London-based Pearl Diver Capital has pursued investment opportunities across the global CLO market since 2008, when the firm was co-founded by industry experts Neil Basu and Chandrajit Chakraborty. The firm has a particular focus on sub-investment-grade tranches; but it also plays at the bottom of the capital structure, where it deploys a ‘control equity strategy’ by seeking majority control of the sub notes.
According to market sources, the firm’s seventh CLO fund is due to close in the coming weeks and will target control equity CLO positions, CLO mezzanine, and opportunities in CLO risk retention.
A control equity strategy has played a significant role in a number of the firm’s most recent funds. “We target control equity in both primary and secondary CLO markets and drive returns through re-financings and resets,” said CEO Neil Basu. “In return for the control equity investments, we expect a say in how the deal is structured and what the portfolio looks like. We also have the ability to call or refinance the deal at an appropriate time.”
With an overall target size of $400m-$500m, the firm’s latest fund is understood to comprise two sub-funds with separate return targets: the first focuses on control equity and CLO risk retention investments. Investors can expect returns in the mid to high teens range.
The second invests in CLO mezzanine positions – particularly junior mezzanine. Floating-rate return targets for this sub-fund are expected to be in the 7% to 8% range.
Both sub-funds are aimed at global institutional investors.
“We continue to focus on CLO equity in both the US and Europe,” said Mr Basu. “As well as being an anchor investor for certain deals, we also buy minority positions in the primary and secondary market.”
Pearl Diver’s funds typically lock in capital for five years and are not open to redemptions. Mr Basu explained that as Pearl Diver is a single-focus, pure-play CLO manager, it does not make sense to structure its funds like a hedge fund. “When the market becomes volatile and values drop, that is the point at which your investors will want to exit, based on purely technical factors,” he said. “Despite what some people may say, CLOs are not a highly liquid instrument. This is an asset class for patient capital. And in return for their patience, investors are rewarded.”
Mr Basu does not expect 2017 CLO equity returns to match the levels attained in 2016. Highlighting the repricing activity in the US loan market and a tightening of CLO liability spreads in the second half of 2016, he suggested that current primary CLO equity investments still make sense, but only just.
“Equity investors have had to bid up a little, so we have stayed on the sidelines in the first couple of months of the year so we can make sure we understand where the market is going,” he said.
BAML analysts commented in their weekly report that, besides tightening loan spreads that are likely to squeeze CLO equity returns, tight new-issue loan spreads are likely to make new CLO issuance difficult. They noted that after a steady tightening in new-issue Triple A spreads during 2016, the sharp tightening in mezzanine spreads at the start of 2017 has helped to further lower the weighted average debt cost for new-issue CLOs.
Nevertheless, the gap in Europe between loan spreads and weighted average CLO debt spreads is close to the tightest it has been since 2.0 issuance started in 2013, the analysts said.
Despite Pearl Diver Capital’s London base, the overall allocation of Pearl Diver’s CLO investments is heavily US-weighted, with a current ratio of 90% US to 10% European CLOs. According to Mr Basu, allocation is ultimately driven by deal supply.
“We follow the CLO market in terms of issuance volume. Our funds have a European basket and US basket. The large allocation to US CLOs is purely driven by supply. Should European CLO issuance increase, we could increase allocations in this jurisdiction.”
A substantial pick-up in European CLO supply seems unlikely in the near term, however, given that suitable collateral for deals is in relatively short supply. According to CapitalStructure CLO data, there have been just four European CLOs issued year-to-date, with a combined total of approximately €1.6bn.
“The underlying raw material is not available in Europe,” said Mr Basu, adding that the US loan market also benefits from better liquidity, more diversity and, in his opinion, lower idiosyncratic risk.
Political and prepayment risks loom
Prepayment risk and political risk are two of the most pressing issues for the CLO market in the year ahead, according to Mr. Basu. Prepayments for CLOs coming out of investment periods could pose issues for managers in particular.
“Managers faced with amortizations around year three or year four of a deal have a very limited supply of loans with which to reinvest, so if prepayment rates are high, managers have to find new loans that fulfill specific criteria. New loan supply may not be able to meet that need,” said Mr Basu.
BAML’s CLO analysts also noted that tightening loan spreads and the loan repricing wave have presented an immense challenge to CLO managers who are looking to reinvest prepaid proceeds and ramp up new-issue portfolios. “The compressed arbitrage also makes equity investments less attractive,” they noted. “That said, equity investors see increased value for the underlying options of their investments. The dynamic nature of CLO vehicles also makes it difficult to rule out the long-term value of CLO equity investments.”
Underlying loan default rates will also weigh on CLO investors’ minds, although Mr. Basu expects the rate to be relatively benign in the short to medium term.
Meanwhile, new political administrations in the US and Europe are also likely to generate volatility in CLO markets. In Europe, the unknown effects of Brexit, elections in Germany and France, and the unresolved Greek debt crisis could provide pockets of volatility for loans backing CLOs.
For example, BAML credit strategists have noted a high correlation between European credits and French OATs going into the French elections: with France now the largest country exposure in CLO portfolios, the sector is vulnerable to election-related market volatility, they suggested.
At the same time, political ructions may ultimately increase liquidity in the CLO market, should the Volker rule or Dodd-Frank be scaled back in the US. “We think that the scaling back of Volker rule is a possibility,” said Mr Basu. “If it happens – and banks are able to resume trading certain securities – that has got to be good for liquidity.”
Number of funds: Six, soon to be seven CLO funds, typically sized between $250m and $400m.
Total AUM: Undisclosed.
Investments: US and European CLOs, predominantly equity and mezzanine.
Fund structure: Private-equity style format. Capital typically locked in for five years with quarterly distributions of 5%-7%.
Team: 12 professionals in total, led by Neil Basu, CEO, managing partner and co-founder and Chandrajit Chakraborty, CIO, managing partner and co-founder.