How is Deerfield's loan group set up and what kind of vehicles do you use to manage your assets?
Deerfield is divided between three main groups--our hedge fund business, which was the legacy business of Deerfield from 1993; our CDO business, which began in 2000; and separate account management. In total we have over $8 billion in management. The bulk of assets under management are in the CDO business--some $7 billion plus in our CDO area. In the CDO business we currently have three asset classes--bank loans, asset backed securities and investment-grade bonds. Within the bank loan arena we have six different CDOs under management with over $2.2 billion under management.
Are you looking to ramp up new vehicles right now?
We're expecting to do a deal which represents a rollover of an existing portfolio. So it doesn't represent us having to source new assets in the difficult market. It's taking an existing portfolio that has come to its scheduled maturity and running that portfolio into a new portfolio and eliminating ramp-up risk.
Our strategy has been to grow this business in a slow, steady fashion. We don't want to sacrifice track record for assets under management. So at least over the last three years, we have had one small deal a year--around $300 million--and have chosen not to significantly upsize, even though we had the opportunity. We didn't want to get into a situation where we have to stretch for collateral to put in the portfolios. That is the fundamental way we look at the business. We want to be in the business for the long term and to focus on having a superior track record that allows us to continue the annuity of the bank loan business we've enjoyed to date. If we focused on assets under management we would probably be bigger than we are today, but arguably our track record might have suffered.
Do you purely invest in leveraged "B" loans or do you buy revolvers as well?
Leveraged loans represent the lion's share of what we do. We've never bought a high-yield bond in any of our portfolios. That's not part of our core strategy. We invest in term loan "B"s, occasionally term loan "A"s, and on occasion revolvers. When we buy revolvers we look for revolvers that have usage. We have historically done it because some of our synthetic CLO transactions are more suitable for revolvers than a typical CLO.
Does Deerfield use synthetics or derivatives?
We like to keep our options open and keep the capacity, but we have not been active players in those markets. Synthetics in the loan area has been an area that needed to mature. We want the flexibility to do them as the market evolves in both those areas, but we have never used them extensively.
How do you deal with the public/private issue if you are responsible for other asset classes?
We think having access to non-pubic information can be a very useful thing and we are unwilling to forgo that option. We don't have a high-yield bond franchise in house so we don't have the natural conflicts that other managers may have. So the overlap between our loan area and other business areas is very small. That being said, we have the bank loan area in a separate room with a firewall in place--all of the appropriate procedures to make sure there is isolation of that non-public information is fully enforced.
I am the cio of the company and all of the various areas report to me, but there are seldom situations where a name that we own in the private bank loan area also becomes a name we own in the public area. When there is an opportunity we have systems and procedures in place to capture that and prevent any shift of information.
What sectors do you favor right now?
History has told me that I never want to say never about any particular industry or sector. I think we do look for credits with an appropriate level of cash flow and an appropriate level of leverage. We have tended to historically avoid industries where margins are low and leverage then becomes that much more of an issue and maybe industries that don't tolerate leverage very well--retailing is one example. But, just as a rule we never say without question any industry is off limits because that would restrict the number of opportunities we look at and certain industries structured correctly may offer compelling value.
Is there still an argument to be made for having assignment fees in this market?
We really don't have a lot of control over that. We do understand that their presence inhibits the development of the market-makers in the secondary which is not necessarily a positive. But I think the overall trend is going towards the rest of the financial markets--as bank loans evolve and become more mature, assignment fees will eventually work their way out. But I don't think that's necessarily imminent.
Are all of these new entrants into the loan market healthy?
I think some of that is reflective of a maturing market and it is clear some of the money is transitory. Credit Suisse First Boston data on hedge funds shows that in 2002 they represented 1.05% of the market and in 2003 they were 9.79%. That kind of swing exacerbates the historical predisposition for it to have demand exceed supply in the bank loan market. But that's the battle we fight and in exchange it helps us get a broader market with greater liquidity and potential buyers for distressed assets down the line. As these new players get comfortable with the loan asset class they will become more permanent members of the market and that helps liquidity. You can look at it as a glass half empty or half full. It is what it is, so I try to look at it presenting us with a broader, deeper, more liquid market.
What does the sell side need to do better?
We continue to struggle with their balancing their relationship with their borrowers and their relationship with their lenders. That is an ongoing challenge. There are times where we feel their relationship with the borrower gets a heavier weighting than their relationship with us.
Also in a market like we have now where there is so much excess demand we still rely on fundamental research. We have had instances where if the deal was going really well the sell side just didn't feel compelled to follow up on some of our detailed research questions. That makes it a harder job for us to do because we are very research focused at Deerfield.
What are the major challenges you face in the current environment?
Managing a portfolio prudently in a very hot market. We manage CLOs--so maintaining an average spread level to the ratings agencies satisfaction is an ongoing challenge and we are constantly retightening our investment discipline to make sure we are not stretching for yield. We are using this opportunity where some assets are overpriced to lighten up our portfolios and that creates higher cash balances than we otherwise would like, but certainly cash is a superior decision to having a bad loan in the portfolio a year or two down the line. We think this is where managers really get paid for their expertise--because while on the surface it appears to be an easy market to manage credit risk in, in fact there are a lot of credit mistakes that can be made in this market that will come back to haunt managers and investors in a year or two's time.
What is your outlook for the underlying collateral spreads versus liability spreads on CDOs?
Clearly both have come in. I don't see any let up. Perhaps the momentum has slowed on the spreads on collateral but no backup is imminent. So our collective focus is to be careful on credit--to make sure the spreads out there in the market reflect the underlying credit value. Spreads while tight, are also communicating that the market believes that default rates in the future will be less than has historically been the case. So just looking at spread levels on loans being tight in the absence of a view that default rates are expected to be lower in an improving economy would give you a one-sided picture on the value of bank loans. If you look at a CLO model and you reflect lower default rates along with lower collateral values you come with a more balanced picture of the value in the bank loan area.