CVC Credit Partners European Opps — Income and growth from credit portfolio

While most investors may be familiar with government and investment-grade corporate bonds, which are often the mainstay of pension portfolios, there are many more elements that make up global credit markets. However, many of these may be relatively new to European investors, where the lending market has been heavily dominated by banks.

Leveraged lending (Exhibit 2) broadly comprises lending to companies that are deemed sub-investment grade because they already have a high level of borrowings. As shown in the left-hand chart, the leveraged lending market in Europe has been heavily dominated by banks (chart shows the average from 2002 to 2016), whereas in the US, collateralised loan obligations (CLOs) – which are structured credit investments made up of loan pools put together by a CLO manager – and direct lending by institutions have been more prevalent. However, as shown in the right-hand chart, Europe is catching up with the US, with CLOs and other institutions each taking a greater share of the market than banks in 2016.

The principal drivers behind this are regulatory pressures on banks, and the continued low level of interest rates meaning that institutional investors are looking beyond traditional, investment-grade bond investments for sources of yield.

The global financial crisis in 2008/09 caused a large amount of bank lending to be written down in value as a result of ‘mark to market’ accounting, which requires assets to be revalued quarterly according to the price they would fetch on the open market. With the open market largely paralysed by the crisis, the ‘fair values’ of loans were marked down substantially, causing the value of the banks’ assets to fall, even where the loans were still being serviced and the borrowers were in no financial distress. In the wake of the financial crisis, factors such as the higher bank capital ratios demanded under the Basel III accord, and the European Central Bank’s Asset Quality Review, markedly decreased the appetite for banks to retain these assets on their balance sheets. This created an opportunity for secondary investors to enter the market.

While banks remain an important source of primary loan funding for companies, it is not commercially attractive for the banks to retain these loans on their balance sheets over the long term. Where borrowers become stressed or distressed, the speed of asset dispositions is likely to increase. Thus, there should continue to be opportunities for institutions to purchase sub-investment grade debt – both performing and non-performing – from lending banks, as well as originating loans themselves.

With interest rates having started to rise from historic lows in the US, other Western markets face the possibility of following suit over the medium term. In such an environment, and with inflation also rising, returns from fixed-rate bonds with ultra-low coupons will look less attractive. Loan investments are typically floating rate and thus have little duration risk (the risk that market interest rates will rise before the end of the investment period). They are also usually senior in the capital structure to bonds, meaning that interest and principal repayments to lenders rank above coupon and par value repayments to bondholders.

A company may offer lenders a variety of ways to invest. First-lien senior secured loans are at the front of the queue for repayment. Second-lien loans offer higher yields but would only be repaid in the event of a bankruptcy if there were sufficient assets remaining after repaying first-lien lenders. Senior secured bonds also rank highly in the capital structure. A PIK (payment in kind) loan is a higher-risk instrument because all of the return to the lender comes at the end of the term, rather than in the form of regular repayments or coupons.

Primary investments are based on the par value of the debt. However, secondary investments – which an investor buys from the original lender or another investor – may be made at below face value if the trading outlook or the creditworthiness of the borrower has declined. This gives the secondary market investor the potential for capital appreciation (principal repayment is usually based on the par value), as well as limiting downside compared with an investor who had bought at par.

The size of the loan market in Europe is well below that of the US and, with European loans excluded from UCITS (open-ended) funds because of a lack of liquidity (settlement of trades can take 15-30 days in Europe, whereas US trades are settled on an exchange in T+5), opportunities to access the market are limited. The corollary to this is that managers are able to take a longer-term view because the closed-ended structure of European funds means they do not have to cope with frequent inflows and outflows of capital. With spreads on investment-grade and high-yield corporate bonds currently at low levels, and risk-free rates (above which the spread is measured) also close to historic lows, a fund with the ability to invest more flexibly across credit markets may hold greater appeal for investors.

CVC Credit Partners European Opportunities (CCPEOL) was launched in 2013 as a listed vehicle investing in the CVC European Credit Opportunities fund (CEC). CCPEOL is domiciled in Jersey and listed on the London Stock Exchange. CEC was set up in 2009 as a Luxembourg company by CVC Cordatus, a European credit investment manager, and today has more than $100m of CVC partners’ personal capital invested in the vehicle, further aligning interest with investors. The management group was renamed CVC Credit Partners in 2012 after it acquired US CLO manager Apidos, a subsidiary of Resource America, and combined the two businesses. CVC Credit Partners is a subsidiary of CVC Capital Partners, a global investment manager with c US$70bn of assets under management, focused on private equity and debt. CVC Credit Partners manages c US$16bn of these assets, with c 50 investment professionals based in London and New York, and a network of 12 offices throughout Europe giving the group extensive deal-sourcing capability.

CCPEOL gives access to the CEC strategy (the investment vehicle) with daily price transparency and exchange trading. CEC is an actively managed portfolio of mainly European leveraged loans and high-yield bonds. The portfolio is managed in two pools, a performing credit segment and a credit opportunities segment, with a broadly equal split between the two in normal market conditions. Returns from the former come principally in the form of income, while the latter focuses on credits that are priced materially below their par value, offering potential for capital appreciation. CEC invests in a mix of floating- and fixed-rate assets, principally senior secured loans originated by banks, but also high-yield bonds, subordinated debt and structured corporate credit (CLOs). The investment vehicle targets total returns of c 8-12% pa, with c 5pp expected to come from income and the balance from capital appreciation.

The investment vehicle portfolio is managed by Jonathan Bowers, CVC Credit Partners’ head of European performing credit; Mark DeNatale, global head of special situations; and Andrew Davies, senior managing director and portfolio manager. Between them, the managers have more than 60 years’ credit investment experience.

While the investment vehicle’s portfolio is built from the bottom up, based on assessment of individual credits, there are certain limits in place:

While CCPEOL may be traded daily, the investment vehicle has only quarterly liquidity. In order to match this liquidity profile, CCPEOL offers contractual quarterly tenders under which up to 24.99% of shares outstanding (subject to an annual maximum of 50%) may be tendered at NAV. Gearing is not permitted at the CCPEOL level.

The volatility across credit in 2015 was largely driven by the energy sector, linked to a falling oil price. In European credit, however, markets were less affected than their US counterparts, because energy accounts for a much higher proportion of high-yield issuance in the US than in Europe. Loan markets were also more insulated from the problems than bond markets, with almost one-fifth of US high-yield bonds being issued by energy-related companies, compared with c 5% of US leveraged loans.

After an energy market-triggered sell-off in late 2015 and the subsequent recovery of energy, continued support by central bank policy and positive investor sentiment on growth expectations, the investment vehicle managers comment that both equity and credit markets have performed strongly, with equity indices reaching record highs and credit spreads seeing multi-year lows.

Portfolio manager, Andrew Davies, says that despite these tight markets, opportunities across the credit spectrum will continue to present themselves, driven by the regulatory changes affecting the European banking sector, macro events, central bank policy moves, structural shifts in specific industries and performance concerns surrounding individual issuers.

Within the performing strategy of the portfolio, the manager comments that due to the size and complexity of capital structures where the strategy focuses, there are continued opportunities to actively seek out relative value trades across the euro, dollar, floating and fixed rate tranches with different coupons and different maturities across the capital structure. Broadly speaking, he says, high-yield bond investors stick to high-yield bonds and senior loan investors stick to senior loans, but the flexibility to invest across both increases the opportunity set as well as the potential return profile. In addition, with a strong primary pipeline and positive technical backdrop for the loan asset class, the trading activity in the primary market will be an ongoing theme through 2017. Weightings to high yield will remain light in the performing segment; however, when volatility does present itself in the sub-investment grade market, this will provide the opportunity to move from the less volatile asset class of loans and into high yield.

Across the opportunistic strategy of the portfolio, the manager is monitoring over €160bn of corporate capital structures, where access direct through CVC’s broad and deep sourcing network as well as the secondary market builds a strong pipeline. The perception is that this segment carries a higher risk profile than performing credit; however, due to the discount at which these assets are purchased, the downside has already been evaluated and considered. The active approach to managing the positions and exit thesis are the drivers of the return profile.

The manager argues that the combination of an actively managed portfolio across large capital structures in performing and credit opportunities has been effective at delivering a low-volatility, high income-generating total return profile in the 8-12% range over the life of the fund so far.

CVC Credit Partners organises its business into three principal areas: credit opportunities and special situations (c $3bn AUM in European and global strategies), performing credit (c $12bn AUM in US, European and global strategies) and private debt (c $1bn AUM in US and European strategies, lending directly to small and medium-sized enterprises). The CEC investment vehicle invests across the first two areas, and is the only CVC strategy to combine exposure across credit opportunities, special situations and performing credit.

On the performing credit side, managers seek mainly senior secured, floating rate credits from liquid, large-cap issuers, offering stable and consistent income generation. These may be sourced in the primary or secondary markets. Return comes mainly through income. The managers look for credits trading from 97 (based on a par value of 100) to just above par, and may take advantage of opportunities to move between different credits within the same capital structure (for example euro or dollar issues, or loans or bonds) to lock in trading gains. In credit opportunities (which for the purposes of the investment vehicle includes special situations), credits may be senior secured or subordinated, fixed or floating rate, offering a mix of income generation and capital gains. This portfolio may include event-driven, opportunistic positions. Positions in the credit opportunities portfolio are usually bought at well below par value, with returns coming through merger and acquisition activity, refinancing, restructuring or a fundamental improvement allowing an exit.

The bias of the portfolio is to floating rate, senior secured debt. The outlook for floating rate assets (which make up a huge majority of the opportunity set in loans), where the interest rate on borrowings can rise and fall according to prevailing market rates, is more favourable given the beginning of normalisation in developed market monetary policy. In a rising interest rate environment the managers are cautious on the outlook for sub-investment grade fixed rate debt, and tend to limit the fixed rate exposure to a maximum of 30%. A minimum of 70% of the portfolio by value must originate from Western European issuers. The credit rating of the portfolio tends to be BB and below, with the majority in B-rated issues, although a significant portion (29% at 31 May 2017; see Exhibit 1) is in credits that do not have an official rating.

The CEC investment approach centres on fundamental, bottom-up analysis of more than 3,000 credits, with around 600 being held in CVC funds at any one time and the rest being monitored as former or potential future investments. There is a bias towards larger-cap, higher-quality companies (particularly on the performing side), which may offer more liquidity than other issuers. Detailed due diligence aims to ensure a vigilant and conservative management style.

There are four main stages to the investment process.

As a major investor in assets that rank highly in the capital structure, CVC Credit Partners may take an active role to drive restructuring or corporate activity to accelerate or strengthen the recoverability of credits. Some investments are held for many years (although the actual asset may vary over time as the managers seek to unlock relative value within the capital structure), while others may reach an exit event, such as a refinancing or takeover approach, more quickly than expected. Across the portfolio, turnover is c 100% a year.

While essentially a long-only strategy, a small number of short positions (4.5% in May 2017) may be held to offset industry-level risk to favoured issuers in areas such as energy or retail.

At 31 May 2017, the investment vehicle portfolio was diversified across issuers from more than 12 business areas (Exhibit 4) and more than seven countries (Exhibit 5). The largest individual issuer exposure was 3.8% of gross asset value (Exhibit 1). While the investment policy requires the portfolio to be at least 70% invested in Western Europe, a major change over the past 12 months has been the increase in US exposure, which now represents the largest single country at 23%. The managers comment that with spreads over US Libor and Euribor being at similar levels, superior returns are available from US assets of a similar credit quality, because the three-month US Libor rate is c 1.2% while the Euribor floor is zero.

At end-May 2017, the performing portfolio accounted for c 58% of assets (including cash balances), up from an average of 44% during FY16, driven by new issue flows and strong market momentum. The first quarter of 2017 saw the highest new issue volume since 2007, with a high level of demand causing yield spreads to fall.

Across the portfolio, more than 70% is invested in senior secured assets (Exhibit 6, left-hand chart), with more than 80% in floating rate. Only 5% was held in structured finance/CLOs. The currency breakdown (right-hand chart) has altered significantly over the past 12 months (comparable figures for 31 May 2016 were 64% euro, 18% US dollar, 17% sterling and 1% other), partly because of the increase in US-based issuers, but also because of opportunities to move within the capital structure of issuers who have both US dollar and euro-denominated debt. The fact that loans can be held by mutual funds in the US means that pricing can be more vulnerable to sentiment, so in a risk-off move a US dollar loan could move to a discount to its par value while a euro-denominated loan within the same capital structure could remain near par. Assuming that the company fundamentals are unchanged, switching from the euro to the US dollar part of the capital structure gives the managers a yield pick-up as well as capital growth potential. UK exposure is usually in the 20-25% range because of strong corporate governance, higher yields and an illiquidity premium due to the relatively small size of the sterling market; however, a strong recovery has reduced the number of opportunities available, and the managers are happy to remain at the current lower level while uncertainty over Brexit negotiations remains a risk.

At 31 May 2017, the weighted average price of issues across the investment vehicle was 95.0% of par, indicating capital upside of c 5pp. Within the credit opportunities portfolio, where more of the return is expected to come from capital appreciation, the weighted average price was 89.3% of par.

The investment vehicle focuses on large, liquid issuers, which helps to create a favourable risk profile. These issuers have bigger balance sheets, better access to international capital markets, strong management teams, diverse cash flows and supportive private equity sponsors.

CCPEOL aims to achieve gross (pre-fees) returns of c 8-12% per annum on a five-year view, with the performing credit portfolio mainly supplying income returns (target gross return of 4-7% pa), and added capital growth potential coming from the discounted assets in the credit opportunities portfolio (target gross return of 7-20% pa). As shown in Exhibit 7 (right-hand chart), NAV and share price total returns over the four years since launch have been c 7-8% pa for CCPG, well ahead of the total return from the S&P European Leveraged Loan index (S&P ELLI). For CCPE, the annualised share price total return since inception has been 7.0%. Over 12 months to 30 June 2017, sterling NAV and share price total returns of 14.1% and 20.9% respectively (CCPE share price return of 18.7%) have been above the target range and are strong in both absolute and relative terms, with the S&P ELLI returning 5.9% for the 12 months. While the share price has historically moved closely in line with the NAV, the outperformance over the past 12 months largely reflects discount management. Both the sterling CCPG share class and the S&P ELLI are fully hedged back to euros, so there has been no effect from the lower level of sterling since the UK’s vote to leave the European Union.

Exhibit 8 shows CCPG returns relative to three euro-hedged loan (S&P ELLI and Credit Suisse Leveraged Loan) and high-yield bond (Credit Suisse Western European High Yield) indices over a range of periods from inception. CCPEOL’s diversified portfolio of mainly floating-rate loan and bond assets, as well as its mix of underlying currencies, has differentiated its performance versus the indices, which focus on individual asset classes.

Longer-term performance versus the S&P ELLI (Exhibit 9) has been relatively steady until the very strong recent period. Over 46 months to end-April 2017, 10 months had produced a negative return, meaning net performance was positive in 78.3% of months. Only two of the 10 down months saw negative returns of more than 1% and the largest monthly loss was 1.6%. So far, positive returns have been achieved every year.

Exhibit 10 shows net return attribution for the investment vehicle in each of its six full years of operation, while Exhibit 11 looks at attribution in the context of allocation between the performing credit and credit opportunities portfolio over the last four full years (covering the period for which CCPEOL has existed as a listed entity). This shows that the credit opportunities portfolio has produced higher returns than the performing credit portfolio not just in buoyant markets such as 2016, but also in more difficult market conditions such as 2015, illustrating the cautious and active approach taken by the manager in volatile market environments. The past two years have seen a move to a more even split between the two portfolios, which allows the managers to take full advantage of the capital growth potential of the credit opportunities portfolio.

CCPEOL’s managers comment that in the overall tight credit market conditions of recent years, 4.5-5.0pp of the gross annual return has come from income, principally from the performing part of the portfolio, while capital gains from the opportunities portfolio have pushed the overall return to at least the lower end of the target range, and in some cases – such as in the 12 months to 31 May 2017 – significantly higher.

At 13 July 2017, CCPG and CCPE shares traded respectively at a 1.0% and a 3.7% premium to the latest reported NAV. Exhibit 12 below shows the CCPG discount over the last three years. The current premium compares with a long-term average discount of 0.1% since launch (CCPE: 0.1% average premium), and is a higher rating than the one-year average discount of 1.6% (CCPE: 1.1%). The shares traded at a premium for most of the period from launch until mid-2015, when more difficult high-yield credit market conditions led to a lack of investor appetite for many strategies investing in these areas. Volatility continued into 2016 amid an equity market sell-off (high-yield credit is more sensitive than investment grade credit to equity market performance), and the CCPG discount to NAV reached an all-time widest point of 7.1% immediately after the UK’s EU referendum. Since the beginning of 2017, the shares have moved back into the longer-term range of a 2% discount to a 2% premium. The contractual quarterly tender facility (see Capital structure and fees, below) should have a limiting effect on the discount.

CCPEOL is a closed-ended investment fund, domiciled in Jersey and listed in London. It has two classes of share: sterling (CCPG) and euro (CCPE), both with no par value. Each CCPE share carries one voting right, while each CCPG share has 1.17 voting rights, reflecting the approximate euro/sterling exchange rate at CCPEOL’s launch. At 13 July 2017, there were 271.81m CCPG shares and 129.76m CCPE shares in issue, with a further 1.04m CCPG shares and 97.39m CCPE shares held in treasury. A ‘C’ share issue in March 2014 raised an additional €111m; these shares were converted into ordinary shares in July 2014. There is a monthly opportunity for investors to convert between the two share classes. The fund invests in the portfolio of unlisted Luxembourg fund CEC (the investment vehicle), which is established as a ‘compartmentalised securitisation company’, via preferred equity certificates (PECs) issued by the investment vehicle in sterling and euro-denominated series. CCPEOL’s investment in CEC accounts for c 75% of the investment vehicle’s assets and there are rolling forward hedging contracts in place to hedge out all non-euro exposures back to the shareholder’s currency.

The fund has an unlimited life, although there is a requirement for the board to propose a continuation vote should the net assets (across both share classes) fall below €75m, or should either class of share trade at an average discount to NAV or more than 10% over any rolling 12-month period. The investment vehicle is scheduled to wind up in 2030.

There is a contractual quarterly tender facility allowing investors to exit their holding at NAV. No more than 24.99% of the shares in issue of each share class may be tendered each quarter, with a limit of 50% in any one year. The quarterly schedule matches the liquidity profile of the investment vehicle, from which investments must be liquidated in order to repurchase the tendered shares. A change to the terms of the quarterly tender, agreed at the 2017 AGM, means that investors must have held their shares for at least six months before they can be tendered. This move was aimed at reducing the opportunities for discount arbitrage – that is, buying shares that are trading at a discount with the aim of swiftly redeeming them at close to par, rather than holding them as a longer-term investment.

The contractual quarterly tender facility offers the certainty of an exit at NAV, which should limit the possibility of the shares trading at a wide discount. Equally, in order to meet excess demand, CCPEOL may reissue shares from treasury from time to time at a small premium. The fund has recently undertaken a successful capital raise through a placing of treasury shares at a 0.75% premium to NAV, which raised £77.55m and €13.87m respectively for the sterling and euro share classes. Following the placing, CCPEOL may choose to cancel any or all of the remaining treasury shares.

For the purposes of the Alternative Investment Fund Management Directive (AIFMD), CCPEOL is a self-managed fund, although investment management is undertaken by CVC Credit Partners (CVC). CVC is paid a 1% annual management fee, which is charged at the investment vehicle level but accounted for as part of CCPEOL’s ongoing charges (1.21% for FY16). A performance fee (also charged at the investment vehicle level), may be paid if total annual returns are more than 5%. The fee is equal to 15% of the return in excess of 5%, and is subject to a high watermark.

CCPEOL is ungeared and has no borrowing facility. The investment vehicle is permitted to gear up to 100%. It currently has a €150m loan facility, collateralised primarily on the performing part of the portfolio, which if fully deployed would equate to c 30% gearing. CCPEOL reports a monthly gross invested assets figure (stated as a multiple), which mirrors the level of gearing on the investment vehicle; at 31 May 2017 this stood at 1.3x (30%). The managers comment that one of the principal purposes of the gearing is to offset the effect of fees.

With the exception of the period from launch in June 2013 to 31 December 2013, CCPEOL has targeted and paid a dividend of 5p per CCPG share and €0.05 per CCPE share in each financial year. For FY14 and FY15, dividends were paid half-yearly in June/July and February. In the second half of FY16, CCPEOL announced it would pay dividends quarterly. Three dividends were paid for FY16 and from FY17, quarterly dividends will be paid in May, August, November and February. On 19 May 2017, CCPEOL announced it would change the dividend target from 5p/€0.05 to 5.5p/€0.055. It is expected that the first dividend to be declared under the new target will be the August 2017 payment (in respect of the quarter to 30 June). A first quarterly dividend of 0.125p/€0.0125 was paid in May 2017 for the quarter ended 31 March. Given the timing of the announcement of the new target dividend, it would be reasonable to assume that dividends for the balance of FY17 will be paid at a rate of 0.1375p/€0.01375, giving a total dividend for the year of 5.375p/€0.05375. Based on this calculation and the current share price, CCPG shares have a prospective yield of 4.79% and CCPE shares have a prospective yield of 4.76%.

The AIC Sector Specialist: Debt sector has 37 constituents (30 distinct funds, some of which, like CCPEOL, have more than one share class). The sector contains funds with a wide variety of investment strategies, including those focusing on collateralised loan obligations (CLOs) and property debt. Exhibit 13 below brings together a group of peers focusing on leveraged loans or specifically on opportunities arising from bank deleveraging as a result of more stringent capital requirements. Specialist debt is a relatively new area of focus for investment trusts/companies, and none of the peers shown below has a 10-year track record, with only two in existence for more than five years. Within the selected peer group, CCPEOL’s sterling shares have the second-highest NAV total return over one year and rank top over three years. Because of the effect of currency hedging, returns from the euro shares are very similar. Returns were below the average for the whole sector over one year and above the average over three years. Ongoing charges are in line with the average for similar funds and below the weighted average for the whole sector. While CCPEOL itself does not charge a performance fee, one may be paid to the underlying investment vehicle (CEC). CCPEOL currently trades at a small premium to NAV, compared to a small average discount for both the close peer group and the sector as a whole. The dividend yield is largely in line with the average for the close peer group, but somewhat lower than the whole sector weighted average.

CCPEOL has three non-executive directors, all of whom have served on the board since launch in 2013. Chairman Richard Boléat (Jersey resident) qualified as a chartered accountant and has spent his career in financial services, including a period as a high-yield credit analyst. Mark Tucker (Jersey resident) worked as a hedge fund and derivatives broker/dealer and is a chartered fellow of the Chartered Institute for Securities and Investment. David Wood was a founding partner of CVC Cordatus (a predecessor to CVC Credit Partners) and is former co-head of European leveraged finance at Deutsche Bank. The regulatory requirements for listed funds incorporated in Jersey state that two of the directors must be resident in Jersey, and a majority of the board must be independent (not having been employed by the manager, investment manager or its associates in the past five years). While David Wood was previously deemed non-independent, it is now more than five years since his retirement from CVC Cordatus in April 2012, so CCPEOL’s board is now fully independent of the management group.