Speciality Credit: Where the cash flows
Niche credit strategies such as shipping and aviation are gaining attention in the persistent low-yield environment
- Speciality finance strategies aim to purchase a stream of cash flows, often generated by physical assets such as ships or planes
- The sector is comprised of niche managers with highly specialised knowledge of assets and their underlying market dynamics
- Speciality strategies are growing in niches where banks are in retreat – trade finance is the latest emerging sector
In the years since the financial crisis, investment management firms have showcased a comprehensive range of strategies that allow institutional investors to deploy capital where banks fear, or are less able, to tread. Assets under management in private credit strategies soared from $245bn (€219bn) in 2008 to $667bn in 2018, according to Preqin. The attraction, so far, has been the ability of private credit managers to deliver results.
According to the September 2019 unitholder presentation from Carlyle Group, which manages $47bn in credit strategies, including structured credit, direct lending and aviation finance, the annualised net internal rate of return (IRR) on private debt funds has exceeded the total return on global high-yield bonds by 660bps on a one-year basis and 230bps on a five-year basis.
The credit universe encompasses numerous strategies, according to Cambridge Associates. These range from capital preservation strategies such as senior debt – typically known as direct lending, and mezzanine debt – to return-maximising strategies such as subordinated capital or structured equity, which target capital appreciation, or distressed debt and special situations funds which seek to profit on turnarounds.
As investors continue to pursue the best available balance between return and risk, there is renewed interest in a third category – speciality finance, a set of opportunistic or niche strategies akin to asset-based lending.
In general, speciality finance strategies aim to purchase a stream of cash flow generated by either a financial or a physical asset, such as a ship or an aeroplane. The primary driver of return, which can range from 7% to 20%, according to Cambridge, is the enhancement or recovery of cash flow through active servicing of the assets.
Funds are typically formed for periods of five to eight years, and the investment period ranges from two to four years. Competition in these niches is generally limited, although some strategies can become ‘crowded trades’ from time to time, according to Cambridge. And while speciality finance is an active strategy, managers typically do not try to influence corporate restructurings; the focus is on cash flow.
Because assets in sectors such as shipping can be highly specialised, and because the strategies are the latest phase of evolution in the private credit market, there is no benchmark as yet for the asset class. Cambridge is developing a speciality credit benchmark, but there are insufficient funds to produce a reliable tool.
Allocations to speciality finance bear many of the classic features of going farther out on the risk curve, into situations where it becomes become increasingly difficult to analyse the security of expected cash flow, the potential value of collateral, and the potential factors that might jeopardise returns. In its private credit report, Cambridge notes, “the highly specialised nature of these strategies makes them among the most difficult to perform due diligence on because each strategy requires unique lines of inquiry”.
Sailing the seven seas
While speciality credit encompasses everything from music and pharmaceutical royalties to consumer finance strategies, the most institutionally suitable are shipping finance, aviation finance and trade finance.
Institutions have long financed ships, mainly through funds or vehicles that make loans against specific vessels, secured by a mortgage on the vessel, with each vessel typically owned by a separate company. Shipping companies with large fleets could owe money to many lenders, under terms that could affect how the vessels could be deployed to serve customers.
In a new structure reported in shipping journal FreightWaves, Citigroup devised a loan in which the mortgage collateral is a variable pool of vessels, rather than linking specific vessels to the mortgage for the life of the loan. The structure was used for a loan of $1bn to Seaspan Corporation, the largest US-listed lessor of container ships.
Secured by a portfolio of 36 of Seaspan’s 112 vessels, the new credit facility will help the company reduce the number of separate loans as well as the time and cost required to manage them. Seaspan will be allowed to change the ships in the collateral pool, which can help it manage changes in service requests from customers. The key from the investment perspective is that the business terms of the vessels in the collateral pool must meet certain criteria at the aggregate level in terms of the charterers of vessels, the duration of charters – which affects the security of cash flow – and other factors like ship size and age.
It is to be seen whether the Seaspan-Citi structure will be used by other shipping lines. But the shipping finance sector is clearly becoming more institutional.
“Shipping is becoming more institutionalised,” says Marcel Saucy, senior partner at Zurich-based Fincor Finance, which raises institutional capital for a variety of specialised investment strategies. “You have larger and larger companies with larger fleets, and certain actors in the shipping space are becoming standalone corporates that have their own credit standing, which is independent of the asset so it’s a natural consequence that banks would start to consider the going-concern characteristics of the corporate credit rather than the individual asset financing of the single ship,” Saucy adds.
A collateral pool consisting of various vessels might be a more attractive credit opportunity to investors than a series of single loans to single-purpose companies secured by different ships, Saucy says. But the sector is risky as it is so cyclical. Saucy notes: “If there’s no backup capital to support the corporation when the market is in a down cycle, lenders or investors might face losses”.
The macroeconomic backdrop presents risks to shipping investors. “Our outlook overall for shipping is negative,” says David Petu, a director at Fitch Ratings. The US-China trade war is affecting shipping rates. GDP growth is slowing in many countries, which has a negative impact on global container shipments. Fitch looks at lessors, companies that own ships and lease them to large container shipping lines such as AP Moeller-Maersk.
Trade finance strategies: low risk and short-term loans
Another niche where private capital is replacing banks is trade finance. “It’s a small niche, probably too small for most institutional investors,” says Marcel Saucy, of Fincor Finance, who is developing a trade finance fund-of-funds.
There are about three dozen managers offering such strategies. Saucy says: “But there’s a lot going on and I heard from a further manager who just reached the billion-AUM mark.”
Trade finance can carry low credit risk because freight is insured and products such as commodities are often contracted for sale to major companies with strong credit ratings.
Loans tend to be short-term, from 30 to 180 days, which means investors can earn an absolute-return type yield without markdowns if rates rise. “It’s going from a niche to a broader, more accessible and professionally-managed asset class,” Saucy says.
Analysing shipping credits entails assessing finance costs and total capacity, as well as economic growth. While ship lessors have a slightly higher cost of funds than sectors like aviation, because ship owners typically borrow on a secured basis rather than through unsecured debt, Petu says, “the supply of ships has stabilised and to some degree we are seeing a relatively stable performance on container shipper lessors”.
While the aviation finance presents investors with unique characteristics, some investment fundamentals such as the supply of aeroplanes and demand for air travel remain important.
“Currently we see high competition in the operating leasing market with pressure on yields,” says Jochen Hörger, managing director of KGAL Investment Management, responsible for the aviation asset class. Hörger says the yield pressure is “caused by the shortage of aircraft available for financing due to the missing Boeing 737 Max in the market”.
Hörger says KGAL is “selective” in considering potential transactions. “Regarding core investments, we are very much focused on choosing the right aircraft type, mainly narrow bodies, which are the most ‘liquid’ aircraft with the largest share of the global aircraft fleet, and leases with reliable airlines and a sufficient security package.”
For the coming year, “we assume that with the return of the Boeing 737 Max the competition will ease”, Hörger says. “In respect to higher-yielding core-plus transactions, which require an even deeper technical asset know-how, we see a less crowded market for investment opportunities, especially in older aircraft,” he says.
For the European market in particular, Hörger continues, “we expect a further consolidation in the airline industry, since especially smaller airlines are struggling with high operating costs”.
Underlying conditions for aircraft leasing are favourable, says Johann Juan, a director at Fitch Ratings. “In terms of aircraft lessors, the overall sector continues to benefit from largely supportive market dynamics,” Juan says. “You’ll see continued increase in air travel, particularly in the emerging markets such as China where there’s continued infrastructure investment, so we expect above-average air traffic growth there.”
“There’s continued adoption of aircraft leasing. There’s capital flowing in from private equity and other investors, and aircraft lessors make up about 45-50% of overall aircraft fleets globally today.” In addition, he says, “the influx of capital stimulates demand for various aircraft types, not just orders on the new side, but also continued demand on the midlife spectrum”.
The capital market continues to be supportive for aircraft lessors, with “quite good issuance within the debt capital markets, particularly in the unsecured side, and asset-backed securities continue to be relatively robust”.
However, Juan warns that “the competition overall continues to place some pressure on lease yields”. As a result, he says: “We expect some modest declines on net margins, given the expectation of lower interest rates in the near term.
“The overall balance sheets of aircraft lessors continue to strengthen. Given their relatively low balance sheet leverage over the last couple of years, funding continues to be very favourable. Nothing from the credit fundamentals speaks to cracks in the system, but the industry is cyclical, so the expectation that there might be some sort of cyclical downturn in the overall market or the sector around the corner somewhat tempers our otherwise positive view.”