Prudential Fixed Income manages more than $4 billion in CDOs, predominantly in loans and high-yield bonds. In the past few months the manager has raised over $1 billion through two structured vehicles. In May, Citigroup issued a $585 million pro rata CLO called Dryden VI-Leveraged Loan CDO 2004, and in late July, the manager closed Dryden VII a $425 million CDO led by Bear Stearns.
Prudential this year has also taken over from other managers five CDO transactions totaling $1.8 billion. These include four CDOs previously managed by Bank of Montreal, which exited the CDO business this year. The fifth was a Cigna Investment Management transaction, called Times Square SERVES CLO that was transferred when Prudential acquired Cigna's benefit retirement business and Cigna's bank loan team moved to Hartford Investment Management (LMW, 5/5). Timothy Aker explains to LMW Prudential's replacement manager business and the need for communication with investors.
LMW: How has Prudential's CDO business grown?
We have added a number of mandates and different types of mandates over the last several years. They have come in the form of Prudential-issued CLOs/CBOs as well as this replacement manager business, where we step in not to originate our own deals but to replace a manager who originated a deal given certain reasons, such as underperformance or getting out of the business.
Our replacement manager business began at the inception of our CDO business. We were approached by a number of constituents including both investors, the underwriters who bring deal as well as managers, who may have chosen to exit the business looking for a capable replacement manager.
LMW: What are the circumstances that may lead to a replacement of the manager?
It's been a combination of one-off ad hoc situations, not ones that we have necessarily searched out as you might market a new transaction but nonetheless have come at a predictable pace over time and seemed to continue given the changing dynamics of the marketplace. There are both situational circumstances that come up that lead a firm to underperform in a particular deal or a firm to exit the business.
At the same time some of those trends are inherent to what our industry is going through. We went through a very difficult credit cycle in the very late 90s and early 2000 that impacted the performance of some of these deals. We have a variety of accounting regulations that have come into play in terms of how firms accounts for these deals. And we have seen a variety of firms go through mergers, or whether its changes in corporate philosophy or focus of business, that goes on at all times, that might bring them to a situation where they would no longer want to participate in a particular area of asset management. All of those are trends that our whole industry faces and have given rise at different times for us to take replacement manager opportunities.
LMW: Where is the demand for new CDOs coming from and who are these investors?
The investors for these deals are generally global institutional investors, with a particular focus on financial institutions, insurance companies and money managers, who are putting investments to work to generate returns. The demand has grown more recently based on the overall desire for more alternative investments, more return and more diversity of return. As we went the through stock market difficulties and as returns in the stock market have been less certain, that has drawn these investors to this alternative asset class. So, we have investors who've had experience over the last several years, augmented by new investors being drawn to the asset class for the reasons above.
LMW: Why has financing for these deals become cheaper and has the cost of the liabilities matched the tightening on the underlying collateral?
The tightening on the liability side is a function not only of specific demand for these type of CDO and CLOs investments, but as much the overall rally or spread tightening that we've seen across the board in asset-backed and structured product securities. The matching is difficult to answer, because it's not a direct exact match on a basis point for basis point basis. But it has allowed managers to maintain the funding gap--the ability to take return out of the difference between the assets and liabilities. It's very helpful that as the spreads on the assets become tighter, so does liability pricing, and that helps equity investors maintain a competitive return.
LMW: Why do you invest in pro rata?
We have CDOs that allow us to invest in the term as well as the revolving credit marketplace. We see that as a very attractive to have because of the unique nature of the revolving credit marketplace. Typically, as a less liquid area to invest in the bank loan market, it can provide some additional opportunistic investing and total return investing without any inherently additional credit risk.
LMW: What separates Prudential's approach in the market to other managers?
Fundamentally, its discipline and opportunistic issuance of transactions--the discipline piece being to do with a lot of thought to structure. This includes the opportunity on the asset side of any transaction equation as well as the liability side and with a very clear understanding of what type of portfolio we would assemble and how we would manage that. Opportunistic--to be prepared to do that at points in time that either the liability or the asset marketplaces dislocate and provide value.
Dedicated resources is also a factor. Having resources as a part of a product management CDO team as well as dedicated portfolio management resources. [This includes] open and transparent communication so that investors never feel that they cannot access either us or information from us that allows them to follow how their portfolios are performing and why they are performing that way.
[This is] all a matter of degree and other firms may talk about or provide certain elements of that service. In particular, one thing we've found quite attractive to investors in our replacement business has been our focus on this, because we have often found in a replacement situation there has been a loss of focus on a particular portfolio--because if someone is getting out of the business, or they have not been performing very well, generally no one likes to spends a lot of time on poorly performing situations.
There is a lack of information available to investors when they need it most. We believe one of the most attractive things we bring specifically in that replacement business is very open and transparent evaluation of portfolios as we step in to be the replacement manager. An ability to give every investor the opportunity to know where they stand and let them make their own decisions. Just one example of how we distinguish ourselves in situations where the manager that is leaving the situation clearly did not.