Year: 2020

As reported by the SEC, there are 68 active interval funds offering unique access to less liquid investments including real estate, mortgage-backed securities, corporate debt, and structured products. The chart below shows the current makeup of these active interval funds, which total $33.5 billion in net assets.

Fig 1. Source: intervalfundtracker.com

Liquidity

Interval funds are a type of closed-end fund. They offer more liquidity than traditional closed-end funds and less liquidity than open-end mutual funds. Per the Investment Company Act of 1940, open-end funds are prohibited from investing more than 15% of their net assets in illiquid assets. Closed-end funds are uncapped and able to invest the entirety of their portfolio in illiquid assets. Interval funds provide a unique alternative to these typically binary options. While interval funds are uncapped and allowed to invest beyond the 15% concentration limit on illiquid assets, they do offer investors periodic liquidity through tender offers that are typically quarterly. Interval funds’ liquidity is limited and for all intents and purposes should be considered a less liquid investment designed for long-term growth. However, compared to similarly illiquid asset structures found in closed-end funds or GP/LP structures, interval funds offer a better liquidity profile.

Below is a chart to summarize the key attributes of closed-end, interval fund, and open-end fund structures:

Repurchase Period

At the predetermined buyback period, interval funds will announce a percentage of all outstanding shares they are willing to buy. This percentage is usually close to 5% but can be as much as 25%. These repurchases are done pro-rata, meaning fund managers allocate all repurchases proportionally and there is no guarantee an investor can redeem the number of shares they want to during that period. This repurchasing structure restricts selling opportunities and reduces liquidity. However, it also reduces the risk that the fund manager becomes a forced seller of assets potentially incurring unnecessary losses.

Why Invest in Interval Funds?

• Interval funds allow investors to capture the illiquidity premium available in less liquid asset classes, while still investing in an SEC regulated entity and maintaining some level of liquidity.
• Interval funds make less liquid asset classes, typically reserved for institutional investors, available to retail investors without the accredited or qualified investor limitations.
• Using interval funds, asset managers can adopt alternatives investment strategies with greater liquidity than typically found in GP/LP investment structures and stronger regulatory oversite than a GP/LP structure. GP/LPs are often structured with draw down provisions that make for an inefficient use of capital as investors retain cash in anticipation of capital calls.

Interval Fund Risks

• It’s important that investors understand the liquidity limitations of interval funds. You get the benefit of expected higher returns in exchange for less liquidity. As a result, interval fund investors should have longer term investment horizons.
• Investors should also understand how a particular interval fund is structured to address its liquidity needs. The fund should have sufficient cash, cash flow and/or liquid assets to meet the periodic tenders.

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On October 21, 2014, the final rules implementing the credit risk retention requirements of the Dodd-Frank Wall Street Reform and Consumer Protection Act were issued (the “U.S. Risk Retention Rule”).  U.S. Risk Retention Rule required a CLO manager or affiliate to retain not less than 5% of the credit risk of the assets collateralizing the CLO.  This could be achieved by the CLO manager owning approximately 50% of the CLO’s equity or a 5% vertical slice of all the CLO’s securities rated AAA down to equity.  It was expected that CLO issuance would be negatively affected by these new requirements, but the opposite turned out to be true.  CLO managers were successful in raising risk retention funds from their largest institutional investors, which was used to satisfy the new requirements.

The risk retention requirement ended on April 5, 2018, when it was successfully challenged in court.  However, risk retention funds continue to exist.  The business agreement between the CLO manager and the fund’s investors will likely continue until all the fund’s capital is called. 

Source: Wells Fargo Research, January 2020

Risk retention funds enabled investors to participate pro-rata in a CLO manager’s next several years of issuance, with the largest managers issuing around four new CLOs a year.  The risk retention fund’s investors were often given management fee rebates to entice them into the fund.  However, management fee rebates have been available in the CLO market for a long time and participation in a risk retention fund isn’t required to benefit from them.    

It is our belief that investors in these funds will be disappointed with their returns.  It’s not because CLO equity doesn’t offer favorable risk-adjusted returns.  It’s because the way the funds approach the market is fundamentally flawed. 

To contrast, for an independent investor in CLO equity, the market is large at approximately $60 billion.¹  There are over 100 managers issuing new CLOs and over 1,000 existing CLOs that could be invested in.¹  Also, many independent investors buy the junior debt securities issued by CLOs when those securities offer high rates.  An independent investor may invest in the primary market when CLOs are created or invest in a CLO that began its life in 2014.  Most independent investors would want to be diversified by CLO manager and by the year of CLO issuance. 

For the the risk retention funds, the investment universe is quite small – subsequent CLOs issued by a single manager.  All other managers and the entire secondary market for CLO equity tranches are excluded.  The pre-selected investment universe is less than 1% of the overall market!  This is a recipe for underperformance. 

In 2019, the debt costs for new CLOs were elevated.  And the difference between the interest earned on the CLO loans and the interest paid on the CLO’s debt (the “arbitrage”) was at multi-year lows.¹  At the same time, CLOs issued prior to 2019 were available in the secondary market that provided attractive risk-adjusted returns; that is where many independent CLO investors saw the best value.  However, the risk retention funds continued to call capital and create new CLOs that arguably should not have been formed.  Because the manager of a risk retention fund gets paid on assets under management, the incentive for the manager is to keep creating new CLOs.      

CLO market participants like to break managers into different tiers. For example, a CLO manager that has a large investor following and good historical returns is considered a tier one manager, while a newer CLO manager might be a tier three or four manager.  Since relative returns are constantly changing, managers’ categorizations are changing as well.   An investor in a risk retention fund may find that its long-term commitment is to a CLO manager whose reputation isn’t what it once was.  The independent CLO investor can quickly invest away from underperforming managers.      

Risk retention fund investors may recognize these issues.  At CLO conferences their strategy is discussed with incredulity on various panels.  If these funds truly marked their holdings to market, fund investors would have put pressure on the managers to stop calling capital a long time ago.     

While the CLO market can be difficult to understand for someone who doesn’t work in it daily, I often find it helpful to give analogies to the equity market.  Imagine being approached for a new equity fund with this pitch: “Invest in our fund today, and we will do the next six IPOs underwritten by investment bank X.  We don’t care about the company’s profitability, business model, management team, etc.  We are doing the next six deals!”  It’s hard for me to imagine this being a successful strategy, but that is the equity-equivalent to risk retention fund investing.  

(1) The CLO Market Monthly Overview, February 2020, Wells Fargo Securities

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While the proliferation of cov-lite loans has garnered significant press, the detailed structure of loan agreements even when a covenant is present is critical to the embedded risk in a given loan.

Imagine you decided to build a waterfront home. One of the first and most important things you will do is hire an architect to draft a detailed blueprint for the engineers and contractors to follow. This blueprint will include everything from your foundation to the electrical layout of the house, which impacts the way you will use your home post-construction. Further, the blueprint will give you peace of mind, ensuring there are clear guidelines on how the home will be developed and that the contractors don’t have free reign.

Think of a credit agreement as a blueprint for leveraged loans. Credit agreements state how a company (the borrower) can act and dictates the term-loan investors’ rights. To protect your investors and advise them well, you must be well-versed in the anatomy of credit agreements and critically examine the elements of their construction. Here’s what you should hold top-of-mind when considering a loan’s structure.

Financial Covenants

In leveraged finance, there are two main credit agreements: cov-lite and non-cov lite, and each is defined by whether or not it is governed by financial promises called covenants. Cov-lite means that the term loan in question does not have a financial covenant and leaves the investor with less decision-making authority when the company faces financial hardships. Non-cov-lite means that the term loan has financial covenants, which give the investors more control over the investment when a company’s financial performance deteriorates.

Common financial covenants include:

Leverage Covenant = Company’s total debt less cash on hand divided by Earnings Before Interest, Tax, Depreciation, and Amortization (“EBITDA”). For example: “a company’s total debt cannot be more than 6x its EBITDA”

Interest Coverage = Company’s EBITDA divided by their interest expense. For example: “A company’s interest coverage cannot be less than 2x its EBITDA”

Defining EBITDA is Critical

The power of each financial covenant hinges on the definition of EBITDA in the agreement. EBITDA is a term that is as frequently used in a credit agreement as latte is used in a Starbucks. Not every latte is the same, just like the definition of EBITDA it is different in each credit agreement. It is crucial that EBITDA is clearly defined in a credit agreement and that a company does not have free rein in creating EBITDA add-backs, which are usually classified as non-recurring one-time expenses, restructuring expenses, management fees, etc. A credit agreement should cap each individual add-back at a dollar amount or a percentage of EBITDA, in addition to capping the total amount of add-back as a percentage of EBITDA. (For example, “total add-backs cannot exceed 25% of EBITDA.”) It’s a misstep to assume general conditions for EBITDA. The definition of EBITDA can make or break your financial covenants, as EBITDA can be easily inflated with egregious add-backs.

The Value of Negative Covenants

n addition to financial covenants, it is also important to look for tight negative covenants. Unlike a financial covenant, which binds the investor, think of a negative covenant as a restrictive measure on what a company can and cannot do. Negative covenants play an extremely important role, as they govern the amount of additional debt a business can incur, subsidiaries they can sell, IP they can transfer, payments they can make, etc. For example, someone that invests in a first lien term loan needs to ensure that another party cannot file a superior lien on the same assets. A credit agreement should cap incremental debt and/or carve-out a dollar amount for said debt and subject it to an acceptable leverage ratio.

Freedom for Unrestricted Subsidiaries

In regards to a company’s freedoms, it is also important to ensure that the credit agreement captures a company’s ability to form and transfer assets to unrestricted subsidiaries. Unrestricted subsidiaries are not included in the credit facility and are not subject to covenants or any other terms of the credit agreement. J.Crew is a great example of a company that found and capitalized on a loophole in its credit agreement. In 2017, J.Crew had notes that were due and needed to raise additional debt. So through multiple inter-company “investments,” the company transferred ~72% interest in its trademarks (worth ~$250MM) to an unrestricted subsidiary. This subsidiary now held the collateral, which was meant for the first lien term loan investors and used it to raise additional debt on the newly created subsidiary.

Summing Up

Like a well-built home, a loan is only as good as its foundational framework. Identifying properly structured loans with reasonable financial and negative covenants, a clear definition of EBITDA, and breathing room for unrestricted subsidiaries, is critical in choosing high quality, low-risk investments. The best way to maximize the use of higher quality loan structures is through employing a capacity-constrained strategy. In today’s market, smart credit investors need to position their funds to pass on the increasing number of poorly structured loans.

At Flat Rock, we focus on traditional covenanted middle market investment opportunities, which include negotiated credit agreements that offer our investors critical protections. As we continue to screen new opportunities, we look out for the aforementioned touch points in our credit agreement analysis and negotiation.

For further information feel free to email info@flatrockglobal.com