Crisis Talk — with Jeremy Ghose, global head of Investcorp Credit Management
Investcorp's Credit Management business is one of the largest CLO issuers in Europe, with 24 deals under its belt, and a firm focus on the large cap, broadly syndicated market. GlobalCapital spoke to its boss, veteran leveraged finance investor and banker Jeremy Ghose, about how the coronavirus crisis has changed the LBO market, what CLOs will look like in the future, and the grim outlook for direct lending.
When did you realise the magnitude of the crisis?
I remember coming back from one of the business trips, and that’s when it started hitting home because we were in the middle of a fund roadshow. I had a trip planned to Singapore that was cancelled, and we did the rest of the fundraise through WebEx and Zoom calls.
We managed to get that fundraising [referring to the Mount Row Credit Fund] with the rest of it from my home here.
Were you able to start positioning your funds ahead of the full Covid-19 crash? Did you have enough time to exit the most challenged names or move into cash?
We’re focused on the large cap end of the credit spectrum. We’re invested in almost 600 global companies based mainly in the US and western Europe, with average Ebitda ranging anywhere between €300m and €500m. So we’re not in small or mid-cap, and our investment style has always been pretty much down the middle of the fairway.
Based on Moody’s industry mapping, our concentrations in the most affected industries are less than 10%, simply because we’ve always run a very conservative strategy. We’ve always been light on consumer retail, we had very little exposure to the airline industry and the restaurant industry. We had a bit more exposure in other industries once removed — cinema chains, or even big dentistry chains have been heavily affected — but even pre-Covid we were in the more defensive sectors.
How was the operational transition?
I've been logging on from here, just outside London, for the last two and a half months. I must say I’ve been very impressed with the back-up and the technology that has really worked well for us.
We’ve substantially increased the contact we have with our existing investors, and we have close to 400 in our global funds. So we took the proactive decision to increase those updates, and make sure we’re telling them on a daily or weekly basis what’s happening with the portfolios. We’ve also been doing webinars on specific topics, looking at certain themes and credit topics.
We are currently contemplating reopening our London and New York offices in September, although I think spending anywhere between 25% and 40% of the time working from home could become a new normal. We’re lucky enough to be able to keep doing what we’re doing even when we’re doing it from the home office.
We’re seeing primary markets open for leveraged loans and high yield, but an increasing number of restructurings on the cards. Is bifurcation the way forwards for leveraged credit?
In my view, we could be seeing the start of what I’m calling Version 3 CLOs. Version 1.0 were the original CLOs, then after the 2008-09 crisis we saw so-called Version 2.0 CLOs. Coming out of this crisis we are going to see the start of Version 3.
Furthermore, a lot of the credit dynamics and metrics will be in our favour, going forward. We’re just beginning to have conversations with the private equity community in terms of what the market looks like and investing in new transactions. We’re talking about margins of Libor plus 5%-6% and on top of that, one to three points of upfront fees, and I’m expecting documentation to be tightened in our favour.
Last but not least, I also expect to see more equity going into transactions. Pre-Covid, equity contributions in LBO capital structures averaged around the 40% level. In the new normal, I’d expect to see close to 50% coming from private equity contributions and the rest from senior secured debt.
We saw these trends coming out of 2008-09 when the market recovered in 2010-11, and I see a similar pattern here. That’s why I feel that it’s a great time to be investing in credit, and why we were able to launch a fund in short order.
Given the success of that raise, we are considering launching other strategies, again, because all of these metrics are moving in our favour. The returns from credit funds are going to be very attractive for the reasons I mentioned.
As you can imagine, anyone investing in a new business today, whether a private equity fund as buyer or us as a lender must be investing in a so-called Covid-19-resilient company. The business model must be a model that survives the virus. So we are expecting defensive sectors like pharmaceuticals, healthcare, food retailing, IT services, utilities, telecoms and so on.
Could you explain the Version 3.0 CLO model a little more?
I’m inventing it — you heard it here first. For a while, I think volatility is likely to remain in the markets, and so we are having conversations with the rating agencies and other investors about possible changes. These include whether there should be a higher triple-C bucket. A normal triple-C bucket in version 2.0 deals is 7.5%, but I won’t be surprised if we see it at around 10%. WARF [weighted average rating factor] scores are also likely to go higher, to around the 3,000 level or even beyond. And documentation is tightening up again. It’s just improving the structures, learning from the past. That’s what we saw after 2008-09 as well.
The good thing we’re seeing is there continues to be quite a lot of demand from investors. Post-Covid issuance in Europe is around €1.2bn from five deals, with post-Covid triple-A issued at 180bp-200bp. I think that tightens even more in some of the new transactions.
The issue size of the new deals are going to be more in the €250m-€300m range — more along the lines of ‘print and sprint’. Because of the volatility in the market, you’re not going to see the €450m-plus sized deals. As the market reopens into the new normal, people will do smaller deals, get them done, get them placed, move onto the next.
Do you expect any European Central Bank (ECB) support for sub-investment grade credit, perhaps following suit from the US Federal Reserve?
I don’t think the ECB goes as far as the Fed has gone. That’s not been their style, that’s not been in their DNA, and I don’t expect that to change. However, I think the fiscal and monetary support has been tremendous. It’s close to $10tr of monetary and fiscal support and stimulus packages, it’s a huge positive for our market, and it’s rightfully needed because we are coming out of a complete standstill.
It’s good to see it feeding through into the companies we have invested in as well — government and central bank stimulus has been a critical component to protect the economy.
On April 9 the Fed announced support for certain types of triple-A CLO issuance, specifically static deals. The conditions outlined by the Fed for the sale of triple-As do not currently work for most of them, but the Fed’s willingness to consider the asset class has put a price floor in place.
In Europe, we’re not expecting the ECB to follow the Fed’s recent TALF [Term Asset-Backed Loan Facility] programme, but we believe the Fed’s actions could also be beneficial for the European CLO liability market. And frankly, as I mentioned earlier, we’re already beginning to see that.
Even though TALF only covers new issue static CLOs in the US, it will nevertheless affect the overall market and it’s conducive for us to get the CLO arbitrage right. As new loans come in with higher pricing, and as CLO liabilities tighten, the arbitrage will work better, and that’s why one could expect the Version 3 CLO to come to the market in the next six to 12 months.
Is there still an adequate supply of equity capital for CLOs? The equity in outstanding deals sold off a lot and could see losses.
We expect investors will be very interested in putting equity money to work into Version 3.0 CLOs. The warehouses affected in this crisis are the pre-Covid portfolios, because the pricing of the loans in their portfolios averaged around 3%-3.5%. With CLO liabilities where they are today, clearly the arbitrage is not so attractive out of the gates.
Managers also have industries that have been quite severely impacted in some of those pre-Covid warehouses, which investors really don’t want exposure to.
If you’re constructing a portfolio as the market reopens, though, investors will absolutely come in and invest equity in the new normal, because the arbitrage is going to work very favourably. From our experience coming out of 2008-09, the CLO equity vintage 2010-12, had some of the best returns of any vintage we’ve seen. In the new world you are likely to get loans priced at around Libor plus 5%, with upfront fees of 1%-3%, and that translates into low to mid-teens equity returns.
What do you expect to see from the private debt market? Before the crisis some people talked about it as a bubble, where too much money had been raised and it was a struggle to deploy cash.
I always thought that far too much money had been raised in the direct lending space. And as a result, even pre-Covid, we could see companies getting into trouble, or portfolios getting into trouble.
Post-Covid, I think you’re going to see a bit of a bloodbath in that sector. Because far too much money was raised, the risk-return, in my view, was not attractive at all, because too much money was chasing too few deals.
If you overlay that with the losses we’ll see in the portfolios, you are absolutely facing write-offs on some of these investments over the next 12-24 months, specifically in the direct lending SME space.
I would expect there will be a consolidation of managers ahead. In Europe alone, there must have been over 100 managers that are doing direct lending, and I wouldn’t be surprised to see that number halve, because a lot of managers will not be able to raise another dollar after the portfolio troubles play through over the next years.
They can’t reorientate the funds towards credit opportunities strategies?
I think that's going to be tough when you've got current investors who are sitting on big losses. Of course there is opportunistic money sitting on the sidelines, and a lot of people, including us, have continued to raise funds for these purposes.
But if you’re an investor in one of the direct lending funds and you have been promised 7%,8%, or 9%-type returns, those are not going to materialise, and you’re going to face actual losses.
The other point to bear in mind is that restructurings take a long time, especially in continental Europe. More often than not, you have to follow your money with more in order to protect your earlier investment, and that makes it a longer haul in terms of getting returns.
All of that is going to play out over the next 12-36 months, and you’re going to see a big differentiation in managers coming out of that.
These private debt loans are also illiquid assets — you can’t just get out of the position. In the large cap liquid world where we focus, you can trade out at a price, be that 95 or 70 or whatever it is. There is a bid in the market every day.
But if you’re in the mid-market, these are highly illiquid, and you’ve got to be prepared to follow the money, do the restructurings, and wait for the company to turn around.
In my view, a lot of the direct lending fund managers don’t have the operational capability to work through the complexities of restructurings. So I expect a lot of managers will see default and loss ratios that are very high, will not be able to raise new funds, and you will see huge consolidation.
How far do you think sponsors will row back on the weakened documentation we have seen in the last few years in the post-crisis world?
All these things happen in waves and cycles. Some of us who have been around for 35 years or so have seen enough of these cycles come through in the past decades. This time around, it won’t be any different.
The private equity community is sitting on close to $1.5tr of dry powder, funds they have raised but not invested. So this is a great opportunity for private equity to come back and acquire companies, whether that’s taking companies private, or buying the subsidiaries of conglomerates, as conglomerates themselves are under pressure to generate liquidity and shore up their main business.
There will be lots of opportunities out there for private equity to invest this money they’ve raised.
When they do, senior debt providers like ourselves will be there with cash alongside them. But, as I said, I believe most if not all of the metrics will move in our favour. I mentioned before the margin, the upfront fees, and the equity percentage.
But that also includes documentation tightening in our favour. I wouldn’t be surprised if we see the re-emergence of maintenance covenants. Almost 80% of the market is now covenant-lite, but we could easily see a range of covenants reintroduced back into documentation and capital structures.