, by 2005 the firm had begun fundraising for a European mezzanine limited partnership vehicle called Almack, structured to provide parallel leveraged and non-leveraged exposure for different investors. The market dislocation of 2008 then opened up the real opportunity: June and July 2009 saw the closing of Almack Mezzanine II (100% non-leveraged and dedicated to LBO mezz and equity) and Babson Capital European Senior Loans (a 100% non-leveraged open-ended fund), respectively.
Now managing a total of almost €7bn, Hazelton says that about half of that is in non-leveraged structures. It did not pull out of the leveraged market in 2005 - Duchess VI and VII closed in late 2006, and its Malin and Fugo CLOs appeared in 2007 and 2008, respectively, raising about €2bn in all. But it now has the sense of the tide having turned and natural source of demand having changed.
"Loans as an asset class have slipped under the radar of even the biggest asset allocators around Europe, until now," says Hazelton. "But we have been doing a lot of work with pension funds and their consultants and we are starting to see the message take hold. We certainly think that there is a big opportunity for pension funds and that they are the natural buyers of these issues for core fixed income portfolios."
One reason loans have not figured prominently in pension fund portfolios in the past is probably that the market was indeed dominated by CLOs as the credit bubble expanded (only about half the institutional CLO managers active in mid-2007 had been in business 12 months before, Hazelton reckons). Investors didn't fancy the leverage in the structured products and didn't consider the non-leveraged yields compensation enough for taking on an unknown asset class. As a result, investment grade and high yield bonds took the lion's share of credit allocation, even though these spreads were often even tighter.
The outlook changed completely as credit was pulled from all over the markets in 2008, and the credit rally of 2009 has, if anything, backed the case even more. CIOs who considered loans as part of their opportunistic credit move in early 2009 might have felt that the time it would take to get the asset class cleared with investment committees and trustees did not sit well with the speed with which they needed to act. Investment grade and high yield was, back then, the more obvious choice.
"We're not stretching for yield, as we've seen in some other markets as some of the liquidity premium has come off with last year's rally," says managing director Andrew Godson. "There have always been good value assets in both unleveraged and CLO structures - it comes down to the sort of risk/return profile that investors want, and for the time being there's no reason why they should not stay unleveraged. New issuance is returning 400bps or more over Euribor. The secondary market issuance that we've had in the commingled funds enjoyed returns of 10-12%, unleveraged, in the second half of 2009 into 2010. Some of that was the dislocation trade, which is not sustainable. But we do think that 8-10% is possible for 2010. That's plenty for a pension fund's fixed-income book."
Loans are of course a secured asset class, so it begins to look as if investors are being offered a pick-up in yield against bonds for taking less risk. Moreover, with floating rates, there is potentially some inflation protection baked-in, too. "Right now, Euribor plus 4% might not look all that exciting, but if you think Euribor might head to 3-4%, it starts to look pretty interesting," as Hazelton observes.
Thanks to the credit crunch, the size of that opportunity set and the amount of time investors will have to position themselves looks set to be extensive. The typical re-investment period for a CLO is five years, and peak issuance came during 2006 and 2007. That means a big run-down in CLO assets beginning this year, and a wave of supply into 2011 and 2012. The fact that much of the original capital was leveraged as much as 10 times or more, and that hardly any of that leverage is available now, offers an indication of how much real money will be required to fill the funding gap.
Then there is the key role that mezzanine financing is going to play in the wall of balance-sheet restructuring that the LBO industry faces over the next few years on its high-quality - but inappropriately indebted - companies. Spreads of 1300bps are already 70% better value than the lows of mid-2007, despite the fact that post-restructuring equity levels in these quality companies have gone up considerably - and Hazelton believes that the LBO industry has yet to face up to the real extent of its need. "At the moment some of the private equity guys see mezzanine yield as too high for them to be interested, but I'm sure that's going to open up, because they need to make better returns than mezzanine to make their equity funds work," he says.
Of course, the very fact that these kinds of yields are available - and that they will outlast the opportunity in investment grade and high yield - raises the question of how loans might be most appropriately deployed by pension funds.
While the cash flows and the floating rates present interesting liability-matching possibilities, the mark-to-market volatility resulting from the liquidity crunch might make some investors think twice and consider placing them elsewhere in the portfolio. Hazelton acknowledges that no-one ever really expected loans to trade outside their steady range of 96-102 cents on the dollar. "It happened - some prices were driven down to the mid-50s - so you can't say it's impossible," he says. "But it's very unusual for the loan market to be showing that kind of volatility. We do have stumbling blocks accessing institutions who need paper to be demonstrably liquid, but the practicality of the matter is that loans are now a liquidly-traded asset - we did about €1bn worth of trades during 2009, and virtually all of that was in secondary market." Godson notes that Babson's commingled funds have no trouble offering monthly liquidity to investors and that underlying assets are more than liquid enough to be reliable marked.
As so often, this is something of a chicken-and-egg situation - the more real money there is in this market, the less volatility and illiquidity risk it will pose. "We've raised money through 2009, and it was real money," says Hazelton. "The prize for us is that we have institutional investors writing €20-80m tickets for our commingled funds, but we know that these are huge institutions with vast amounts of capital to allocate and we are certain that this is going to be a core product for them in the future."