Introduction to credit opportunity funds Richard Parkus Deutsche Bank

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1 2 Introduction to credit opportunity funds Richard Parkus 2007 Credit opportunity funds have been the largest and fastest-growing segment within the market-value collateralised debt obligation (MV CDO) sector and represent, in many respects, a hybrid of traditional CDO and credit hedge fund technologies. Similar to cash-flow CDOs, credit opportunity funds provide non-recourse term financing at a low cost relative to other financing alternatives. Similar to credit hedge funds, credit opportunity funds are structured to create maximum flexibility for the manager to trade actively in order to generate alpha for equity investors. This includes the ability to alter deal leverage quickly and efficiently. In addition, like hedge funds, credit opportunity funds effectively de-link equity and debt investments and allow for equity redemptions after a lock-up period and subject to certain restrictions. It has become much more common for credit hedge funds to have minimum investment lock-up periods and restrictions on the percentage of capital that can be withdrawn in a single period. Credit opportunity funds employ a master fund/feeder fund structure that utilises a specific type of MV CDO (or series of MV CDOs) to finance, or leverage, its investment purchases. The MV CDO is restricted to investing primarily in liquid credit assets and employs only a moderate degree of leverage. Semi-liquid assets (ie, assets that cannot be marked more frequently than on a monthly basis) are generally limited in aggregate to 50 per cent of the fund s net asset value. The fund net asset value is defined as the market value of the collateral minus the aggregate par amount of the outstanding debt. The basic structure is depicted in Figure 1. Global Securitisation and Structured Finance

2 Global Securitisation and Structured Finance 2007 I Introduction to credit opportunity funds Figure 1: Basic structure of a credit opportunity fund Investment manager Equity investors Credit opportunity fund (master fund) Onshore feeder fund Offshore feeder fund Dividends Capital suboordination MV CDO I Future MV CDO II Future MV CDO III Class A-1 notes Senior (Aaa/AAA) Class A2 variable funding notes Senior Senior Portfolio (Aaa/AAA) Portfolio Portfolio assets Second senior Class B-1 notes/ assets Second senior assets Second senior loans (Aa2/AA) Mezz/junior Class C-1 notes/ Mezz/junior Mezz/junior loans (A2/A) Source: Structure of equity investments Equity investors typically invest in the credit opportunity fund through either an onshore feeder fund (for US investors) or an offshore feeder fund (for non-us investors). The onshore and offshore feeder funds streamline the overall fund structure by allowing both US and non-us investors to invest directly in a single fund. A financing subsidiary - the MV CDO - is created that is wholly owned by the credit opportunity fund. The fund contributes equity to the CDO, which then issues debt securities and uses the proceeds to purchase the collateral pool. The fund may create multiple separate financing subsidiaries and each one is an MV CDO. The terms credit opportunity fund and MV CDO are often used synonymously. However, the two are not precisely the same - credit opportunity funds employ MV CDOs as wholly owned financing subsidiaries. Each MV CDO receives an equity contribution from the fund, which represents 100 per cent of the subsidiary s equity capital. The MV CDO issues debt and invests in a portfolio of 16 Global Securitisation and Structured Finance 2007

3 Introduction to credit opportunity funds I Global Securitisation and Structured Finance 2007 collateral. The investment manager manages the fund as well as all the underlying financing subsidiaries. The use of a master fund/financing subsidiary structure adds significant flexibility and efficiency to credit opportunity funds for the following reasons: The fund can be structured to allow it to invest directly in a much wider array of assets than would be permitted under the MV CDO. Leverage on these direct investments, if desired, would need to be supplied from an alternative source. In effect, the MV CDO would fund only a subset of the investment activities of the fund. Investments outside the MV CDO could include special, highly illiquid and/or speculative investment opportunities that might be well suited to the fund, but not to the MV CDO. The format also adds much greater flexibility for growing the credit opportunity fund over time. A credit opportunity fund can grow in at least two different ways: It could inject additional equity capital into an existing MV CDO, which could then issue additional debt tranches; or It could create a new MV CDO. However, rating agencies prefer that individual MV CDOs not become excessively large and thus cap their maximum size at approximately $2 billion of debt issuance. In order to grow the fund beyond this level, multiple MV CDOs would need to be created. The format adds greatly to the evergreen character of the fund. An MV CDO itself has a limited evergreen capacity; the CDO could issue new debt tranches over time (subject to the existing restrictions and the debt ceiling) with staggered maturities so as to continue operating effectively. However, at some point this becomes constraining as a financing structure because the original portfolio limitations (investment constraints) are always in effect. For example, if the original MV CDO were of the income-oriented type, the credit opportunity fund could not engage in eventdriven strategies. As in most hedge funds, offshore/onshore feeders are typically employed, allowing for an efficient way to include both domestic and non-domestic investors without having to create separate equity funds. In general, credit opportunity funds have several classes of equity that differ according to their lock-up period. To date, lock-up periods have varied from one to three years. Following the lock-up period, typically investors have the option to redeem their shares at the fund s net asset value (ie, the market value of the collateral minus the aggregate par amount of the outstanding debt). However, the manager may have some degree of discretion in limiting equity redemptions (eg, the ability to limit redemptions to 25 per cent per year). Management fees are paid directly by the equity investors as a percentage of net asset value (not the total ). Fees have an incentive structure and a magnitude that is typically in line with those of hedge funds. In addition, equity classes with longer lock-ups are often rewarded with lower fees. Unlike in a cash-flow CDO, where the excess cash flow is directed to the equity class, the equity class in a MV CDO is a non-current pay class - although the manager may attempt to pay a specified regular dividend, the manager is not obligated to make disbursements prior to maturity. The manager may state that it will use its best efforts to pay a specific periodic dividend to the equity class, but such payments cannot be assured. To date, most credit opportunity funds have not elected to pay a specified dividend. In cases where a dividend has been specified, it has been small (approximately 5 per cent) relative to equity distributions in cash-flow deals. Table 1 presents fairly typical characteristics for the equity class of a credit opportunity fund. In this hypothetical example, the fund has two equity classes, Class 1 and Class 2. Unlike in a cash-flow CDO, the equity class in an MV CDO is not the controlling class. The senior debt Global Securitisation and Structured Finance

4 Global Securitisation and Structured Finance 2007 I Introduction to credit opportunity funds Table 1: Typical characteristics for equity shares in a credit op fund Shares Lock-up period Management fee Class 1 1 year 1.5 to 2.0% of NAV plus 20% of profits Class 2 3 years 1.25 to 1.5% of NAV plus 20% of profits after 5% hurdle rate Source: Global Markets Research class is in control of potential liquidations resulting from over-collateralisation test violations. Moreover, it is the decision of the manager to call the deal, not the equity investor. However, while equity investors may not have the option to call the deal, they may be able effectively to achieve the same goal simply by redeeming their shares (after the lock-up period and subject to constraints). MV CDO financing subsidiary One of the defining characteristics of credit opportunity funds is the structure of the underlying MV CDOs. These CDOs focus primarily on liquid credit assets (exposure to semi-liquid assets is highly restricted) and employ a fairly modest degree of leverage relative to first-generation MV CDOs. To date, credit opportunity funds have focused their investment strategies on either bank loans or high-yield corporate bonds, or a combination of the two. There are also typically larger buckets for structured product investments, which tend to improve diversification of the collateral portfolio. The CDOs also have the capacity to invest in synthetics. In particular, they are able to take short positions through collateralised debt securities, typically up to 25 per cent of the fund s total capitalisation. MV CDOs have portfolio limitation schedules defining various restrictions and concentration limits. These diversification constraints entail limits on the maximum concentrations of the collateral pool in, for example, single issuers, single industries or the top two or three industry concentrations. The CDO is subject to these specified concentration limits at all times, and compliance with limits is calculated as part of overcollateralisation testing. Historically, the rating agencies have given no credit in calculating the advance amount for collateral that exceeds the concentration limits. This has been modified in recent years to allow for partial, but not full, credit. Table 2 presents the portfolio limitations for a typical loan-oriented credit opportunity fund. The targeted operating leverage for loan-oriented credit opportunity funds has typically been in the two to four times range, with a maximum leverage of five to six times and an ability to operate with leverage as low as one to two times. For event-driven credit opportunity funds, targeted leverage has been one to three times with a maximum of approximately four times. As a point of comparison, the minimum operating leverage in first-generation MV CDOs was two to four times. Market pricing and over-collateralisation tests Although compliance with over-collateralisation tests and portfolio limitations is typically checked daily, the market value of each investment is, with few exceptions, required to be updated weekly, with market values determined by: the closing price from an approved exchange; the lower of the bid prices submitted by two approved dealers; the average of the bid prices submitted by three approved dealers; or the quote provided by an approved pricing service. 18 Global Securitisation and Structured Finance 2007

5 Introduction to credit opportunity funds I Global Securitisation and Structured Finance 2007 Table 2: Sample portfolio limitations for a loan-oriented credit op fund Portfolio limitations Maximum industry concentration Pecentage of total capitalisation 20% top industry, 15% for all others Maximum obligor concentration 5% Bank loans from credit facilities with less than 15% $150mm of issuance Convertible bonds and convertible preferred stock 25% Preferred stock 10% Non-cash pay instruments 25% Non-US obligors (subject to country limitations) 25% Non-US$ denominated assets 15% Unhedged non-us$ denominated assets 5% Semi-liquid assets Semi-liquid assets and non-performing assets 50% of financing SPE s NAV 100% of financing SPE s NAV Aggregate counterparty exposure 25% Emerging markets 5% Maximum short exposure 25% Source: For semi-liquid assets, which are quoted less frequently than weekly, dealers and/or third-party appraisers must provide valuations at least quarterly. Advance rates and advance amounts are updated daily. Using the daily updated advance amounts and the most recently updated collateral valuations, the overcollateralisation test is checked on a daily basis. If, on any date, the over-collateralisation test fails for any debt class, the manager generally has 10 business days to submit a statement to the trustee outlining actions taken to remedy the over-collateralisation test failure. If the manager fails to take action or submit a statement by the 10th business day, or the trades fail to settle by the 30th day, a majority of the most senior debt investors may vote to liquidate the assets. Capital structure The capital structures of MV CDOs reflect the fact that they are actively managed, debt-financed credit funds that have special operational requirements. In particular, managers need the ability to alter the deal s leverage in response to changes in market conditions. Managers also need the ability to alter the amount of debt outstanding so as to be able to manage dynamically the overcollateralisation triggers. Both these needs are addressed by having a large senior, triple-a-rated revolving debt tranche, which often represents 30 per cent to 40 per cent or more of a deal s capital structure. The fee for the revolver has two components: a funded component that applies to the drawn portion of the commitment and an unfunded component that Global Securitisation and Structured Finance

6 Global Securitisation and Structured Finance 2007 I Introduction to credit opportunity funds Table 3: Details of the initial capital structure of the financing subsidiary Tranche Amount Rating Maturity Spread S&P MV O/C amount ($ mm) (Moody s/s&p) committment (Revolver fully funded) fee Class A Aaa/AAA 7 years 32 bp 25.6 % Class A-2 VFN* Aaa/AAA 7 years 35 / 23 bp 25.6 % Class B Aa/AA 7 years 52 bp 20.1 % Class C A/A 7 years 82 bp 14.5 % Fund capital NR/NR NA NA NA Total Source: Note: * VFN refers to variable funding notes. applies to the undrawn portion. The spread on the funded component of the fee is typically slightly above the spread on senior term debt of the same maturity. The spread on the unfunded component tends to be 50 per cent to 75 per cent of the spread on the funded component (the rate on the funded component is LIBOR plus the funded spread, while the rate on the unfunded component is simply the unfunded spread). Although first-generation MV CDOs also had revolving classes, they were typically a smaller proportion of the total capital structure. They were also typically double-a rated, and thus more expensive than the current revolvers. The innovation of using large triple-a revolving debt classes helps to allow credit opportunity funds to focus on liquid (and thus lower spread) investments, while employing lower leverage. There is typically also a senior (triple-a rated) term note that is pari passu with the revolver. In some cases, instead of a senior term note, there may be a senior delayed-draw note, with full draw being required within 12 to 18 months (for delayed-draw notes, the draws may be either automatic or voluntary with the number of allowable draws varying across deals). Similar to revolvers, the fees on delayed-draw notes have both funded and unfunded components. Subordinate debt classes tend to be small (10 per cent to 15 per cent of the capital structure) and may also have delayed-draw features. There tends to be little debt issued below the single-a or triple-b levels. Unlike in cash CDOs, subordinate debt classes cannot be financed by payment in kind. In general, all term debt tranches are redeemable (either in whole or in part) by the manager after the end of the non-call period. Non-call periods are typically two to three years for senior classes. In some cases, subordinate classes may be redeemable immediately (ie, they have no non-call period). Redemption is typically at par plus accrued interest, although there are some cases where a redemption premium is required. The redemption option gives the manager the flexibility to close the fund if, in the manager s view, there are insufficient investment opportunities. The CDO typically has the right to issue additional debt tranches in the future as long as such issuance would not result in any violations of the overcollateralisation tests or any ratings downgrades of existing debt tranches. Any additional debt tranches issued would be pari passu with the existing tranches of the same class (eg, any additional Class A tranches would be pari passu with all existing Class A tranches). 20 Global Securitisation and Structured Finance 2007

7 Introduction to credit opportunity funds I Global Securitisation and Structured Finance 2007 Table 4: Basic types of credit opportunity fund Event driven Income oriented Strategy Core holdings are high yield and bank loans; emphasis on changing markets High yield Crossover credits Distressed Convertibles Mezzanine Equity Use revolver to enter and exit Seeks to pay a stated dividend markets during sell-offs and rallies Credit shorting to hedge or take Emphasis on relative value of industry a specific view or issuers Liquidity 18 or 36-month lock-ups 12 or 36-month lock-ups Asset mix 32.5 Aa/AA 7 years 52 bp 20.1 % Bank loans 30% 50% 60% 100% High yield 50% 70% 0% 40% Special situations 0% 40% 0% 20% Target leverage 1 3x 2 4x Source: Table 3 summarises the initial capital structure of the MV CDO underlying a typical loan-oriented credit opportunity fund. Types of credit opportunity fund Two different investment styles can be found within the broad category of credit opportunity funds: event driven and income oriented. Event-driven credit opportunity funds tend to have lower allocations to bank loans and greater allocations to high-yield bonds and special situations. Due to the higher volatility of high-yield bonds and the lower liquidity of special situation investments relative to bank loans, eventdriven funds tend to employ lower leverage than income-oriented funds. The characteristics of each are compared and contrasted in Table 4. This chapter is taken from previously published Deutsche Bank research. Global Securitisation and Structured Finance

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