AIMA

The Alternative Investment Management Association

Alternative Investment Management Association Representing the global hedge fund industry

The operational challenges to investing in leveraged loans

By Phil Masterson, Senior Vice President & Managing Director

SEI

Q3 2012

Q3 edition

 


 

Today’s climate of European banks deleveraging and scaling back their loan financing commitments is causing a significant dislocation in the capital markets.

Amidst a rising sea of debt maturities, companies are faced with the reality that their key source of funding is evaporating like a Saharan rain puddle. A recent Reuters article noted that the volume of European sponsored loans set to mature between now and 2014 stands at €264 billion yet the European Banking Authority has determined that banks need to raise €115 billion in new capital1.

Not that banks are bolting out of the stable to sell collateralised loan obligations (CLOs); their bottom lines couldn’t handle the losses. Rather, it is creating fertile ground for non-banking institutions – hedge funds, private equity firms, insurance companies – to step into the breach, particularly hedge funds that specialise in distressed debt. Today, the biggest global asset managers hold approximately $500 billion in CLOs.2 

Whilst CLO issuance in the US for 2011 was a respectable $12 billion3, it pales when compared to 2006, when, at the height of the buy-out boom, $96 billion in CLOs were issued4. “Listed loan funds could be the new version of CLOs for European investors,” Joseph Lynch, a Chicago-based managing director at Neuberger Berman Fixed Income LLC, told Bloomberg5. In fact last year, Alcentra and Neuberger Berman successfully launched leveraged loan funds.

CLOs continued to be the single largest source of institutional loan demand in 2011, enjoying a 40% market share according to the London-based Loan Market Association’s sister organisation, the Loan Syndication & Trading Association in its annual 2012 Loan Market Chronicle. In the same report, 34% of respondents thought that banks would be the main source of leveraged loan financing in 2012.

That may be so, but banking regulation is undeniably changing the goalposts. Hedge funds are launching funds to capitalise on cheap valuations in the CLO secondary markets and the need for European banks to divest their debt holdings – indeed Avenue Capital Group has already raised $2.1 billion for its latest distressed debt private equity fund.6 

Given the attractive yields on offer and the perniciously low interest rate environment, institutions appreciate the benefits of bank loan funds and are willing to commit capital for a number of years.  Last year, issuance in leveraged loans was $375 billion7 and over $400 billion was traded across 2,300 separate loans8. US loan mutual funds attracted inflows of $16 billion, while high yield bond funds netted another $12.6 billion9. Additionally, investment-grade lending in the US jumped to $845 billion10; double that seen in 2010 and setting an issuance record. Refinancing activity and a jump in merger-related bridge loans were the main catalysts.

Operational hurdles

As alternative investment managers become more active in this space, many don’t realise or are just waking up to the reality of just how complex it is to manage leveraged loan assets.  Valuations, accounting, data management and risk and investor reporting are some of the key challenges managers face, while communication with counterparties can be time-consuming and frustrating. Managers who build portfolios of leveraged loans often face difficulty calculating NAVs because the deals they enter into aren’t realised by agent banks until after the deals have settled. A lack of system automation can result in position inaccuracy for NAVs, forcing the back-office team to retroactively adjust the figures. 

Today, investors increasingly expect managers to demonstrate institution-grade infrastructures. While a fixed income manager who has decided to move into the leveraged loan space might be able to manage other parts of the portfolio through spreadsheets, it’s nigh on impossible to create consistent and appropriate bank loan spreadsheets and report templates. The basic fact is, bank loans are complex and hard to value. The operational burden is often further accentuated by the fact that getting relevant loan confirmation details from agent banks and custodians can itself take significant time and effort.

Perhaps unsurprisingly, managers are looking for outsourced solutions that can provide the operational expertise needed, whilst also giving managers more time to focus on the investment process and avoiding the middle- and back-office headaches. This is particularly important when considering data management and investor and risk reporting. Most managers’ internal systems aren’t set up to track and verify loan positions, making the generation of high-quality investor reports a real uphill challenge.

Primary and secondary sources of bank loan information are needed to produce meaningful reports. Many of these sources, however, are disparate and require managers to incur the cost of using third-party data providers. Managers are reluctant to spend capital ramping up their operations teams when they know that outsourcing to specialist firms may well likely solve the problem in a cost-efficient fashion.   

Outsourcing as ‘firm arbitrage’

Another reason managers are selecting to outsource is because it presents a form of ‘firm arbitrage’. In this niche investment area, finding the best talent is critical, particularly if it’s a manager’s first foray into the bank loan arena. However, it may not be worth it to hire specialised operational talent when outsourcers may have this dedicated expertise. Furthermore, particularly in the current environment where incentive fees are harder to come by, additional staff can put pressure on the firm’s profits, whereas outsourcing allows managers to charge many of the operational services to the fund rather than incur them through the management company.

With extensive, automated systems at the core of their business, outsource providers in the bank loan space are providing managers with faster, accurate NAV production; for example, it may be able to reduce the time of NAV production by up to 25% for some clients. Moreover, as positions are reconciled daily, it’s a straightforward process to drill down and scrutinise individual positions and flag potential errors or queries in the NAV.  This offers a level of reliance that both managers and investors greatly appreciate, and indeed, are coming to expect.

Another way managers can benefit is when administrators have the capabilities to link their accounting engine to the firm’s portfolio management system. This is a key advantage given that multiple data sources create a heavy operational burden on managers who lack the necessary systems. This is particularly pertinent at a time when overall data governance, normalisation and aggregation are becoming increasingly important for managers and investors alike.

Economies of scale

One ‘economy of scale’ advantage of which managers should be aware ties back to the earlier communication challenges of obtaining details on loan positions. If an administrator is already servicing some of the syndicated loans that a manager buys a portion of for perhaps two or three other managers, all managers end up benefiting from that leverage and can gain efficiencies.

It’s also more efficient for the manager to let its administrator deal with the various counterparties for recordkeeping purposes than attempt to take it on itself. Oftentimes administrators have close relationships with agent banks, and together with their specialised bank debt staff, they may be able to receive a response rate of close to 100 percent—something that few managers may be able to achieve by themselves.

Look before you leap

While this complex asset is gaining popularity and presents a compelling opportunity, it’s not without its challenges. Beyond having a clear idea of how an investment management firm can add this to its investment expertise and package it for investor interest, it’s critical that managers consider whether their internal operational environment can withstand the challenging nature of bank loans or whether working with a specialist provider is a more prudent approach.  With a scalable, automated operating environment in place, managers will have one less thing to worry about and can instead focus on capitalising on the market momentum and gaining a competitive advantage.

[1] Reuters, 13 February, 2012. “European distressed debt opportunities loom large.”
[2] www.creditflux.com
[3] LSTA 2012 Loan Market Chronicle
[4] Financial Times, 22 February 2012. “Sales of CLOs at strongest pace since crisis.”
[5] Bloomberg, 5 October 2011. “European CLO Fund Managers Seek Life in Listed Loan Funds: Credit Markets”
[6] FINalternatives, 12 January 2012. “Avenue Scores $2.1 Billion For Distressed Debt Fund.”
[7] LSTA 2012 Loan Market Chronicle
[8] Pensions & Investments, 13 January 2012. “Fixed income investing in a low interest rate environment.”
[9] LSTA 2012 Loan Market Chronicle
[10] LSTA 2012 Loan Market Chronicle

pmasterson@seic.com

www.seic.com/ims

This information is for educational purposes only and not intended to provide legal or investment advice. SEI does not claim responsibility for the accuracy or reliability of the data provided.

 

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