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Cairn Financial Products has been at the forefront of the structured credit market since its formation in 2004. Rachel Wolcott talks to Paul Campbell, chief executive of the specialist asset manager, about the firm's plans for 2006

A high level of structured credit literacy is the foundation on which Cairn Financial Products has built its asset management and advisory business. The London-based asset manager was established by and has attracted the market's foremost structured credit experts with the aim of developing a multi-discipline credit asset management firm. Since its debut in August 2004, the company has amassed a staggering $13 billion under management.

"Credit is a complex environment, and to be effective as an asset manager you need to be structurally highly literate," says Paul Campbell, Cairn's chief executive. "You need to know the parameters within which you are operating and to be confident that as a manager you have the flexibility to manage the product for your investors."

Currently, Cairn manages a credit hedge fund, a collateralised debt obligation (CDO) of asset-backed securities (ABSs), a CDO backed by investment-grade credit default swaps (CDSs) and a structured credit constant proportion portfolio insurance (CPPI) product, as well as a few private transactions. The firm also offers a structuring and advisory service, which was involved in one of last year's largest synthetic securitisations in the form of a regulatory capital trade conducted for a European commercial bank.

Cairn has an ambitious business plan for 2006. In addition to launching another hedge fund – the Cairn ABS Investment Fund, which will focus on CDO equity – the firm will continue to develop CDO of ABS and credit CPPI products.

The manager plans to launch its second CDO of ABSs, Cairn High Grade Funding I, this month. The CDO will probably have a notional portfolio of $1.8 billion and will invest solely in AAA-rated residential mortgage-backed securities and ABSs. The deal incorporates a new funding structure, developed by Barclays Capital, which should provide low-cost financing based on aspects of structured investment vehicle (SIV) technology and a commercial paper (CP) programme to provide leverage. An SIV is a limited-purpose operating company that undertakes arbitrage activities by purchasing mostly highly rated medium- and long-term fixed-income assets, while funding itself with cheaper, mostly short-term, highly rated CP and medium-term notes.

"Rather than going down the credit curve to meet investors' needs for returns, the approach we took was to focus more on the liability side. To date, our deals are characterised by investing in high-grade assets, and where I think we've differentiated ourselves is from a structuring perspective," says Campbell. "If you are precise and creative about how you manage the liabilities, there isn't the pressure to go down the credit curve and take leverage through the assets, instead of through the funding. At this stage of the cycle, I think that's by far the best way to generate returns."

SIV technology is increasingly being used by hedge funds and CDO managers to tap into cheaper financing. Last year, London-based hedge fund Cheyne Capital launched a $4 billion SIV called Cheyne Finance through Morgan Stanley, and now other asset managers such as France's Axa Investment Managers are looking to launch similar structures.

"CDO managers are increasingly looking at SIVs as a way to de-risk their business," says Campbell. "For many managers, a rational reason for wanting to sit SIV and CDO businesses next to each other is because they are very similar technologies."

Last year, Cairn completed its first CPPI product, Cairn Credit CPPI I, in partnership with Credit Suisse – a deal that has so far raised more than €200 million. "When we first launched the business there were a lot of highly leveraged products that were being issued into the markets. We declined to manage any of those products on the basis that the leverage was inappropriate given where we are in the credit cycle," says Campbell. "What we sought to do is design products we felt would perform well throughout the cycle, and those products had both a long and a short technology embodied within them."

Cairn Credit CPPI takes a long equity/short mezzanine strategy based on the iTraxx credit derivatives index. The portfolio could, for example, be long the equity tranche of the 10-year iTraxx, short the mezzanine tranche of the 10-year index, short single names in the iTraxx, and long or short the untranched iTraxx index.

The transaction was launched just as the correlation meltdown began in April. Nonetheless, the trade has performed well despite the circumstances around its debut. "We certainly earned our spurs in the first months of that deal, but it has performed extremely well. It's well above par and we're about to hit some re-leveraging triggers, where we can increase leverage because the deal's performed so well," says Campbell. "It emphasises our strengths because the reason that deal did not de-lever in that very difficult environment is that we understand the correlation market as well as anyone."

Cairn has used this long/short strategy in other products, namely the $550 million Managed Absolute Return Strategy (Mars) CDO it put together with UBS, which was launched last May. In this transaction, the principal is linked to the credit risk in a long-only portfolio and the coupon is linked to credit spread widening in a short portfolio. The long portfolio comprises 95 credits with an average rating of A1/A2, and the short portfolio is currently made up of 18 credits.

Campbell and Tim Frost, who joined Cairn in March 2004, lead the risk management side of the business. Frost is well known in the market for his role in developing JP Morgan's credit derivatives business. Campbell, meanwhile, was formerly managing director, Europe, at Banque AIG, the European subsidiary of AIG Financial products, where he headed the global credit business.

"We've invested a lot of money in proprietary technology and we've got a lot of quantitative resources in the company, but ultimately what we're trading is credit. We have guys who can pull apart a balance sheet, as well as having a good legal resource," says Campbell.

The firm uses a combination of internally developed technology and systems from third-party vendors for risk management and research purposes. It uses the Securities in Violation Extractor (SiVE) filter, an internally developed early warning system that monitors news flow, ratings events and spread movement, to flag up potential problem credits. Credits picked out by SiVE are reviewed and may be placed on a watch list. In addition, Cairn uses Markit Portal, a web-based service from UK-based pricing and valuation services company Markit, which offers asset pricing, news and independent credit research.

On the operational risk side, Cairn has brought in two of the market's leading figures. Luke Venables runs the firm's operations department and is head of its CDS settlement operation. Prior to joining Cairn, Venables was responsible for the front- to back-office co-ordination of complex products at Goldman Sachs in London. Christopher Bentley, who spent 10 years at Credit Suisse, heads Cairn's business risk management.

Vigilant

Cairn has been particularly vigilant about its approach to credit derivatives trade confirmation – an issue that has been highlighted by the New York Federal Reserve and the UK's Financial Services Authority. Through a daily process called trade review, Cairn ensures it does not have any outstanding trade confirmations. Each day, two people – neither of whom is involved in the transaction under review – go over all the day's trades. With each transaction, the legal confirm is checked against the system entry, which in turn is checked against the written or electronic blotter.

"It goes to the importance we place on our operational robustness," says Campbell. "By the close of business every day, we know that the confirmations the system has produced matches what the trader thinks he's done and matches what's been input into the system."

Achieving high standards of operational efficiency could prove important in 2006. Campbell reckons there could be continued volatility in the auto sector, with some isolated defaults. At the same time, there could be an increase in leveraged buyout (LBO) activity. That, combined with high commodity prices and potential rate hikes from European and Asian central banks, is a recipe for spread widening.

"That being said, we've seen bouts of LBO activity over the past 18 months, but it's been offset by the very strong bid from synthetic CDOs, which has kept a lid on the absolute level of credit spreads, and that synthetic pipeline remains strong," says Campbell. "Spreads will widen, but it's unlikely to be violent or significant – it's more of a drift in broader indexes that will mask a lot of single-name volatility."

Cairn has been watchful of LBO situations, keeping an eye out for cases where it can benefit from spread tightening. Common wisdom is that CDS spreads on an acquisition target will widen in the event of an LBO due to concern that bondholders might be subordinated in the subsequent corporate structure, or that the company might be downgraded for taking on too much leverage. But that is not always the case. In fact, Cairn has successfully picked LBO names where spreads have tightened.

"In two of our most successful trades in the last quarter, we were actually long the credit risk in an LBO because of the perception that the CDS would not reference any outstanding debt in the new entity," says Campbell.

The firm also has a top-notch legal adviser in James Starky, who has 20 years' structured credit legal experience, which has helped Cairn identify opportunities coming from the legal side of LBO situations. Starky was associate general counsel at Banque AIG before joining Cairn, and he has also worked as a partner at US law firm Cadwalader Wickersham and Taft and UK firm Freshfields.

What Starky and the workout specialists are looking for is a lack of a successor CDS after the completion of the LBO – meaning that the CDS would not reference any outstanding debt in the new entity. This approach paid off for investors who bought Cablecom, a German cable television company. The CDS spreads on that LBO target tightened by 300 basis points over the final quarter of last year on the perception that there would be no successor CDS.

Cairn's legal and workout specialists also spotted Heidelberg Cement, a German cement company that was an LBO target. Through its understanding of the German legal framework, Cairn's team was able to discern that the deal wouldn't be as leveraged as anticipated, which meant the CDS was going to tighten, which it did to the tune of 100bp.

These kinds of trades show that it is not just structural literacy that has made Cairn a success, but also the firm's ability to look at all angles of a credit to generate returns for its investors.

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