Marble Point Loan Financing — Disciplined leveraged loan investment specialist

Leveraged loans are loans issued by companies with relatively high levels of debt, which have lower credit ratings and offer higher yields than more secure, investment grade debt. The primary appeal of leveraged loans to investors is the relatively high, usually floating rate, interest that they pay. Although yields are higher to compensate for the greater risk of default associated with more highly geared companies, leveraged loans are secured on the assets of the company and usually rank at the top of the capital structure (senior secured loans), which has led to relatively high recovery rates being achieved historically in default events, in comparison with high yield bonds, which are generally unsecured. The Credit Suisse Leveraged Loan Index (CSLLI) has recorded a 5.5% annualised return over its 27-year history (1992–2018), with positive returns in 25 of the 27 calendar years (see Appendix: Introduction to leveraged loans and CLOs).

A CLO is a portfolio of leveraged loans that is securitised and managed as a fund, offering investors a series of interest-paying bonds (CLO debt) and a smaller equity investment class (CLO equity), which makes up the majority of MPLF’s investment portfolio. CLO debt securities are lower-risk floating rate investments with a strong credit rating, which offer a higher yield relative to equivalently rated non-CLO debt securities. CLO equities are higher-risk, higher-return investments that effectively arbitrage the higher yield on the leveraged loan portfolio with the CLO’s lower-cost, primarily investment-grade, debt financing. Although CLO equities bear the first risk of default in the loan portfolio, they also offer investors potential upside from periods of loan price volatility, when CLO managers can often take advantage of a CLO’s fixed-term financing to purchase loans at a significant discount to their par value.

Based on a 2.75% US dollar Libor rate, a typical leveraged loan portfolio would yield c 6.5%, while a CLO equity could achieve a net annualised return of 10–15% (see page 16). The highly leveraged CLO structure (typically c 9:1 debt to equity) increases investment risk, but this is partly mitigated by long-dated financing and the control exerted by the majority CLO equity holder (see page 18). CLOs are also actively managed and incorporate structural protections that further mitigate risk.

In the very short term, CLO equity valuations tend to react positively to spread tightening and negatively to spread widening, similar to most other credit instruments. However, medium-term loan spread widening provides the opportunity for the CLO manager to reinvest in higher-return loans, thereby increasing loan portfolio cash flows while financing costs remain fixed, and thus improve the valuation of CLO equities, making them relatively unique in the credit universe.

MPLF is a closed-ended investment company that was incorporated in Guernsey on 13 April 2016 and commenced operations on 2 August 2016, with its ordinary shares admitted to trading on the Specialist Fund Segment of the Main Market of the London Stock Exchange on 13 February 2018. MPLF’s investment objective is to generate stable high current income and capital appreciation by earning a return on equity in excess of the amount distributed as dividends. MPLF targets an annualised total return in the low-to-mid teens over the long term, including an initial quarterly dividend of 2.0% of the US$1.00 per share issue price (increasing to 2.5% per quarter in the second year following initial admission).

MPLF seeks to achieve its objective by investing in a diversified portfolio of US dollar-denominated, broadly syndicated floating rate senior secured corporate loans. Direct and indirect exposure to loans is primarily gained via MPLF’s wholly owned subsidiary MPLF Funding, together with investments in loan accumulation facilities (LAFs) and the equity and junior debt tranches of collateralised loan obligations (CLOs) that are all managed by Marble Point Credit Management (Marble Point) and its affiliates (see page 8). As well as managing a number of CLO and LAF investment vehicles, Marble Point serves as investment manager for MPLF and MPLF Funding.

Marble Point is a specialist asset manager (registered with the US Securities and Exchange Commission – SEC) that focuses exclusively on leveraged loans, with c US$4.0bn in assets under management as at 31 December 2018. Marble Point was formed in 2016 by Tom Shandell, who has over 30 years’ credit market experience, in partnership with Eagle Point Credit Management (Eagle Point), one of the world’s largest CLO equity investors, with US$2.4bn in assets under management as at end-December 2018. Led by Tom Shandell and Corey Geis, Marble Point’s investment team includes five industry-specialist credit analysts, with more than 17 years’ average credit market experience across the team.

In Q117, a portfolio of indirect CLO investments was contributed to MPLF in exchange for shares of common stock. This portfolio included investments in the equity tranches of seven CLOs acquired by MPLF’s shareholders on 30 December 2016 in connection with the investment manager’s acquisition of the CLO management platform of American Capital, a US‐based business development company. Each of these CLOs is now managed by Marble Point.

MPLF was a private unlisted investment vehicle with its investments managed by Marble Point for the whole of 2017. Over the year, MPLF increased its net assets from US$10.2m to US$165.1m and NAV per share increased by 20.39% (rising from US$1.03 to US$1.24).

On 9 February 2018, MPLF raised US$42.5m in gross proceeds in its IPO, through issuing 42.5m ordinary shares at US$1.00 per share. All MPLF’s pre-existing founder and co-investor shares were converted (at a ratio of c 1:1.23) into 163.2m ordinary shares immediately prior to admission, and no other share classes exist. On 13 February 2018, all of MPLF's 205.7m ordinary shares were admitted to trading on the Specialist Fund Segment of the London Stock Exchange.

In September 2018, MP CLO VII was reset, entailing the extension of its reinvestment period by one-and-a-half years to October 2020, and revision of its collateral quality tests, which greatly enhanced its ability to reinvest loan sale and repayment proceeds. MP CLO VII (initially issued in 2015) had experienced a decline in its equity value due to accumulating a significant amount of cash that was not invested in leveraged loans, as reinvestment possibilities were limited by its very short weighted average life test (see page 19). The high level of cash led the market to place a lower value on the CLO equity.

In November 2018, MPLF issued US$29.5m of 7.50% senior unsecured notes due in 2025 in a private placement, with net proceeds of US$28.4m. This capital was raised to enable MPLF to make further investments and thereby broaden the vintage period diversification in its CLO portfolio. The manager also expects the raising to be accretive to net interest income per share, while the seven-year maturity of the notes was important as it enables MPLF to continue to seek attractive risk-adjusted returns over a long-term investment horizon.

In December 2018, the issue of Marble Point CLO XIV was closed. This was a new issue US$400m CLO with an estimated effective yield of 12.4%, in which MPLF committed to invest US$26.2m, directly and indirectly via its ownership interest in the CLO manager, to acquire 77.8% of the CLO equity. Marble Point CLO XIV has a five-year reinvestment period, two-year non-call period and 13year maturity. Its expected weighted average cost of debt is 195bp above Libor (Libor+195bp).

With regard to the leveraged loan market volatility during the fourth quarter of 2018, Marble Point CEO Tom Shandell observes that S&P and Credit Suisse leveraged loan indices data showed a 1.75 point decline in the average par-weighted price (loan price relative to a par value of 100) from end-September 2018 to end-November 2018, followed by a 2.74 point fall during December 2018, marking the worst month for loans in over seven years. He confirms Marble Point’s assessment that the drawdown in loans in December was principally technical in nature, as much of the sell-off was concentrated in large, more liquid loans, with only a limited increase in the number of loans trading at deeply discounted prices (which would indicate credit risk). He notes that December 2018 was also one of the worst months on record for US equities, with the S&P 500 Index registering a total return of -9.03%, while the CSLLI and the ICE BofAML US High Yield Index (ICE BAML HYI) recorded total returns of -2.29% and -2.19%, respectively.

Commenting on the sharp decline in MPLF’s NAV during November and December 2018, Shandell is keen to emphasise that this reflects Marble Point’s ‘mark-to-market’ valuation methodology rather than any deterioration in the fundamentals of MPLF’s underlying loan portfolio. He explains that the rationale for employing this valuation approach is to address the criticism that the alternative ‘mark-to-model’ methodology ignores market price fluctuations, as it is based on the CLO manager’s internal forecast of underlying cash flows. Nonetheless, MPLF is not a forced seller of CLO equity securities when prices fall, and the key value driver for these investments remains the cash flow generation of the underlying loans held by the CLOs, rather than secondary market prices.

The manager highlights that MPLF received quarterly cash distributions totalling US$6.2m from its CLO equity holdings in January 2019, compared with US$4.2m in October 2018. While a large part of this increase comes from the first distribution by MP CLO VII following its September 2018 reset transaction, distributions by the other CLO equity positions were 9.3% higher in aggregate.

Shandell firmly believes that MPLF is well positioned to take advantage of the opportunity created by leveraged loan market volatility. He notes that, unlike many mutual funds investing in leveraged loans, Marble Point CLOs were not forced sellers during the market decline, and were able to take advantage of lower loan prices to increase levels of investment. This is demonstrated by MPLF’s portfolio investments (including Marble Point CLOs) deploying over US$200m aggregate net capital during December 2018. Shandell highlights that, all else being equal, the greater investment balances resulting from loans being acquired at lower prices should lead to increased net interest income and therefore higher equity distributions from the CLOs in which MPLF is invested.

The closing of Marble Point CLO XIV on 31 December 2018 crystallised MPLF’s returns on the associated LAF, in which it had invested US$28m, and the manager notes that a realised internal rate of return (IRR) of over 15% was achieved on this investment. Also during December 2018, MPLF invested US$15m of the proceeds from its US$29.5m November notes issue in a newly formed LAF, which has commenced accumulating loans to be converted into a future new CLO investment. MPLF invested a further US$4.5m into this LAF in January 2019.

Looking at the leveraged loan market at the start of 2019, the manager notes that retail net outflows moderated to US$4.7bn in January, well below the US$15bn net outflows in December 2018, but still higher than the US$2.9bn recorded in November 2018 (see Performance – page 10). Easing selling pressure, combined with opportunistic buying by many investors who believed the market was oversold, led to the leveraged loan market retracing a significant portion of its December 2018 loss, with the average par-weighted price of the CSLLI increasing by 1.72 points to 95.81 at end-January 2019, and by a further 0.42 points to 96.23 as at 19 February 2019.

Marble Point has a conservative, differentiated approach to credit investment, with four key elements to its philosophy:

Marble Point has a well-defined, disciplined and repeatable investment process, which breaks down into two main stages: loan selection and credit approval.

The loan selection process incorporates the following considerations:

Credits that meet the loan selection criteria are eligible to be considered for investment via the credit approval process, which comprises the following stages:

Following investment, there is an ongoing assessment and risk management process, with the covering analyst responsible for monitoring every position in their specialist sectors, while the team sits in an open environment, which fosters regular communication.

MPLF primarily obtains exposure to loans through its subsidiary MPLF Funding (which invests in loans directly), through investments in Marble Point CLO equity and debt securities, and also via Marble Point LAFs. MPLF invests in Marble Point CLOs directly and also has indirect exposure through holding minority stakes in Marble Point’s CLO manager subsidiaries, which maintain risk retention interests in each CLO they manage, generally to the extent required by law or regulation.

Depending mainly on an assessment of market conditions, a Marble Point CLO manager may initiate the securitisation of a Marble Point LAF, or loans within MPLF Funding, into a Marble Point CLO; the issuance of a new Marble Point CLO; or the refinancing or reset of an existing Marble Point CLO. To the extent it has available capital, MPLF intends to obtain exposure to each new Marble Point CLO when it is issued, thereby gaining vintage period diversification across its portfolio of CLO securities, which is considered important from a risk management perspective.

MPLF may acquire Marble Point CLO securities on the secondary market, and is permitted to invest directly or indirectly in other related investments, such as CLOs or LAFs managed by third-party CLO managers; interests in other pooled investment vehicles that invest in loans or CLOs; interests in CLO collateral managers; other types of loans; and any other investment that the manager believes is consistent with MPLF’s investment objective and policy.

Exhibit 2 shows MPLF’s portfolio investments at end-January 2019. The most significant valuation changes from end-December 2018 were c 5–11% gains across MPLF’s CLO equity holdings in MP CLOs III and VIII and Marble Point CLOs X and XI as these were marked up to prevailing market prices. These gains largely offset the declines reported in December 2018, confirming that no material deterioration was seen in the underlying loan portfolios of these CLOs. In December 2018, loans held by the Marble Point LAF were securitised into Marble Point CLO XIV, and capital was reallocated from MPLF Funding to a newly formed Marble Point LAF, which explains the majority of the decline in value of these investments from US$54.0m and US$27.8m at end-November 2018.

Exhibit 3 shows the breakdown of MPLF’s portfolio by investment category and the underlying loan exposure by industry at end-January 2019. CLO equity exposure increased from 49.9% at end-November 2018 to 61.5% at end-January 2019, reflecting the natural cycle of loan accumulation by MPLF Funding and Marble Point LAFs (which both act as CLO warehousing facilities) followed by securitisation of the loans into a new CLO issue. MPLF’s CLO equity exposure was a comparable 60.9% at end-February 2018. The portfolio’s underlying industry exposure is broadly spread across Moody’s 35 industry groups, with the top 10 industries representing 71.9% of the portfolio at end-December 2018, compared with 70.9% at end-November 2018 and 68.5% at end-February 2018.

As shown in Exhibit 4, MPLF had exposure to c 300 corporate borrowers at end-January 2019, with average exposure of c 0.5%. The largest portfolio exposure to an individual borrower was 1.1% and the 10 largest exposures made up 9.7% of the portfolio (Exhibit 1), similar to end-December 2018 and end-February 2018. The average par-weighted market value of the underlying loans in the portfolio was 96.22 at end-January 2019, having recovered from 94.56 at end-December 2018, but still below the 97.11 and 99.61 average market values at end-November 2018 and end-February 2018, respectively. The underlying loan portfolio’s weighted average credit rating has remained at B1/B2 since MPLF’s launch, with loans concentrated in the Ba3, B1, B2 and B3 categories, although there has been a slight shift to the lower rating categories at end-January 2019 compared with end-February 2018.

As illustrated in Exhibit 5, MPLF’s underlying portfolio is skewed to longer maturities, with 68.1% exposure to loans maturing in 2024 or later as at end-January 2019, similar to the distribution at end-December 2018, but more skewed to longer maturities than at end-February 2018, when exposure to loans maturing in 2023 or later was 59.7%. The manager reports that the current portfolio’s higher proportion of longer-maturity loans is consistent with the overall loan market. The price distribution of MPLF’s underlying loan portfolio changed considerably during January 2019, with 59.2% trading at 97.5% of par or higher at end-January 2019 compared with 16.5% a month earlier, marking a move back towards the 77.6% and 92.9% levels recorded at end-November 2018 and end-February 2018. This shift reflects a recovery from the significant market price declines during December 2018, which resulted from an exceptionally high level of net outflows from retail loan funds, rather than any deterioration in loan fundamentals. This redemption-driven selling typically creates an attractive buying opportunity for CLOs, which have fixed-maturity financing.

As illustrated in Exhibit 6, MPLF’s NAV total return modestly lagged the S&P Leveraged Loan index from its IPO in February 2018 through to end-October 2018, but then suffered a significant setback, recording 8.5% and 5.0% declines in November and December 2018, while the S&P Leveraged Loan index saw respective declines of 0.9% and 2.5%. MPLF’s weaker performance was primarily due to its conservative valuation policy, with its reported NAV reflecting a market-wide decline in CLO equity prices, while no material decline was seen in the cash generation prospects of its CLO portfolio. Marble Point’s methodology contrasts with the widely used ‘mark-to-model’ approach, where CLO valuations are based on expected underlying cash flows and not adjusted for trading price fluctuations. While MPLF’s reported NAV rebounded in January 2019, this valuation approach has made its performance appear significantly more volatile than that reported by many of its peers.

Loan market declines in November and December 2018 largely reflected redemption-driven selling by mutual funds invested in leveraged loans, rather than a rise in the level of defaults by corporate issuers. Net outflows from retail loan funds reportedly exceeded US$15bn in December, including US$3.5bn in the final week of the year, which represented the largest weekly outflow in the market’s history. This followed US$2.9bn of net outflows in November 2018 and took total net outflows from retail loan funds to over US$20bn for the fourth quarter of 2018. Three defaults were reported in November and December 2018 among constituents of the S&P Leveraged Loan index; MPLF had exposure to only one of these – 0.07% exposure to Catalina Marketing as at end-December 2018. Only one default was reported in January 2019 and MPLF had no exposure to this issuer.

Exhibit 7 shows MPLF’s performance relative to a range of credit and equity indices over one, three and six months, and since its launch in February 2018. MPLF’s share price and NAV total returns lagged the selected indices over all periods shown except for one month, when its NAV total return was in line with the S&P 500 Index and notably ahead of the leveraged loan and high-yield bond indices. MPLF’s NAV performance relative to the S&P Leveraged Loan Index is shown in Exhibit 8.

As shown in Exhibit 9, MPLF’s shares traded at a premium to NAV from its IPO up to end-January 2019, when its share price had not reacted to the recent rebound in its NAV. At 28 February 2019, the share price stood at a 4.9% discount to the latest reported (end-January 2019) NAV per share, which compares with the average 5.7% premium since MPLF’s launch. MPLF has no strict discount control policy, but shares may be repurchased if they trade at a three-month average discount wider than 5%, measured at each month end. Repurchases will only be made at prices below the prevailing NAV per share, when the directors believe such purchases will be value accretive.

MPLF currently has a single share class, with 205.7m ordinary shares in issue. The directors have annually renewable authority to make market purchases up to 14.99% of MPLF’s outstanding ordinary shares. There are no rules restricting the ability of the directors to issue additional shares on a non-pre-emptive basis at any time. The directors may issue additional shares, pursuant to a placing programme or otherwise, if they determine this to be in the best interests of shareholders and MPLF as a whole. No shares have been allotted or repurchased since MPLF’s IPO in February 2018, when it raised c US$40.5m in net proceeds through issuing 42.5m ordinary shares at US$1.00 per share, and all of its 205.7m ordinary shares were admitted to trading on the Specialist Fund Segment (SFS) of the London Stock Exchange.

Prior to its IPO, MPLF had two classes of share: ordinary redeemable participating management shares (founder shares), and non-voting, ordinary redeemable participating shares (co-investor shares), which had been issued over time since MPLF’s incorporation, in connection with previous capital raises. All founder and co-investor shares in issue were converted into ordinary shares at a ratio of c 1:1.23 immediately prior to admission to trading on the SFS, so that there were 163.2m ordinary shares in issue and the founder shares and co-investor shares ceased to exist. The holders of these 163.2m shares were subject to a lock-up agreement for 12 months following initial admission, which restricted them from selling, transferring or otherwise disposing of the shares. The end of this lock-up (which covers 79% of the outstanding shares) in February 2019 could lead to an increase in share liquidity, which has been relatively low since MPLF’s IPO.

Sumitomo Mitsui Trust Bank (which provides a non-recourse US$200m revolving credit facility to MPLF Funding) has an option to acquire up to US$1.0m in MPLF ordinary shares, at the US$1.00 issue price if the option is exercised within 12 months of initial admission, or at the most recently determined or estimated NAV per share if the option is exercised at a later date.

A continuation vote will be proposed at MPLF’s first AGM following the fourth anniversary of its IPO unless, prior to this anniversary, MPLF has raised US$400m or more in capital – calculated as MPLF’s NAV at initial admission plus gross proceeds of further capital raises, less gross amounts paid to shareholders through share buybacks, repurchases or redemptions. If the continuation resolution is not passed, the directors are required to put forward proposals for reconstruction or reorganisation of the company for shareholder approval within six months of the vote.

As set out in its memorandum of association, MPLF is permitted to borrow up to 20% of its gross assets, at the time of borrowing. This limit excludes non-recourse financing obtained by MPLF Funding or any other entity in which MPLF is invested. MPLF previously held a one-year US$10m revolving credit facility with China Merchants Bank, which expired in October 2018. In November 2018, MPLF issued US$29.5m aggregate principal of 7.50% senior unsecured notes due in 2025, providing US$28.4m in net proceeds, of which it invested US$15m in December in a newly formed LAF. The US$29.5m borrowings equated to 16.6% of net assets at end-January 2019, while net gearing was 15.7% at this date.

In September 2016, MPLF Funding entered into a US$200m revolving credit facility (which is non-recourse to MPLF) with Sumitomo Mitsui Trust Bank. MPLF Funding utilises the facility to acquire loans directly – these loans should generate net interest income while being accumulated in advance of future Marble Point CLO issuances. Advances under this facility accrue interest at an annual rate of Libor+1.25% plus a 0.10% administrative fee, and there is no undrawn cost. The facility’s earliest maturity date is 16 April 2021, and this automatically extends to 16 September 2021 under certain circumstances. MPLF Funding may draw on the facility up to an 80% loan-to-value ratio, and at end-September 2018, US$95.6m was drawn (78% LTV ratio).

MPLF’s investments are only subject to one layer of management fees, and the manager sees MPLF’s overall fee structure as one of the most investor friendly among its peers. Marble Point LAFs do not pay any management fees to Marble Point, and no fees are borne by MPLF’s CLO debt investments or fee participation interests. As a result, 20% of MPLF’s portfolio investments at end-January 2019 (see Exhibit 2) were not subject to any fees.

As MPLF’s investment manager, Marble Point is entitled to a management fee equal to 0.40% per annum of MPLF’s consolidated total assets, excluding assets managed by Marble Point. To date, all MPLF’s investments have been in Marble Point-managed assets and it is expected that they will continue to comprise the majority of MPLF’s investments in future. Marble Point is also entitled to be reimbursed for reasonable costs and expenses. CLOs in which MPLF is invested generally each pay management and incentive fees, which in certain cases are greater than 0.40%. MPLF indirectly bears these fees as they are deducted from the net returns of the CLOs. MPLF Funding pays Marble Point a management fee equal to 0.40% per annum of its average gross assets.

Marble Point is usually entitled to receive CLO management and incentive fees at levels agreed at the time of issuance, in accordance with prevailing market conditions. As a direct or indirect investor in the equity tranche of Marble Point CLOs, MPLF bears its pro rata portion of such fees. However, MPLF does not bear CLO management fees in excess of 0.40% per annum or CLO incentive fees in excess of 20% over a 12% hurdle. Where fees are higher, MPLF receives a fee participation interest or rebate, except where the CLO interest has been acquired in the secondary market.

Based on assumed gross issue proceeds of US$100m, MPLF’s total annual operating expenses were forecast to be c 0.82% of its estimated unaudited net asset value on initial admission. These expenses primarily comprise directors’ fees, administration and audit fees, and do not include fees payable on underlying investments, where MPLF receives returns net of fees. Adjusting for the actual gross IPO issue proceeds of US$42.5m, we estimate MPLF’s ongoing charges at 1.05%.

MPLF pays dividends quarterly in April, July, October and January. It has an 8.0% target annualised yield based on its US$1.00 per share IPO price, with the intention to raise the target yield to 10.0% one year after its listing in February 2018. Based on its US$0.82 share price at 28 February 2019, MPLF’s current annualised dividend yield is 9.8%. If the quarterly dividend is lifted as intended from April 2019, the prospective annualised yield would rise to 12.2%, based on the same share price.

MPLF’s original dividend policy was to commence distributions following the first anniversary of its initial closing date (2 August 2016), with the intention to pay an initial dividend of 2.0% of net asset value each quarter (equating to an 8.0% annualised return), with the target dividend subsequently increasing to 2.5% a quarter. MPLF paid an inaugural dividend of US$0.0238 per share (US$0.0194 per ordinary share – adjusting for IPO share conversion ratio) in December 2017, representing 2.0% of its net asset value as at end-September 2017. In January 2018, MPLF paid a dividend of US$0.0142 per share (US$0.0116 per ordinary share – adjusting for IPO share conversion ratio) in respect of the portion of the first quarter of 2018 prior to its IPO.

In April 2018, MPLF paid a US$0.0104 per share dividend in respect of the portion of the first quarter of 2018 following its IPO, equating to an annualised distribution in line with the targeted 8.0% dividend yield. In July and October 2018 and January 2019, MPLF paid US$0.02 per share dividends in respect of the second, third and fourth quarters of 2018. This took total post-IPO dividends for 2018 to US$0.0704 per share, which represents an 8.0% annualised yield based on the IPO price of US$1.00 per ordinary share, pro-rated for the period from MPLF's IPO and admission to trading on 13 February 2018.

Exhibit 10 shows a comparison of MPLF with a selected peer group of funds from the AIC Sector Specialist: Debt and AIC Sector Specialist: Financials sectors that have significant holdings in CLO securities or similar investments. Carador Income Fund has been excluded as it has commenced a managed wind-down. As less than one year’s data is available for MPLF, we show performance over six months and since MPLF’s inception to allow comparison to be made, while also showing longer time periods for the peers, to give greater context to the short-term performance data.

MPLF’s NAV total return is the lowest in the peer group over six months and over the c 11.5 months since its inception. This is primarily due to the sharp mark down in MPLF’s NAV in November and December 2018, which is due to MPLF’s conservative policy to reflect market pricing in its reported NAV. This contrasts with the more widely used ‘mark-to-model’ valuations, which are based on expected underlying cash flows and not adjusted for trading price fluctuations. Market declines in these two months reflected redemption-driven selling by mutual funds invested in leveraged loans, rather than a high level of defaults – three defaults were reported among constituents of the S&P Leveraged Loan index, and MPLF had only 0.07% exposure to one of these issuers.

With its share price having moved to a discount to NAV at end-January 2019, MPLF’s current 4.9% discount is at the median within the peer group, with only one of the peers trading at a premium. Our estimate of MPLF’s ongoing charge is below the peer group average. MPLF’s dividend yield is slightly ahead of the peer group average, and it has a target to increase its payout from 8% to 10% of the US$1.00 per share IPO price one year after its February 2018 listing, which would lift its yield to c 12% based on the current US$0.82 share price.

MPLF’s board comprises five non‐executive directors, four of whom are independent of the investment manager. The current independent directors were all appointed in December 2017, when former directors Dan Spinner and Chris Le Page retired from the board. Chairman Robert Brown is a financial services professional with over 20 years’ experience in the UK, Europe and the US, encompassing asset management, private banking and investment banking. John Falla is a chartered accountant and investment professional with over 30 years’ experience in the UK and Channel Islands. Sandra Platts worked at Kleinwort Benson from 1986 to 2010, serving as chief operating officer for the Channel Islands business from 1992. She is a director of NB Global Floating Rate Income Fund, UK Commercial Property REIT and Sequoia Economic Infrastructure Fund. Paul Greenberg has been a fund manager focused on equity and debt investments in special situation, distressed and bankrupt corporations for the past 17 years. He is currently managing partner of Clermont Capital, a family office with a focus on private equity and fixed income markets.

Non-independent Director Thomas Majewski was appointed to MPLF’s board in 2016 as a nominee of its investment manager Marble Point. He has spent his entire career in structured finance and credit markets, and his experience in the CLO market dates back to the 1990s. Majewski serves on the board of Marble Point and holds an indirect minority interest. He is also managing partner and a board member of Eagle Point, holding a minority interest. Eagle Point is the sole member of EPCM Holdings, a shareholder of MPLF and the holder of a majority interest in Marble Point.

Leveraged loans are loans issued by companies that have relatively high levels of debt, which consequently have lower credit ratings (generally Ba1/BB or lower) and offer higher yields than loans issued by investment-grade companies that present lower credit risks due to their lower levels of gearing. Many companies issue leveraged loans as part of a leveraged or management buyout (LBO or MBO) transaction when they are acquired by a private equity investor.

Companies that issue leveraged loans often also borrow through issuing high-yield bonds, with bonds usually paying interest at a fixed rate, while loans generally pay interest at a floating rate, typically measured as a margin or spread over a benchmark rate such as Libor. Loans are typically secured on the assets of the company, while bonds are usually unsecured. This means that loans are repaid in priority to bonds in the event of a default, and consequently average recovery rates historically have been much higher for loans than bonds (Exhibit 11). Loan agreements also usually contain covenants that give lenders more control over the borrower’s actions. While less restrictive ‘covenant-lite’ loans now account for c 75% of the US leveraged loan market, Standard & Poor’s reports similar historical default rates for these loans relative to fully covenanted loans. However, a rise in the prevalence of loan-only capital structures has led Moody’s to project a decline in first-lien loan recoveries to 61%, with second-lien debt recoveries projected to fall to c 14%.

Statistically, companies with higher leverage and lower credit ratings are more likely to default on debt repayments than investment-grade companies. The higher the perceived risk of default, the greater the yield demanded by investors to hold the debt. The primary attraction of leveraged loans is the high yield that they offer to investors, who can seek to mitigate the risk of default in a number of ways, such as by holding a diversified portfolio of loans, conducting their own detailed credit analysis prior to investing, and carefully monitoring the loan investments they hold.

Collateralised loan obligations or CLOs are closed-ended investment vehicles that have been structured specifically to invest in leveraged loans, aiming to maximise investment returns while minimising the risks inherent in its leveraged structure. A CLO is financed by a series of interest-paying debt tranches (CLO debt) and a smaller equity investment class (CLO equity). CLOs typically hold a portfolio of 80 to 350 leveraged loans, highly diversified across industry sectors, covering a range of non-investment-grade credit ratings, with low concentration of exposure to individual borrowers. CLO portfolios are actively managed by a collateral manager, who can buy and sell holdings to improve the potential returns from the portfolio as market conditions change, as well as being able to refinance the CLO’s debt when more favourable rates can be secured.

CLO equity returns are driven by the arbitrage between the cost of the CLO debt tranches and the interest income generated by the loan portfolio. In Exhibit 12, the weighted average cost of the debt tranches is Libor+190bp. If the loan portfolio generates an average coupon of Libor+375bp, the arbitrage opportunity available for CLO equity investors is about 185bp, before deducting fees and expenses. This arbitrage is magnified by the c 9:1 embedded leverage in the CLO for the equity tranche. CLO managers’ fees typically comprise a senior management fee of c 15bp, which is paid prior to servicing the CLO debt, and a subordinated management fee of c 35bp, which is paid after servicing the CLO debt before excess interest is distributed to CLO equity holders. The CLO manager is also usually entitled to receive an incentive fee, typically 10–20% of returns above a CLO equity IRR hurdle of 8–12%. Net of fees, a CLO equity would generally be expected to achieve an annualised return of 10–15%.

While leveraged loans are rated below investment grade, most CLO debt tranches are rated investment grade as they benefit from diversification, credit enhancements, and subordination of cash flows. CLO debt securities are floating rate investments that generally offer a higher yield relative to other equivalently rated debt securities. CLO equities are higher-risk investments that are entitled to the excess cash flows from the loan portfolio after interest and principal payments to the CLO debt tranches, management fees and other costs. Although CLO equities bear the first risk of default in the loan portfolio, they offer investors higher returns than CLO debt, and also potential upside from periods of loan price volatility, when CLO managers can often take advantage of a CLO’s fixed-term financing to purchase loans at a significant discount to their par value.

The main perceived risk of CLOs is that they are highly geared and therefore vulnerable to incurring considerable losses in a market downturn or in the event of defaults occurring in the portfolio. However, while CLOs have a substantial level of debt funding relative to the equity component (typically c 9:1 debt to equity), CLO debt securities are issued with maturities that are longer than the typical five-year maturity of loans held in the portfolio, and cannot be redeemed early by the holder. Additionally, CLOs are closed-ended, with a fixed life, and do not have to manage inflows and outflows from investors, unlike mutual funds that invest in leveraged loans.

Historically, leveraged loans and CLO returns have been more consistently positive than might be expected given the generally perceived risks over their highly geared nature. Looking at calendar year returns, the CSLLI (which tracks the investable universe of US dollar denominated leveraged loans) recorded a 5.5% annualised return from 1992 to 2018 (Exhibit 13). During this 27-year period, only 2008 and 2015 saw negative returns (28.8% and 0.4%, respectively), and both were followed by a year with a more than offsetting positive return (+44.9% in 2009 and +9.9% in 2016).

Marble Point’s analysis of US CLO equities issued between 2002 and 2011 shows that 50% generated internal rates of return (IRRs) of more than 15%, while 46% generated IRRs of up to 15%, and only 4% generated negative returns (Exhibit 14 left-hand chart).

Standard & Poor's data shows that historically CLOs have experienced significantly lower default rates than corporate bonds (Exhibit 14, right-hand table), with AAA-rated CLO tranches never experiencing a default or loss of principal, even during the global financial crisis.

Managed CLOs have a dynamic asset pool, with loans actively bought and sold by the manager to improve returns and reduce the risk of exposure to a default. Interest and principal cash flows generated by the loan portfolio are treated separately and distributed to CLO debt and equity holders in a predefined sequence, known as the payment waterfall, with the most senior tranches receiving payments first. Under normal circumstances, interest received on the loans is used to pay CLO debt interest and fees, while loan repayments are reinvested in loans or used to redeem CLO debt, depending on the period of the CLO’s lifecycle.

Senior secured loans are usually prepayable at par, with borrowers repaying part or all of a loan ahead of its maturity to reduce interest costs, and such loan prepayments are reinvested or used to redeem debt alongside scheduled loan principal repayments. While leveraged loans typically have a term of five to seven years, S&P Leveraged Loan index data shows a c 35% average annual rate of leveraged loan principal repayment (from prepayments and mandatory amortisations) from 2002 to 2017, while the lowest annualised rate over a two-year period (2008–09) was c 12%.

Due to the dynamic nature of the loan portfolio, the CLO manager has a significant degree of influence over the returns generated by a CLO’s assets, and consequently the level of excess returns distributed to CLO equity holders. Alignment of interest between CLO managers and CLO debt and equity holders is achieved through the payment of performance-linked incentive fees, as well as part of the management fee being subordinated to debt interest payments.

Each CLO has a defined lifecycle during which loans are purchased, managed and redeemed, and cash is returned to debt and equity investors. The lifecycle can be divided into five periods:

The periods within the CLO lifecycle are defined by key dates:

After the non-call period has ended, CLO equity holders can elect to reset the CLO structure, refinance selected CLO debt tranches, or call the CLO and redeem all CLO debt. Resets and refinancings involve one or more CLO debt tranches being repriced when loan spreads narrow significantly, which has the effect of reducing interest payments to CLO debt holders, and therefore a refinancing can serve to increase the excess cash flows that are payable to CLO equity holders. Reset and refinancing transactions involve the CLO issuer calling the original CLO debt tranches and issuing new CLO debt tranches with lower spreads, and the proceeds of the new debt issued are used to redeem the existing debt. In a reset transaction, the CLO debt is issued with a later maturity and the reinvestment period extended accordingly, while in a refinancing transaction the reinvestment period and CLO debt maturity are unchanged.

CLO equity investors can also call the CLO by electing for the CLO manager to liquidate all the loan assets in the portfolio, redeem all the CLO debt tranches, and return excess proceeds to the CLO equity holders. This generally occurs during a CLO’s amortisation period, when the projected rate of return on the CLO equity becomes less attractive than the prospective return on alternative investments. As the most senior, and lowest cost, CLO debt tranches are repaid first during the amortisation period, the CLO’s weighted average cost of debt increases over time, resulting in a decline in the return to CLO equity holders.

‘Call and roll’ transactions effectively make use of a significant portion of an existing CLO’s loan assets to recast and renew the CLO's liabilities into a new CLO with updated (often lower) pricing and a new extended maturity. During 2017, there were seven refinancing, reset and ‘call and roll’ transactions involving the Marble Point CLOs held directly or indirectly in MPLF's investment portfolio, representing the issuance of approximately US$3.1bn of CLO debt and equity. Each of these transactions resulted in a reduction of the CLO’s weighted average cost of debt or an extension of the CLO’s reinvestment period, which allowed the managers of the Marble Point CLOs to continue actively managing the loan portfolio underlying each of these CLOs.

CLO managers are required to ensure that each CLO operates within a defined framework, and a number of monitoring tests are regularly performed to ensure adherence to various performance metrics. Tests are carried out at each payment date throughout the life of the CLO, starting at the effective date, and the metrics most commonly tested are as follows:

The OC tests are the most onerous tests applied to the CLO and therefore receive the greatest attention. An OC test compares the par value of the loans in a CLO’s investment portfolio (adjusted for defaults and imminent defaults, where applicable) to the par value of the CLO debt securities it has issued. The consequence of an OC test failing to meet its threshold is that distributions to CLO equity holders are withheld and used to repay the most senior AAA-rated CLO debt down to a level where the OC test is back in compliance. There is no forced sale of loans or any mandatory injection of equity capital. The CLO manager can lower the risk of the OC test failing to meet its threshold during the reinvestment period by using loan redemption proceeds to purchase loans at below par value, known as par building.

The most junior OC test is the test that relates to the lowest-rated CLO debt tranche (generally BB or B rated), which ranks directly above the CLO equity in the CLO capital structure. This test therefore defines the level at which the CLO manager must maintain the total par value of the loan portfolio above the total par value of the CLO debt tranches, and this indicates the minimum level of assets that are attributable to the CLO equity. This test threshold is typically around 105%, which indicates that a minimum c 5% of the loan portfolio is attributable to the CLO equity holders, compared with its typical c 10% share of the CLO liabilities. Where a junior OC cushion is quoted for a particular CLO, this indicates the level of loan assets at par value in excess of the junior OC threshold, so a 5% cushion indicates that c 10% of the loan portfolio is attributable to the CLO equity holders, where the threshold is 105%.

Many CLOs also have an interest diversion test (IDT), which applies only to the most junior debt tranche and has a slightly more conservative threshold than the OC test, so is triggered earlier. When the IDT threshold is breached, up to half of the excess interest payments that would accrue to the CLO equity are diverted to reinvest in loans or repay the most senior CLO debt tranches.