Napier Park finds value in concentrated portfolio of pre-crisis CLOs

In-depth analysis drives performance and picks up underlying quality dispersion

A strategy that likes collateralised loan obligations (CLOs) may give investors pause. One that positively delights in pre-crisis CLOs is even more rare. However, Napier Park Global Capital’s head of European credit strategies, Michael Micko, says: “The CLO model actually survived through the crisis quite well. The evidence of that is new CLOs are being issued in the US and Europe.”

He says: “The market has come back and it's open again. The reason why we prefer CLOs that were done pre-crisis is because they've been around for so much longer and have just picked up a wider degree of dispersion of quality, because of time, because of managers, because of certain credits that may have gone wrong within the portfolio. When we do a look-through into the underlying portfolio, we can analyse the quality of that portfolio because we do a bottom-up review name by name. We don't look at these statistically. We can analyse the granularity and quality of the dispersion better than the market.”

In-depth knowledge and attention to detail is just one of the characteristics that sets Napier Park’s strategy apart from the rest. “The wider market when they look at CLOs typically treat it as an asset-backed security (ABS) type asset. They will typically use statistical top-down methodology where it probably doesn't pick up the dispersion of underlying quality as well as we can. The ability for us to extract value from CLOs is better in the pre-crisis ones,” concludes Micko.

These pre-crisis CLOs should still be around for the next six or seven years. While the new issue CLO is “an interesting market for us” Napier Park has not yet done anything in this area. “There are good managers in that space; there are good structures in that space. We just want to find the right ones to invest in,” he says.

Micko’s team is certainly putting its money where its convictions lie. Gross exposures by asset class at the end of March showed CLO mezzanine and equity making up three-quarters of the overall portfolio. Mezzanine, at 42.5% was made up of 29 positions in 22 deals, with 70% rated BB and 30% BBB. Equity CLO positions totalled 18%.

The rest of the exposures were made up of high-yield bonds at nearly 12%, senior secured and secondary lien at 10.2% and a smattering of investment-grade credit default swaps and bonds at less than 3%, with mezzanine payment-in-kind barely registering.

The approach to CLO investing starts with a bottom-up credit analysis For CLO mezzanine, Napier Park looks for adequate over-collateralisation and at the quality of individual credits. It is interested in duration-reducing features and early repayment as well as short expected duration and short investment periods. On the CLO equity side, they want certainty and quantity of cash flow and deals that have a low risk of payment cut-off, among other features. They are also interested in long reinvestment periods and look for rating actions along with embedded optionality by seeking deals that can reinvest after the end of the reinvestment period.

Interestingly, most of the opportunities spotted by Napier Park are non-peripheral Europe exposures. Core Europe makes up 60% of the portfolio, with the UK taking a further 20% chunk. Spain, Italy and Ireland make up just over 10% together with the US at a mere 8%. Of these CLOs the vast majority (95%) are senior secured loans.

Micko brings around 15 years of relevant experience to the team. He joined Citi Capital Advisors in 2004, Citigroup’s alternative investment arm from which Napier Park separated in February 2013. Before that he headed high yield at Mellon Newton Investment Management in London and was an investment banker in London at Deutsche Bank and Bankers Trust International focusing on leverage finance. Micko was also treasurer of a listed corporate high-yield issuer.

His experience, coupled with the European credit team, which manages more than $500 million, has helped maintain comparatively strong performance versus the market. The team has on average more than 15 years of experience apiece in European credit markets. This has given them strong relationships with the people that matter in this area: dealers, advisers, sponsors, issuers and investors. They are able to source and generate investment ideas because they have deep knowledge spanning many years of the issuers in both private and public markets.

At inception the team invested the majority of the strategy in single-name credit. Over the years, it has increased exposures to the CLO trance market where it believes there is a better risk-adjusted return. Since inception, the team has continued to refine its investment process and expertise in CLOs tranche investing with impressive results.

This dream team racked up an impressive 31.11% performance in 2013 compared with a mere 11.23% by the EuroHedge Credit EUR Index. By March this year, the strategy was up 4.72%, again above the index’s 2.04%.

“There are a lot of investors that invest in CLOs, whether they are new issues or in the secondary market from the ones that have been around since the crisis,” says Micko. “We will look at every single asset in the portfolio, name by name. The reason why we can do that is because we actually know the loans, know the bonds from when we invested in the bonds and loans themselves. We've known them because they have been previous issuers. That's one value that we have: the team and myself have been in Europe our whole career. We've been in the credit markets in Europe for over 20 years and we just know the credits much better than others.”

Since the European market tends to be fairly private, most loans are actually not publicly rated, unlike in the US where every loan is publicly rated. Having a credit team that already knows the underlying credits is a distinct advantage. “That background in the single-name credit space, bringing it to the CLOs, gives us a competitive advantage which we feel is sustainable,” Micko says.

Balancing risk and reward is an art, says Micko. “We have to look at risk/reward compared with other alternatives and compared with the wider market. We have to look at each individual investment thesis. We have to carefully weigh what the upside or the downside opportunity is and to make sure that that upside versus downside is more than compensated for by the analysis we've done, the view we have and the catalysts we expect. Fundamentally we have to understand that individual investment thesis better than the market does.”

Looking at risks to this strategy, Micko says the main concern is a “sort of technical correlation of risk on/risk off”. Anything that creates volatility in this area and is not fundamentally driven, but caused by extraneous factors such as the crisis in the Ukraine and other unexpected events, will create general market fear. Such fear will create liquidity disruption and will affect the strategy.

“We try to mitigate that through the hedge overlays that we do. In terms of the fundamentals of what we invest in, we are very, very good at credit selection,” he notes, adding: “We feel like we're not going to be impacted by any change in the environment in those theses, unless there is something very significant in which case we monitor very carefully. If something happens in one of our investments and we have a change in view, then we'll reassess that in real time and decide whether we want to sell it or not.”

The risks are quantified in order to determine the correct amount of hedging needed in the portfolio. Micko believes the days of hedging against something like a break-up of the eurozone is remote. “We don't have to hedge for that type of risk right now, although we always have to remain vigilant for change in risk and to make sure that we have the right overlays on the portfolio at any point in time.”

For this year the strategy will continue to invest in CLO legacy issues. “We have some very high-quality cash flow that's been generated by that portfolio and which is very predictable and sustainable. We also have a fair degree of spread compression that we expect in the mezzanine of those CLOs because they are deleveraging.  As they deleverage, the credit spreads contract as the tranches look better in quality. We’re taking advantage of that and trading that quite a bit. Most of the portfolio right now is focused on that space,” he says, adding: “In the single-name space, there are some individual opportunities where we have made money and we will [continue to] make money but I don't think we want to change the asset allocation too much this year.”

Moving into 2015 and 2016, Micko expects the portfolio to migrate “a little bit more” back into single-name high yield, slightly stressed dislocated bonds and loans. At present the market has too much liquidity so it is not a good entry point for Napier Park, according to him.

“We do think there's going to be a better entry point probably in one and a half to two years' time. I think also the portfolio that we manage will migrate into that space as the opportunities in the pre-crisis CLOs start to materialise over the next two to three years. There's going to be a natural transition and it's actually a very nice place to be right now.”

As for increasing assets under management, Micko says investor interest in this area is increasing. While in the past many investors have been “fearful” of Europe, he says many now want to enter the credit market. “Being in credit in a focused space in Europe right now is getting a lot of traction.”

Napier Park European Credit Opportunities Fund run by Napier Park Global Capital was named hedge fund of the year at the European Single Manager Awards 2014.

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