James Williams | Editor in Chief | Hedgeweek, FIS
October 15, 2020
With the global economy feeling the ripple effect of COVID-19, investment opportunities in high-yield credit, and in particular distressed credit, have been numerous as investors seek out higher yield at a commensurate higher risk.
CNBC recently reported that Oak Hill Advisors, a US$42 billion investment manager that focuses on distressed credit, noticed a lot of investor interest in the asset class. Oak Hill’s president William Bohnsack stated they invested US$2 billion to US$3 billion dollars during March and April.
Private credit vehicles raised US$57 billion in the first half of 2020, according to research firm Preqin, and with yield opportunities in structured credit, CLOs and distressed credit coming to the fore, the worlds of hedge fund and private equity investing are likely to converge.
“This is an area of growth we’ve been seeing over the last couple of years,” comments Trevor Headley, head of Hedge Fund Product Management at FIS. “We are seeing large specialist PE firms expanding their investment horizons on the debt side of the capital structure, whether that is distressed credit, syndicated loans or structured credit. This is creating some convergence with specialist credit-focused hedge funds.”
This convergence theme is emerging as alternative asset managers seek to diversify and scale their businesses. In a new report entitled “To Infinity and Beyond”, FIS points out that current volatility and price dislocations are prompting fund managers to launch new distressed credit funds and CLOs. Indeed, Hedgeweek reported that Dutch hedge fund allocator Theta Capital Management just launched a dedicated vehicle in anticipation of a multiyear multifaceted distressed credit cycle, as a result of the pandemic.
As managers diversify their investment strategies, however, they need to remain vigilant in respect to ongoing risk management. In assets such as CLOs, there are complex compliance rules and risk metrics to consider, such as coverage tests to guard against collateral deterioration. Interest coverage and over-collateralization tests are also important to maintaining robust risk management.
This requires having specialized systems that can support investment operations across the trade life cycle.
“Diversification and the need to be agile is important, to break into new strategies and asset classes,” comments Adrian Holt, head of Hedge Fund Strategy at FIS. He continues:
“On the risk management side, those moving into illiquid areas of the market face the challenge of knowing what their risk exposure is when the securities are not priced in the market. One ends up with periodic valuations, which can give the illusion that their portfolio’s risk exposure is under control. The question is, how does one measure risk more accurately, especially in a higher volatility regime, as we saw in Q2 this year?”
Moreover, as hedge funds and private equity funds seek ways to extend their asset class coverage in credit markets, they need to consider operational risk issues when dealing with securities that have more settlement risk. Not to mention sourcing sufficient data to plug into valuation and risk models. As Headley points out, “There’s an ecosystem of data and operational support that is required to take advantage of opportunities in the marketplace today, in order to minimize operational risk.”
One example of how the two worlds of hedge fund and private equity investing are converging is CAVU Investment Partners, which was established when TowerBrook Capital Partners joined forces with New York-based LibreMax Capital, a structured credit specialist asset manager.
CAVU invests in the equity tranches of new issue CLOs managed by Trimaran Advisors, LLC, the CLO management platform of LibreMax.
“This trend towards PE groups moving into areas such as CLOs is something we’ve been seeing for a couple of years,” observes Headley. “Firms see this as a midterm opportunity to generate returns over and above what they are seeing across other asset classes.
“Helping managers take advantage of these opportunities, while still maintaining the same risk profile, is absolutely key.”
FIS is now seeing an increasing number of clients using multiple products to manage different investments, such as Virtus from FIS, which supports loan and CLO investing, alongside FIS Investran, a private equity accounting and reporting solution. The inference one can draw here is that as managers diversify, they want to ensure they get an enterprise-level view across multiple asset classes.
“The management and operational dynamics become different as you move across the illiquidity spectrum,” says Holt. “Getting that right combination of technology and business intelligence is a key requirement for investment managers.”
Ultimately, if an investment manager is looking to broaden their asset class coverage, they need confidence in their operational framework. As do their end investors.
During higher market volatility, if a hedge fund diversifies then investors will want to know that the manager has the ability to monitor and manage the risk effectively. “It’s never been more critical than it is now, while the macro outlook remains uncertain,” says Holt, who adds:
“Asset owners recognize they can earn a significant illiquidity premium and are allocating more assets towards private equity and alternative credit. If a fund can be a one-stop shop and satisfy investors’ needs for liquid and illiquid asset classes, you’re going to be in a very strong position. FIS is developing our systems to support managers in terms of their diversification objectives.”
Crucially, technology is leveling the playing field. Whereas in years past, only the biggest asset managers could deploy sufficient resources to scale up and move into new asset classes, this is now achievable for midmarket players, free of the burden of building internal systems and headcount.
“It’s all about technology plus service. It’s that combination we are utilizing to propel managers beyond their current scale,” asserts Headley.
Looking ahead, it is not inconceivable to suggest that specialist PE groups and credit hedge funds will find themselves fishing in the same waters, potentially leading to more acquisition or joint venture activity.
“If you look at the PE market it is quite overheated. There’s a lot of dry powder that needs to be put to work. I think managers will look more broadly to deploy that capital to exploit opportunities, so we might see more convergence in the credit space,” concludes Holt.