Corporate debt offers investment opportunity

Hybrid Structured Credit Funds: Securitisation moves into new paradigm

Over the last 18 months many fund managers have been able to take advantage of the significant discounts offered on collateralised loan and debt obligations (CLOs/CDOs), a result of the previous boom in global issuance of CDOs and synthetic equivalents. Investment vehicles structured as hybrid investment funds have been able to take advantage of market factors that have combined to offer investment opportunities through these arrangements.

While these particular investment possibilities may have run their course, a permanent change to the structure of investment capital markets coupled with continued market volatility is likely to continue to throw up new opportunities in the future.

The new generation of fund vehicles that have emerged hold underlying assets such as leveraged loans and other investment assets similar to those traditionally found in the collateral pool of a CDO (and of CDO variants). Hybrid structured funds have emerged as a way to access opportunities that have arisen as investment markets begin to normalise. Funds have been able to acquire investment assets at prices at or below intrinsic value.

The advantages of a hybrid structured fund as a vehicle to finance the acquisition and holding of investment assets has been attractive to investors keen to take advantage of what many see as a short-term opportunity in this market.

The hybrid structured funds can be used to access a variety of asset types, from fixed-income investments to alternative asset classes. In the recovery period investment opportunities will be concentrated in asset classes such as distressed debt, stressed financial credits, mezzanine and leveraged loans and others.

Leveraged loans as an asset class have appealed to investors, says Michael Devane, vice president, corporate trust, securities servicing, BNY Financial Services. These structures have appealed to investors who saw the opportunities offered in the loan market as an attractive proposition to access through a variety of fund structures.. The popularity of leverage locans was strongest in he first nine months of 2009, driven mainly by an imbalance between supply and demand in the syndicated commercial loan market. This imbalance has now eased which may lead to a less enthusiastic appetite for this asset class in 2010.

Ireland has been well placed to take advantage of this offering, says Brendan O’Regan, vice president, alternative investment services product manager, BNY Mellon Fund Services (Ireland) Limited. He says the ability of Ireland to offer a fund structure that takes advantage of the country’s numerous double-taxation agreements as well as the high level of knowledge on hedge fund structures, trustee services and other services related to funds has led to a proliferation of hybrid credit fund structures over the last 18 months.

Welcome competition
Ireland’s reputation as a jurisdiction with sound but flexible regulation has also attracted managers, says O’Regan.

While Luxembourg may be catching up on Ireland’s initial lead in this area, he believes there is room in the market as there are opportunities yet to be exploited by the fund structures.

O’Regan sees an uncertain landscape for funds in the future. However the current climate where leverage is restricted has played well for the credit funds. For O’Regan the opportunities remain; he believes further writedowns, particularly in the banking sector, are likely to fuel future demand for these funds. He believes BNY Mellon was well placed to take advantage of the emergence of these hybrid structures. Its ability to marry hedge fund and equity administration functions with the bank’s significant corporate trustee and custody services has given it a first-mover advantage over others. Its experience, too, in helping fund managers structure appropriate vehicles for the investments has led the bank to create what is in effect a new service offering that O’Regan believes will continue to have applications in the future.

As these hybrid structures develop, O’Regan believes BNY Mellon will continue to improve its service offering. “Transparency, disclosure, information and reporting have become important areas for funds following the financial crisis,” he says. He believes the ability of BNY Mellon to use its existing technology together with a combination of services not easily available elsewhere, will continue to make it a leader in servicing these new structures in the future.

Derek Delaney, head of client services and new business, alternative investment services, BNY Mellon Fund Services (Ireland) Limited, agrees that the bank and Ireland should continue to benefit from the emergence of different credit fund vehicles.

Mortgage-backed and corporate asset-backed securities as well as bonds, sovereign debts and other corporate securitisations will continue to create opportunities for investors and fund managers in future, he believes.

Delaney points to the innovation by fund managers seeking to capitalise on the opportunities offered in the debt markets. He has seen fund managers offering innovative fee structures based on varying lock-in periods where management fees are discounted if investors opt for longer lock-in periods. This benefits not only the investment manager but also the investors, as it allows the portfolio sufficient time to realise the underlying assets, most of which are distressed debts. The bet is that by the time these come to maturity, the value will have risen considerably compared with the discounted prices at which they were obtained.

“Now some managers who are not historically debt managers are starting to look at these assets. They have no expertise specifically in buying debt but they are able to give investment capital to a number of specialised investment managers to exploit the opportunities,” notes Delaney. He says a number of investors are seeking exposure to these funds, including funds of hedge funds.

In the US the Public Private Investment Program (PPIP) introduced by Treasury Secretary Tim Geithner, is aimed at combining public and private money to buy commercial and residential mortgage-backed securities (MBS) from banks in an effort to get these illiquid assets off their balance sheets and at the same time increase their lending capacity. With the US government committing $75 –$100 billion to PPIP, there are significant opportunities for investors, too.

This has also created an opportunity for BNY Mellon. It is servicing seven of the nine PPIPs set up so far. This experience will further add to the bank’s existing expertise in administering and supporting hybrid investment funds dealing in illiquid instruments available in the credit market.

A new business team created by BNY Mellon is able to help managers talk through various structures that can be used for this type of fund. Delaney believes the service BNY Mellon can offer these funds benefits on both sides. “We offer experience. I’m a qualified accountant and most of my team are, too. We are able to support all the operations needed to administer these new hybrid fund structures, including valuation, custodian and trustee functions,” says Delaney.

Another member of BNY Mellon Fund Services (Ireland) Limited, Conor MacGuinness, alternative investment client services, agrees the bank’s ability to act as a trustee, protecting shareholders, coupled with its other services in administering the funds, has made it a good choice for fund managers seeking to open these funds.

“Mortgages, corporate debts, mortgage-backed securities – they are all different. We can receive various trade files for different sub-portfolios on a daily basis and consolidate this up to a master fund value. That requires our expertise and infrastructure,” says MacGuinness.

IT attraction
He believes the technology and skills the bank offers in providing systems to process and monitor these complex portfolios have been attractive to originators of hybrid fund structures. Through systems such as Wall Street Office, the bank is able to offer transparency to investors and fund managers, giving them the ability to see and monitor individual loans in the fund with great detail. MacGuinness also thinks the banks’ ability to handle the cash flow and intricate periodic payment profiles for the underlying assets held by these funds has given confidence to fund managers and their investors that these structures will be administered efficiently and cost-effectively.

“Within the regulated Irish qualified investor fund [QIF] market pricing is needed,” explains MacGuinness. He says the corporate trustees are expected to find pricing vendors to provide independent valuations. “Markit is one of the leaders in institutional loan pricing,” says MacGuinness, confirming BNY Mellon’s partnership with the company (article, page 16).

For these funds, the pricing of each pool of assets usually grouped within a section 110 special purpose vehicle under the umbrella of the Irish QIF, is a complicated and time-consuming activity which the bank is well placed to perform. “The funds are used to the alternative investment services we offer. These coupled with the trustee functions allows us to service these funds in a joined-up service. We work closely together internally to provide a seamless service to clients,” confirms MacGuinness.

“We have seen these funds grow quickly. The opportunity is focused on ‘cheap’ debt. As the general economy picks up, however, inflation worries will surface. As the interest rates start to rise, it is likely we will see more distressed debt coming onto the market as well as banks continuing to write down debt,” predicts MacGuinness.

He believes these emerging fund structures will continue to attract investment interest not only from the high net worth investors but also from institutional investors. Both are keen to diversify portfolios into what is seen as a good investment opportunity but one where special fund management skills and expertise are needed.