A short diversion to focus on one of the sectors that I’ve been looking into recently, listed credit funds (i.e. not the traditional investment grade or high yield ETFs): since the beginning of 2022, euro-denominated IG corporates (-14%) have indeed been hit harder than European equities (around -3%). Credit & distressed hedge funds also had a bad year.
For historical reasons (it has the biggest pool of capital and number of international banks / asset managers), the London Stock Exchange is by far the favourite venue for European closed-end funds and investment trusts. Below is a list of the “debt” funds that I find interesting (there are others that I have excluded, the full list is available from the Association of Investment Companies):1 there might be more debt funds listed on other European exchanges that I’m not aware off.2
And this is their recent performance:
While not the largest by AUMs, the one that caught my eye is Blackstone Loan Financing Limited (BGLF LN), for the underlying securities (CLOs are floating rate) and for the sponsor’s name and track record: given the size of Blackstone’s private capital business it should have some sort of priority access to the most interesting opportunities in the space.
“Funds run by heavyweights such as Blackstone Inc., Ares Management Corp., Apollo Global Management Inc., HPS Investment Partners and Goldman Sachs Group Inc.’s asset management division are among a number of funds to have used the confidential agreements, known as side letters, in financing recent acquisitions in a variety of ways, said the people, who asked not to be identified discussing confidential matters.”
“[…] More than a dozen lawyers and fund managers spoke to Bloomberg News about the increasing use of side letters. While they declined to cite specific deals in which the agreements have been used, they said the letters might, for example, allow a lender to get more frequent updates than other creditors on a borrower’s financial health.
Other potential terms include better pricing - a private lender can negotiate a bigger so-called original issue discount that increases the return on the loan - as well as greater restrictions around further borrowing than contained in the main financing documents.” (“Private Debt Titans Use Hidden Contracts to Get an Edge on Rivals”)
Last but not least, it’s traded in EUR and more than half the portfolio is invested in EUR-denominated securities: other funds have typically a much higher allocation to USD (regardless of the currency of trading).
Among the funds in the table above, I also like – but have not done any deep dive analysis - Chenavari Toro Income Fund (similar strategy to BGLF) and BioPharma Credit (senior secured loans to listed companies; $1.2 bn invested across just 12 transactions; only invests in approved life sciences products, so nothing with clinical trial or approval risk).
Some quick facts on CLOs (and how to invest in them)
Probably not necessary, but better dot the i’s and cross the t’s, and also bust some myths.3
CLOs are not that complex, and their structure does not make them inherently risky. A CLO is a simple financial entity with assets on one side (a portfolio of leveraged loans compiled by the CLO manager), financed on the liabilities side by issuing floating-rate bonds in tranches with varying levels of seniority and credit ratings (from AAA to BB). The interest and principal payments of these bonds are made using the cash flows from the underlying loans, and the debt tranches are always paid in order of seniority. The cash flows left over after the debt has been serviced go to the equity tranche, which offers the highest return potential but also the greatest risk, as it absorbs the initial losses if the loans in the portfolio default.
Today, CLOs are the biggest buyers of non-investment grade loans, with pretty standardised structures and terms.
Given their structure, CLOs allow investors to target a very specific risk / return profile, from AAA slices with no prior defaults (but never say never) to the equity tranche, with theoretical returns in the low teens.
CLOs are not CDOs (which caused mayhem in 2008): for a starter, they are currently structured more conservatively than before 2008.
CLOs are also backed by simpler, more diversified pools of collateral, as they are almost entirely composed of first lien senior secured loans, which sit at the top of a company’s capital structure and thus have senior claims in the event of a bankruptcy. The collateral of CDOs mainly consisted of subprime MBS (not the senior-most tranches of mortgage-backed securities), and CDOs backed by other CDOs (so called CDO-squared) were common. And while CDO collateral was highly correlated (the values of all the assets were dependent on real estate prices and mortgage availability), in contrast CLOs have diverse portfolios of loans that span many industries, so a problem in one part of the economy is unlikely to affect all of these loans in the same fashion. Finally, contrary to what happened to CDOs (where the creditworthiness of the underlying borrowers wasn’t monitored after origination – as the originators and bankers were highly incentivised to continue churning out mortgages, mortgage-backed securities, and CDOs), CLOs are actively managed and regularly receive detailed financial statements about the underlying borrowers. Active management also enables CLO managers to act opportunistically and buy loans at discounts when market volatility increases, potentially mitigating any losses that do occur. (This process is referred to as “par building”.)
Historically, defaults on CLOs are very, very low: they did experience significant volatility during the GFC, as well as during the Covid-19-induced market panic in 2020, but this volatility didn’t translate into widespread permanent losses. In fact, default rates among CLOs are not only lower than those of CDOs, but also lower than those of similarly rated corporate bonds.
Retail investors participate in the market underpinning CLOs, leveraged loans, via floating rate loan funds, public/private BDCs, and more, although their (direct) ownership is not material.
In the US there are dozens of mutual funds and ETFs dedicated to floating rate loans: one example of ETFs is SPDR (State Street) Blackstone Senior Loan ETF, managed (again!) by Blackstone. For those interested in owning CLOs, there are also some opportunities via ETFs (only available for US investors):
BlackRock AAA CLO ETF (CLOA)
Janus Henderson AAA CLO ETF (JAAA) and B-BBB ETF (JBBB)
VanEck CLO ETF (CLOI)
Panagram BBB-B CLO ETF (CLOZ)
Only JAAA has some “size” (around US$2.6 bn in assets), the other ETFs are all well below the US$100m mark (even the Blackrock and Invest ETFs only have around US$30 million in assets). To be honest, I’m not sure why these exist: I can understand an AAA ETF positioning itself as a cash alternative (although the rebalancing of these illiquid assets could eat up a lot of the yield), but there also several scenarios where these ETFs can get into short-term troubles (inflows/outflows due to market sentiment). I believe that these assets are better held via a permanent structure, i.e. closed-end funds.
So, back to BGLF
First of all, it’s Blackstone, so it’s complicated (also on fees).
BGLF was incorporated on 30 April 2014 and is registered under the laws of Jersey: it provides investors with exposure to a loan investment company, Blackstone Corporate Funding (BCF), incorporated in Ireland. That’s the trick: BGLF invests in European and US floating rate senior secured loans and bonds solely and indirectly via BCF, of which it owns around one third (the rest is owned by other Blackstone entities and their clients). BCF ha around €1.2bn in assets, of which €400m “belongs” to BGLF.
According to tikr.com, Blackrock is BGLF’s largest shareholder (23%) followed by Quilter (~20%), a UK wealth management platform (so holding the shares on behalf of their clients). Blackstone Inc. (BX) owns a further 10%. These “niche funds” are typically used by wealth managers for private clients, not by big institutional investors (which can access these alt strategies directly): they very rarely appear in mutual funds run by Fidelity or Schroders, so I’m surprised Blackrock is the biggest shareholder (still trying to find out whether via some ETFs of active funds).
BGLF was initially called Blackstone/GSO Loan Financing, as it was launched under the GSO brand, a multi-strategy credit hedge fund that Blackstone acquired in 2008.4 That acquisition was a massive success, growing GSO assets and Blackstone credit business from $10 billion at the time of the purchase to nearly $130 billion in 2020. But the two companies had different cultures (and also different pay structures) that led to internal fights: Ostrover moved from managing money to being just an adviser to Blackstone in 2015; Smith left for other opportunities in 2018 and Goodman “retired” in 2019, when many senior analysts and traders had already departed. In 2019 Blackstone removed the GSO letters from all their funds and strategies.
Further, in 2018 shareholders in Carador Income Fund (CIFU), an Ireland-based closed-end fund investing in CLOs and also managed by Blackstone/GSO, were given the opportunity to either have their capital returned or to be “rolled-over” into BGLF: those who chose the latter were given newly issued BGLF C-shares in consideration for the transfer of a pool of CLO assets. After the sale of most of these assets, in 2019 the C-shares were converted into ordinary shares.
How do BGLF/BCF invest and is it a good opportunity?
BGLF target a performance in the mid-teens net total return per annum, predominantly coming from dividend income. Dividends are paid quarterly with a target 10% p.a. (on the €1.00 per share IPO issue price).5 In January BGLF announced that it plans a total 2023 dividend of between €0.08 and €0.09: €0.02 for the first three quarters and a final payment of a variable amount to be determined at that time. At the current €0.67 share price, that means a dividend yield of between 11.9% and 13.4%.
BGLF does not use gearing at all, while at BCF level senior secured loans may be levered up to 2.5x with term finance. Hedging derivatives are allowed: BCF can buy securities denominated in EUR, USD and GBP and for non-EUR securities it will use hedging if and when required.
In terms of maximum exposure:
Per obligor (i.e. company): 5%
Per industry sector: 15% (with the exception of one industry per time, which may go up to 20%)
To obligors rated lower than B-/B3: 7.5% (in total)
To second liens, unsecured loans, mezzanine loans and high yield bonds: 10%
BGLF does not charge directly either management or performance fees; at BCF level, Blackstone Credit (i.e., the entities managing Blackstone’s CLO platform and the adviser to BGLF) earns a 50bps management fee and a 10bps performance fee on the aggregate principal balance of each CLO with an IRR trigger of 12%. However, Blackstone Credit rebates around 20% of the CLO management fees to BCF: after costs allocations, the net rebate is expected to be at least 10% of the management fees received by Blackstone Credit.
Overall, under the AIC methodology, the ongoing annual charges for BGLF are 0.4%.
The portfolio is very actively managed: for example, in 2022 BCF purchased €1.5bn and sold €1.3bn of assets (including CLOs and warehouse portfolio). Since 2019, BGLF also repurchased approximately 8% of its outstanding shares at an average price of ~€0.75.
Thankfully, BGLF provides a lot of information on the underlying investments and their performance: both the monthly factsheets and the quarterly update break down the performance across each single CLO owned and by vintage.
On a look through basis, the portfolio is currently invested in primarily senior secured and floating rate assets almost equally split between EUR CLOS and USD CLOs, and is diversified over 675+ issuers across 29 sectors and 26 countries, with the top 10 issuers combining for around 9% of NAV.
According to its own marketing literature, BGLF has performed well and delivered market-beating returns across different periods.
However, the nice light green bars in the chart above are somehow misleading: indeed, the company provides a reconciliation of published NAV to IFRS NAV, an exercise which has been done on a semi-annual basis since 2018 and quarterly more recently.
As at March 2023, the published NAV/share (“mark-to-model”) was €0.9069 while the IFRS NAV/share (“mark-to-market”) was €0.6844, which means that as of today BGLF is not trading at a juicy 26% discount to NAV but rather at just a 2% discount to a more conservative valuation of its portfolio.
The difference is entirely due to the valuation bases used:
“The Company publishes a NAV per ordinary share on a monthly basis in accordance with its Prospectus. […] These valuations are, in turn, based on the valuation of the BCF portfolio using a CLO intrinsic calculation methodology, which we refer to as a "mark to model" approach. As documented in the Prospectus, certain "Market Colour" (market clearing levels, market fundamentals, BWIC, broker quotes or other indications) is not incorporated into this methodology. This valuation policy is deemed to be an appropriate way of valuing the Company's holdings and of tracking the long-term performance of the Company as the underlying portfolio of CLOs held by BCF are comparable to held to maturity instruments, and the Company expects to receive the benefit of the underlying cashflows over the CLOs' entire life cycles.” (BGLF 2022 Annual report)
Conversely:
“[…] to comply with IFRS as adopted by the EU, the valuation of BCF's portfolio is at fair value using models that incorporate Market Colour at the year-end date, which we refer to as a "mark to market" approach. IFRS fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants as at the measurement date and is an "exit price" e.g. the price to sell an asset.“ (BGLF 2022 Annual report)
While the mark-to-market NAV can be higher than mark-to-model (it happened in early 2021), it is typically lower - sometimes much lower - during market dislocations, as during 2020 and today. Since BGLF started publishing it, the market price has been more aligned to the IFRS NAV than published NAV.
To buy or not to buy?
If you’re looking for something that will compound over time and outperform equity markets, this ain’t it: this is purely a yield play, with regular dividends paid out every quarter from a portfolio of credit instruments.6
A quick summary of the pros and cons of BGLF:
Pro
It mostly invests in the “safest” portion of the leverage loan market
Long-term realised returns from loans and CLOs have been robust during normal market conditions and even the last financial crisis
Returns from loans benefit from rising interest rates, provided default rates remain low
Current high annualised dividend yield is sustainable given the prevailing CLO distribution rates
Being exposed to the entire CLO life cycle ensures the full value is captured: the CLO warehouse structure allows the managers to take advantage of credit market dislocations and issue new CLOs quickly when the opportunities arise
Substantial investment in BGLF by Blackstone should provide investor alignment
Weaknesses
Published NAV is not a reliable measure of performance and “cheapness”: do read the fine prints!
Not much liquidity in the shares: prices can swing much more than NAV in periods of stress
A recession will see a rise in realised loan defaults, negatively affecting the performance of the BGLF/BCF investments
Concerns over the rise of covenant-lite loans, possibly leading to credit downgrades of underlying collateral, increased risk and lower recovery rates
Inability to extend reinvestment periods due to market conditions
Rising defaults are obviously the main risk to BGLF’s juicy dividends, but current market metrics (in aggregate) do not point (yet?) to a significant deterioration. What will happen in the next few months is anyone guess: for what is worth, we don’t even know if we are in recession (already have been?) or if we’ll ever have one (“hard or soft landing, sir?”).
Things like private credit, leveraged loans, CLOs, … have been in the headlines as the next thing to blow. There is a tendency (by credit specialists, too) to paint private credit as a binary scenario: either “It’s free money!” or “Good Lord, it’s 2008 over again, aaarghhh!!!”. In reality, it’s likely shades of gray: there are some difficult deals that banks can’t sell – especially debt issued to finance LBOs - because they were priced in far rosier times: Citrix and Twitter are just the two most famous names here, but that’s not representative of the entire market.
There are also some real garbage private credit lenders out there (in terms of quality), and some that actually care about not losing investors’ money. But when rates (and defaults) are low, all you see are top-line metrics that look the same. Giant asset managers tend to “shadow” support their issuance, with their financial metrics just not showing this support.
I personally have no clue of what will happen, but some of the expected returns for CLO tranches (in particular in the European space) are now very interesting, especially the equity tranches for those with a high risk appetite.
As explained, the discount from NAV might not be - by itself - the best representation of value. But a 26% discount rate – as used in the mark-to-market valuation for BGLF – is punitive for senior loans (although leveraged), a “2008 crisis scenario” I would say.
With the usual boilerplate provisions (“past performance blah blah blah, …”), if (and it could be a big if) default rates stay low, these managers are going to make a lot of money.
On LSE there is also a listed credit hedge fund, Highbridge Tactical Credit Fund Limited (HTCF LN), but in December 2020 the company entered into a managed wind down: it is currently being liquidated with capital returned to investors over time.
Euronext does have some and a specific sector for “Closed end investments”, but it does not allow to search all its listed companies by sub-sector unless one subscribes to their data feeds.
For those interested in the mechanics of CLOs, I highly recommend this website which has tons of resources on the private credit/leveraged finance world: I’ve taken most of the charts from there.
GSO are the initials of the firm’s founders: Bennett Goodman, Tripp Smith and Doug Ostrover.
BGLF is traded in EUR since the IPO in 2014, but in June 2017 a GBP class was also introduced under the ticker BGLP LN.
Investment trusts trade like equity but they might not be available to buy in every jurisdiction or have other restrictions/limitations (for example regarding their tax status). Also, income is returned in the form of dividends, so non-UK investors need to make sure to avoid double taxation. Please do your own research.