UK firm thinking long term, credit cycle in sights

Pear Diver Capital recently opened its first US office and also closed two new CLO funds. While the loan and CLO markets still seem to be immune from macroeconomic disruption, the company is preparing for a potential change in the credit cycle.

Matthew Layton, partner at Pearl Diver Capital, comments that the firm recently closed Pearl Diver Capital (PDC) Fund 7, totalling US$250m and, in line with previous funds, it will invest in CLO majority equity positions. In the same week, the company also closed a CLO mezzanine fund which will be its first evergreen fund.

Later in the year, the company aims to market and launch PDC Fund 8. investing in majority equity positions across European and US CLOs.

Concurrently, Pearl Diver has opened its first base in the US, an office in New York, in order to engage with the larger size of the CLO market there and to capitalise on its majority US investor base. As part of this, Tim Carroll – having joined from Moneda Asset Management – will head its US business development and marketing programme, reporting to Neil Basu.

In terms of ongoing strategy, Layton says that Pearl Diver is taking a forward looking approach and is now preparing for a potential movement in the general macroeconomic landscape.

Layton says: “By nature CLO equity is long credit therefore portfolios have to be constructed and managed to be able to withstand a credit cycle. This is especially true now that re-sets of CLOs have become the norm and transformed the asset class into a longer term semi-permanent vehicle.”

In terms of their selection process, Pearl Diver takes a discerning approach to CLO managers. “We track and monitor over 70 CLO managers grading their trading behaviour, style and performance through different vintages and periods of the credit cycle. The results show that it is not true that the longer standing, bigger managers always provide the best performance,” says Layton.

He points out that his firm also takes a highly quantitative approach to manager selection, as well as extensive monitoring of loan manager trading patterns. Additionally, he says the firm takes an “an extremely active role in structuring the CLO and drafting the documentation. The aim is to invest in CLOs which combine the best credit portfolios run by the best managers with the best CLO structures and documentation. It is this detailed and rigorous approach which we have applied to equity investing which will be applied to mezzanine investing.”

Recent events have also benefited firms such as Pearl Diver, including the easing off of a long period of spread tightening in the underlying loans, which, Layton says, will allow loan managers to build up spread, benefiting CLO equity cashflows. He adds that CLO liabilities recently saw the reversal of a tightening trend seen since mid-2016 to 1Q18, but CLOs still remain at tights seen at the end of 2017.

In general, Layton thinks that the floating rate nature of CLO notes still provide an advantage over other asset classes and are especially useful as a natural hedge when compared to other fixed rate products.

In terms of the future, Layton comments that the potential for rising corporate defaults is “always a concern” as is the ongoing deterioration in loan documentation quality and rising leverage on loans. However, he adds that Libor probably “needs to exceed 4% before most companies’ cash flows are challenged by their cost of debt.”

Additionally, while the potential for a turn in the credit cycle is a concern, Layton isn’t immediately worried with – for example – US macroeconomic conditions still very positive in terms of GDP growth, employment prospects and wage growth, reflected in strong corporate earnings. Layton concludes that it’s hard to see anything in the near term that will have a huge impact and that, “even the trade war has so far had only a very limited – if at all measurable – impact on leveraged loans.”