Carador Income Fund Carador Income Fund (CIFU), managed by GSO Capital Partners (of the Blackstone Group), has underlying investment exposure to a highly diversified portfolio of US corporate senior secured loans through direct investments in collateralised loan obligations (CLOs). The portfolio is split (c 50:50) between US CLO income notes and mezzanine debt. Income notes are still producing high cash income returns, but these have reduced with the increase in loan refinancing and re-pricing at lower spreads. The reduction in income note cash flow has been reflected in the market value of these investments. Meanwhile, mezzanine debt investments have increased in value as investors seek attractive yield opportunities. Despite the pressure on cash flows, management believes that assuming current market conditions continue, the Q1 dividend is a reasonable guide to future 2013 payments, annualising at US$0.136 (a 13.1% yield).
Investment trusts 17 June 2013
Price
US$1.04
Market cap*
US$560m
AUM
US$538.3m
NAV*
US$0.9908
Premium to NAV
4.0%
*Company NAV as at 30 April 2013 ex-dividend. Yield*
13.1%
*Based .Q113 dividend annualised.
LSE
AIC sector
SSD
Share price/discount performance 10
1.1
5
1.0
0
0.9
-5
0.8
-10
Mar/13 Apr/13
1.2
Jan/13 Feb/13
gains. More recently, investors’ search for yield has seen loan spreads narrowing, driving high levels of loan re-pricing/refinancing, reducing current and expected future cash available to CIFU’s income notes (albeit from high levels), and this has been reflected in the valuation of the income notes. Mezzanine debt investments have seen their lower but more stable cash flows reflected in higher valuations.
Primary exchange
Nov/12 Dec/12
Through direct investment in CLO income notes and mezzanine debt, CIFU is exposed to a diversified portfolio of US senior secured bank loans. Over the past three years, its investments have benefited from strong cash flow and revaluation
CIFU
CIFU LN Equity
Discount (%)
US corporate loans via CLOs
543.3m
Code
Sep/12 Oct/12
Note: *Twelve-month rolling discrete performance.
Ordinary shares in issue
Aug/12
S&P 500 TR (%) 38.8 17.2 4.8 16.9
Jun/12 Jul/12
Total NAV return Credit Suisse HY (%) US$ (%) 26.5 41.5 58.3 11.1 18.8 7.9 30.6 13.3
May/12
30/04/10 29/04/11 30/04/12 30/04/13
Total share price return (%) 71.5 100.6 12.1 23.7
Share Price
12 months ending
Discount*
*Positive values indicate a discount; negative values indicate a premium.
Three-year cumulative perf. graph 500
Valuation Stronger underlying loan prices and improving mezzanine debt valuations have been more than offset by declining income note valuations ytd. However, with still high income in absolute terms, NAV total return has been an annualised 5.9%. Management guidance suggests a prospective 2013 dividend yield of c 13%. The NAV is struck at market value (P/NAV 1.04x), a reasonable guide to liquidation value, but the real value is in the dividends and principal returned over the life of the fund. If shareholders decide to extend the fund’s life, we see the prospect of continuing attractive returns, although lower than in recent years.
200
Apr/13
Jan/13
Jul/12
Oct/12
Apr/12
Oct/11
Jan/12
Jul/11
Apr/11
Jan/11
0
Jul/10
100
Oct/10
The company believes there is now an attractive opportunity to commit an increasing amount of capital to primary (new) CLO income notes, in addition to ongoing but diminishing investment in the secondary market, CIFU’s current focus. An EGM on 26 June 2013 will consider a number of proposals, including extending the life of the company (replacing a 2017 continuation vote with a redemption opportunity), which will give CIFU the flexibility to pursue this objective.
400 300
Apr/10
Proposals to extend the life of the fund
CIFULN Equity Credit Suisse HY US$
52-week high/low
US$1.12
US$0.90
NAV* high/low
US$1.06
US$0.86
Gearing Gross
0.0%
Net cash
-2.1%
Analysts Martyn King
+44 (0)20 3077 5745
Matthew Read
+44 (0)20 3077 5758
[email protected] Edison profile page
Carador Income Fund is a research client of Edison Investment Research Limited
Exhibit 1: Fund at a glance Investment objective and fund background Carador Income Fund (CIFU) is an Irish-registered, closed-ended investment company, launched in April 2006 and listed on the main market of the LSE. It aims to produce attractive and stable returns with low volatility compared to equity markets, through investments in a diversified portfolio of equity and mezzanine tranches of CLOs.
Recent developments 24 May 2013: Notice of EGM 22 April 2013: Q113 dividend per US$ share: US$0.034.
Forthcoming AGM Preliminary results Year end Dividend paid
Fund details Group The Blackstone Group Manager GSO Capital Partners Address 40 Berkeley Square, London, W1J 5AL Phone +44 (0)20 7758 9000 Website www.carador.co.uk
Capital structure Est. TER* Net cash Annual mgmt fee Performance fee
30 June 2013 2013 31 December Quarterly
Launch date 1 April 2006 Trust life Wind-up date 2021 Loan facilities Portfolio top 10 look through exposures by individual issuers Issuer HCA Aramark Mediacom First Data Energy Transfer RPI Finance Trust (Royalty Pharma) Warner Chilcott Texas Competitive Electric Sungard Dtat Systems Ausrion Security breakdown (as at 30 April 2013)
Rating Ba3/BB B1/BBBa3/BBB1/B+ Ba2/BB Baa2/BBBBa3/BBBCaa3/CCC Ba3/BB Ba2/B+
Income notes (unrated) (49.9%) Mezzanine notes (Original Rating A/BBB/BB/B) (48%)
1.81% -2.1% 1.5% 13% on NAV total return > 12m $LIBOR + 2%. 2021 None
Sector Healthcare Food Service Cable Television Financial Intermediaries Oil and Gas Financial Intermediaries Healthcare Utilities Financial Intermediaries Insurance Portfolio by par value and NAV (as at 30 April 2013)
Holding 1.03% 0.93% 0.92% 0.86% 0.85% 0.74% 0.71% 0.69% 0.66% 0.65%
Portfolio by par value of securities Mezzanine notes (original rating A/BBB/BB) Income notes (unrated)
US$276,935,597 US$317,559,780
Portfolio by NAV of securities Mezzanine notes (original rating A/BBB/BB) Income notes (unrated)
US$258,372,059 US$269,055,889
Cash (2.1%)
Top five S&P sector exposures (as at 30 April 2013)
Currency breakdown (as at 30 April 2013)
Healthcare (11%) Business equiment and services (8%) Electronics/electric (5%)
US$ (100%)
Retailers (except food and drug) (5%) Financial intermediaries (4%)
Source: Carador Income Fund, Edison Investment Research. Note: *TER is Q113 estimated TER annualised.
Carador Income Fund | 17 June 2013
2
Update CIFU is an Irish-registered, closed-ended investment company, launched in April 2006 and listed on the main market of the LSE. Its investment objective is to produce attractive and stable returns with low volatility compared to equity markets, by investing in a diversified portfolio of CLO securities, income notes (50%), and mezzanine (48%) and senior debt (nil). Underlying the CLO investments is a highly diversified portfolio of US bank loans, predominantly senior secured loans. For a more detailed summary, please refer to the note High-yield, low-volatility NAV (February 2013). The company is seeking shareholder approval at an EGM on 26 June 2013 to, among other things, extend its likely life (replacing a 2017 continuation vote with a redemption opportunity), thereby giving it the flexibility to increase its exposure to primary (new) CLO income note transactions. The company believes that recent market developments, primarily a lower cost of debt to newly issued CLOs, have increased the attractiveness of the income notes in a newly created CLO, providing investors with an attractive risk-adjusted alternative to the managed wind-down of the current pre-financial crisis, income note portfolio. We believe shareholder returns under this proposal will be potentially attractive, although lower than the exceptional returns of the past three years. These have benefited from enhanced cash flows (higher loan spreads versus pre-financial crisis CLO funding spreads) and a re-rating (as investors have become more comfortable with risk while seeking yield).
The US loan market continues to perform strongly… The US loan market has continued to perform strongly in 2013 to date. New loan issuance has been strong, supported by heavy re-pricing and refinancing of existing loans. Demand for loans has been strong, driven primarily by loan funds and strong new CLO creation (there was US$29.9bn of new US CLO creation in the first four months of the year compared with US$54bn in 2012 as a whole, already sharply increased on recent years). Credit performance remains benign. In April 2013, the 12-month lagging default rate for 2012 was 1.91% (by principal amount), an increase from December 2012’s 1.27%, but well below the long-term average of c 3%. The general expectation is that credit quality will remain benign in 2013. Even in Europe, the market has seen its first CLO issuance since the financial crisis, with five issues to date in 2013. CIFU has been wholly invested in the US since early-2012, but is keeping a watchful eye on Europe, where CLO debt spreads are generally higher.
… But diminishes the outlook for the ageing portfolio It may seem paradoxical to some investors, but the strength of the US loan market, the assets that underlie the CIFU portfolio of CLO investments, has actually been negatively affecting cash receipts (although these remain strong) and the market valuation of its investments in CLO income notes (49.9% of the portfolio at 30 April 2013, compared with 56.1% at 31 December 2012). This is because the wave of primary loan refinancing at lower spreads has reduced the interest income flow into the CLOs, which is then reflected in lower residual (or excess) cash flows available to income notes after payment of interest on CLO debt funding (at fixed, unchanged spreads). The market valuation of CLO income notes reflects both the net present value of the expected excess spread plus the expected CLO NAV attributable to the income notes once the senior and mezzanine debt has been repaid. Rising loan prices are a positive for NAV, but in recent months this has been more than offset by the reduction in expected future excess spread. In April 2013, CIFU’s income note investments declined by a weighted average 4.0%, after declines in February and March. Some of this decline will reflect the repayment of principal on CLOs that are no longer re-investing, but some reflects the adjustment to future income expectations. If market conditions stabilise then it would be reasonable to assume that the impact of loan yield compression should be
Carador Income Fund | 17 June 2013
3
expected by the market and the decline in income note market valuations should slow or even halt. CIFU’s current focus is on pre-crisis CLO income notes, with relatively low funding spreads, although these continue to mature. By the end of 2013, 52% of the CLOs, by NAV, will have reached the end of their investment period. The current re-pricing of loans may inhibit repayment and extend the life of these CLOs (lower cash returns, but for longer), but as the income notes’ positions increasingly wind down, cash flow will include a diminishing amount of income and an increasing amount of capital repayment. Over the same time period, CIFU’s investments in CLO mezzanine debt have increased in value, reflecting investor appetite for yield and the lower spreads required on new CLO debt issuance. In the year to date, CIFU’s mezzanine investments have increased in value by c 5%.
While improving prospects for ongoing investment The same search for yield that has improved loan prices and reduced spreads has also reduced the cost of borrowing for new CLOs, making the residual, risk-adjusted cash flows to new CLO income notes more attractive. This has reached a point where the company now believes there is an attractive opportunity to commit an increasing amount of capital to primary (new) CLO income notes, an opportunity that is diminishing in the secondary market that CIFU has previously focused on. We would expect the returns to be lower than the exceptional returns of the past three years (average annual NAV total return in the three years to 31 December 2012 was 39.2%), but still attractive (perhaps nearer 1214%, risk-adjusted, on income notes) in current market conditions. The past three years benefited from strong cash flows to income notes, a function of benign credit quality, higher post-financial crisis loan spreads, and fixed pre-crisis CLO funding costs. At the same time, existing CLO debt has been re-rated as investors have found it increasingly attractive on a risk-adjusted return basis. CIFU sees the following attractions of new CLO income note investment:
Current market conditions provide attractive risk-adjusted returns over a longer duration than is available in secondary CLO income note investments.
New CLOs will potentially offer cleaner, better-quality loan portfolios than older CLOs, where some of the better credits will have repaid earlier.
Greater visibility of cash flows due to loans being closer to current market pricing and less prone to call and prepayment potential.
The ability to secure better long-term returns by leveraging the scale of the fund to acquire larger, majority, controlling stakes in new CLOs.
It is perhaps also worth pointing out that the manager, GSO Capital Partners International LLP (GSO), is a subsidiary of GSO Capital Partners LLP and an affiliate of the Blackstone Group, one of the largest credit-oriented alternative asset management groups in the world and a major participant in the leveraged finance marketplace. The management group is effectively focused on lending with considerable resources and experience, which we consider important for successfully achieving the investment targets, particularly the successful management of credit risk. The income notes of CLOs and the junior, mezzanine debt tranches carry substantially all of the credit risk and we believe that by focusing on this area of expertise, the manager has a greater opportunity to add value. CIFU already has the investment mandate to refocus its investments, but given the existing requirement to hold a continuation vote in 2017, it would make less sense given the longer duration of new CLO investments (with a typical investment period of five years). Hence, the manager is proposing a number of changes to the company articles to shareholders.
Carador Income Fund | 17 June 2013
4
EGM proposals At an EGM on 26 June 2013, CIFU is seeking shareholder approval to amend its articles of association as follows:
Permit the creation of a repurchase pool of shares that will provide a redemption facility in 2017 for those shareholders not wishing to continue their investment.
Replace a winding-up vote in 2021 with a continuation vote to be held in 2022.
Amend the distribution policy, so that the company need not pay out all its income annually.
Permit the issue of 500m shares (currently 543m in issue) on a non-pre-emptive basis.
Increase the performance hurdle from 1 January 2014 to the higher of 12-month US$ LIBOR or 4%, plus 2%. It is currently LIBOR plus 2%. The performance fee, once triggered, is 13%.
Recent performance In the year to 30 April 2013, NAV total return has been 30.6%. Approximately half this return has been earned from dividends and the balance from NAV growth. January 2013 NAV total return was again strong (3.24%), but February and March saw declines. April NAV was up 1.08% before payment of the Q113 dividend of US$0.034. NAV total return in the first four months to 30 April is 1.4% (5.9% annualised). Within this reduced near-term NAV total return, income on the portfolio has continued at high, but reduced levels, and the downward adjustment in the market value of income notes (to reflect the reduction in expected future cash flows) has acted as a drag. If market conditions stabilise to the extent that the market has now priced in the change in income note cash flow, valuations should stabilise. Exhibit 2: Quarterly net income per share 0.0450 0.0400
Net income per share
0.0350 0.0250
0.0200 0.0150 0.0100
0.0050 0.0000
0.0500 0.0450 0.0400 0.0350 0.0300 0.0250 0.0200 0.0150 0.0100 0.0050 0.0000
Dividend per share
0.0300
Exhibit 3: Quarterly dividend per share
Mar-11 Jun-11 Sep-11 Dec-11 Mar-12 Jun-12 Sep-12 Dec-12 Mar-13
Source: Carador Income Fund
Mar-11 Jun-11 Sep-11 Dec-11 Mar-12 Jun-12 Sep-12 Dec-12 Mar-13
Source: Carador Income Fund
As previously flagged by the manager, the Q1 dividend is lower than that paid in Q4 (US$0.043), which included an element of catch-up in paying out distributable income earned during the year. Management guidance is that without a change in market conditions, the level of income earned by the portfolio is likely to be sufficient to maintain quarterly dividends for the rest of the year, within a fairly narrow range of the Q1 level. Taking this statement more literally than management intends, given the obvious uncertainties, maintaining the Q1 dividend level throughout the rest of 2013 would require US$0.136 of annual distributable income, requiring a quarterly run rate for the balance of the year of US$0.0325 compared with US$0.0385 in Q1 (not all distributed). Management guidance on the dividend thus seems consistent with a continuing reduction in income note earnings due to continued refinancing and re-pricing activity in the loan market.
Carador Income Fund | 17 June 2013
5
Valuation As discussed above, the impending potential closure of the fund inhibits its ability to reinvest in longer-duration, primary (new) income notes, with potentially attractive returns, although below the exceptional levels of the past three years. As the existing maturing, no longer reinvesting assets run off, the fund faces the prospects of shrinking cash returns and increasing capital return. Recent market conditions have reduced cash flow, but may extend duration somewhat if recently re-priced loans have an extended life. The value to an investor of the fund under its current mandate is the IRR of the future cash flows. This is extremely difficult to predict, although we do see CIFU being able to maintain high cash returns, with an increasing element of capital return. Within the NAV, income notes and mezzanine debt investments are carried at market values. If the new mandate is adopted by investors, there is the prospect of continuing investment at potentially attractive returns, albeit lower than the past three years. The average annual NAV total return in the three years to 31 December 2012 was 39.2%. Even hypothetically assuming a fall in sustainable distributable returns to 10% pa (broadly, 12-14% on primary CLO income notes and c 5% on mezzanine with a 60:40 portfolio split less costs), this would still represent an attractive nominal return versus a range of alternative investment options, notwithstanding the complexity and risks of CLO investment (10-year US/UK government bond yield c 2%, UK equity yield c 3.5%, US high-yield bonds 6.5%, ungeared floating rate loan fund yields between c 5% and 6%). The main sensitivities to returns are:
Credit risk. The higher the rate of loan defaults and the lower the rate of recovery, the lower are the returns to CLO structures, with first losses concentrated on the income notes.
Refinancing/re-pricing. The rate at which loans are re-priced/refinanced, either up or down, will directly influence the yield on CLO assets.
Loan spreads/re-investment rates. Changes in loan spreads will directly influence the returns (relative to fixed spread funding) that can be earned on CLO assets.
If interest rates increase, for an existing CLO, the cost of debt funding is set at a fixed spread over LIBOR; any increase in LIBOR will increase the cost of CLO funding. The loan assets are similarly priced at a spread over LIBOR and in general can be expected to increase as well, in an offsetting fashion. However, the predominance of LIBOR floors since the financial crisis will take some time to work through. While loans have continued to be priced at a spread above LIBOR, this has typically included a LIBOR floor of c 1%, implying a temporary reduction in CLO cash flow until LIBOR increases above the floor. The impact of rising rates would be more material if it had any significant effect on credit quality, but in the early stages of credit tightening this seems unlikely. Edison, the investment intelligence firm, is the future of investor interaction with corporates. Our team of over 100 analysts and investment professionals work with leading companies, fund managers and investment banks worldwide to support their capital markets activity. We provide services to more than 400 retained corporate and investor clients from our offices in London, New York, Berlin, Sydney and Wellington. Edison is authorised and regulated by the Financial Services Authority (www.fsa.gov.uk/register/firmBasicDetails.do?sid=181584). Edison Investment Research (NZ) Limited (Edison NZ) is the New Zealand subsidiary of Edison. Edison NZ is registered on the New Zealand Financial Service Providers Register (FSP number 247505) and is registered to provide wholesale and/or generic financial adviser services only. Edison Investment Research Inc (Edison US) is the US subsidiary of Edison and is not regulated by the Securities and Exchange Commission. 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