The deal to sell 100% of $7.8 billion1 manager DCI to Blackstone Credit, which closed on December 18th 2020, combines two highly distinguished firms. DCI pioneered quantitative and systematic fundamental credit investing since its founding in 2004, and two of its founders, Stephen Kealhofer and Mac McQuown, have honed and refined its distinctive approach since their seminal research in the late 1960s at Wells Fargo through to the KMV pricing model in the 1990s. Blackstone Credit (formerly GSO Capital Partners) was founded in 2005 and is renowned for its discretionary fundamental approach to credit investing, particularly in loans and also in high yield bonds and structured credit. Blackstone Credit has amassed $149 billion of assets globally2, including a leading private credit platform, making it one of the largest credit investors in the world.
DCI, now Blackstone Credit Systematic Strategies (“SSG”), is being integrated into Blackstone’s Liquid Credit Strategies unit, which is led by Senior Managing Director, Dan Smith. The business plan will seek to accommodate both systematic and discretionary teams while looking for opportunities to optimize the two approaches by incorporating the most positively impactful attributes from each process. Both firms are delighted with the tie up.
At our core are shared beliefs that the best risk adjusted returns are generated through a fundamental quality bias.
Tim Kasta, CEO, Blackstone Credit Systematic Strategies
“After years of being courted by dozens of asset managers globally, we cannot think of a better partner, more complementary and strategic, than Blackstone. We have hit the jackpot,” says Tim Kasta, CEO of SSG. “Maintaining our strong culture was also important to our joint success and we are pleased with the cultural fit,” says Smith. “We come from the same family tree in terms of our fundamental approach to credit investing. At our core are shared beliefs that the best risk adjusted returns are generated through a fundamental quality bias. We need to be confident on fundamentals and not overlook them in favor of technical momentum or the allure of capital flows,” he continues.
Though some systematic and quantitative approaches are associated with style and factor premia, this is not the case for SSG. “SSG excess returns have historically shown no correlation to traditional style premia such as value, momentum, size or quality. It is all about idiosyncratic risk,” says Kasta. SSG has rather formalized and codified the mindset of a fundamental credit analyst.
“We seek better credit pricing relative to a firm’s underlying default probabilities. Rather than making top-down macro calls on credit spreads, interest rates or sectors, we have focused on identifying potential mis-pricings in single names where the spread is too high or low for the default risk. Given the advance warning of our underlying default probability model, our portfolios have avoided the vast majority of fallen angels in our investment grade corporate strategies. We end up being less exposed to names that get into distress in our high yield strategies – and have had no defaults to date,” says Kasta. “Blackstone applies the same philosophy through a discretionary approach and has also seen meaningfully lower default risk than benchmarks over our 22-year track record,” says Smith.
“We are most likely to underperform during a junk rally as seen in November and December 2020,” says Kasta. This sort of speculative frenzy, which can be dubbed a “dash for trash”, can also see Blackstone Credit ephemerally lag long only indices when creditworthiness takes a back seat. Both firms expect to perform best when underlying credit fundamentals as evidenced by firm default probabilities are driving markets and dispersion is present.
“SSG’s default probability-based approach is the biggest attraction amongst countless synergies,” says Smith. “In a discretionary platform it is very difficult to create a common yardstick for measuring default risk across sectors and companies, because analysts have different risk appetites and biases. SSG default probabilities will help to create a level playing field across the entire corporate universe regardless of company, sector and rating. This will be helpful and supplemental to our fundamental credit research, and help to make us a better credit investor overall,” he explains.
We were battling with traditional investors who did not want to believe the asset values of technology firms like Netflix. We had the same discussion in the late 1990s regarding Amazon.
Tim Kasta, CEO, Blackstone Credit Systematic Strategies
The lineage of SSG’s approach is traced back to predecessor firm, KMV, which provided default probabilities and portfolio risk analytics, initially for banks and later insurance and asset management firms, and was sold to Moody’s. A case study of Netflix illustrates how SSG assesses the fair value spread from their proprietary default probability model using equity prices and implied equity volatility combined with balance sheet information – an approach they have been working on for three decades now. “Netflix, according to our models, has had a default probability consistent with an investment grade rated company for some time now despite being rated by credit ratings agencies as high yield and historically has had a relatively high credit spread although recently the credit market has acknowledged the low default risk and has pushed Netflix’s credit spread tighter to investment grade levels consistent with what our default probability has been suggesting for some time now.
Our model has three main drivers. First, we use the equity market value of the firm to infer its asset value or enterprise value by running our proprietary option pricing model backwards. Second, we compare this market value of assets to the firm’s default point – the level of contractual liabilities of the firm that if its asset value fell to it would be in default. And then finally, this distance between the firm’s market value of assets and default point is scaled by the firm’s asset volatility to determine how many standard deviations the firm is away from its default point. This gets converted to a default probability and ultimately a fair value credit spread. Netflix did indeed have a relatively high asset volatility that was increasing before the pandemic given the heightened competition in streaming media. However, given its large and increasing equity market cap, and thus an inferred large and increased market value of assets, its firm asset value would need to drop by a whopping ~$240 billion to hit its default point, estimated at around $20 billion in liabilities. The current probability of this happening, over the next year, is about 0.03% or 3 chances in 10,000. This time last year, the market credit spread on their 5-year CDS was about 130 bps and according to our proprietary default probabilities, our fair value credit spread was well below that – about half that level. Given the fundamental improvement in credit quality, Netflix’s market credit spread steadily converged to our estimate of fair value – and looks like the firm is on a path towards an investment grade rating, following a recent rating agency upgrade and accompanying positive outlook,” says Kasta.
The lesson here is perhaps that the rating agencies were ‘behind the curve’ and SSG models were ahead of the curve – and this is not new. “We were battling with traditional investors who did not want to believe the asset values of technology firms like Netflix. We had the same discussion in the late 1990s regarding Amazon,” recalls Kasta.
Smith agrees that, “SSG’s huge library and history of default information and highly proprietary default probability and valuation models is very useful. A lot of information is also encapsulated in the firm’s measure of asset volatility. We use the power of the models and equity market data to pull out what is relevant on credit. This is not a black box; it is a transparent view into the main drivers of default risk and credit spread valuation, pragmatic and scalable fundamental analysis.” Blackstone Credit also uses fundamental data, but processes and manipulates it in different ways. “Blackstone Credit has 40 sector-focused analysts in the US and Europe, who evaluate public and private company financial and operational information. We access private data through the lender syndicate but supplement with data such as credit card, search and retailer information. Each analyst builds financial models to forecast cashflows, leverage and other important metrics over the next one or two years, which is then used to determine creditworthiness and support investment decisions. Portfolio managers then construct and optimize portfolios based on this information,” explains Smith.
Blackstone Credit has amassed $149 billion of assets globally, making it one of the largest credit investors in the world
Blackstone Credit’s existing framework of proprietary rankings and credit rating factors may be particularly enriched by the synergies with SSG. “Over the years we built a large fundamental database of financial information, capturing analyst models, company information and investment recommendations from which we distill the key factors that have the highest correlation to our credit views. We use these factors to calculate a score for a credit on a scale of 1 to 7. These scores are then compared to the analysts’ fundamental views, and when there are discrepancies, the reasons for the differences are reviewed and evaluated. Analysts might take a different view based on company size, their comfort with a management team, or familiarity with the business. These efforts towards backstopping our process are in principle similar to SSG – but not nearly as robust,” says Smith.
The acquisition is especially complementary because there is limited overlap by asset class, geography, strategy or data types. The SSG acquisition marks the latest move in Blackstone Credit’s slow migration from private and illiquid credit – such as direct lending, mezzanine debt and distressed debt – towards more liquid credit, which Smith has managed since GSO was founded. “The main overlap by asset class is in high yield, where Blackstone Credit is undersized versus our overall footprint, knowledge and experience base. We want to fill that gap completely and then extend it to investment grade and emerging market credit, in a global, scalable way. The SSG platform is a smart way to do so. SSG’s systematic approach and investment results, specifically with respect to high yield for example, provides a real differentiator and source of competitive edge in the marketplace,” he says.
Geographically, the deal marks Blackstone Credit’s first move into emerging market corporates. Emerging markets is an area where DCI has been active recently across its platform, seeking to expand its investing in the space. Data resources can also be augmented: “Currently SSG analytics are based on liquid public data, but it may expand into illiquid or pure private credit over time using our private company data,” says Smith.
“Low touch” execution capabilities are another bonus of the deal. Fixed income markets have been much slower than equity markets to move from over the counter to electronic trading, but the pace of change is accelerating, and Blackstone is keen to capitalize on SSG’s expertise in this area: “A key benefit will be consolidating execution, to take advantage of the electronification of the bond market driving down costs, and improving liquidity. SSG has developed very helpful execution protocols for electronic markets,” says Smith.
It was not easy to identify such a complementary acquisition. Blackstone Credit has been picky with its partners. The firm has grown mainly organically, making only two other acquisitions over the past decade. “Harbourmaster, acquired in 2012, was a very strategic acquisition on the liquid side which helped to make GSO the largest non-bank lender and CLO manager in Europe,” says Smith. “Harvest Fund Advisors, acquired in 2017, was not a pure credit manager, but more of a hybrid given its equity income bias and energy focus. Elsewhere, Blackstone Credit has acquired management contracts rather than entire companies,” he adds.
The plan now is to revitalize the growth drive organically. “The SSG platform gives us the strength, track record and technology to push into more pockets of liquid credit globally. We also expect to source assets through insurance company relationships,” says Smith.
We are aware that as the tide of liquidity goes out, we will see which companies can and cannot stand on their own. But we do not see a surprise rise in defaults.
Dan Smith, Senior Managing Director, Blackstone Liquid Credit Strategies
SSG offers a rather unique alpha stream: “Our excess returns in high yield have been historically uncorrelated to major indices,” says Kasta. This should be a very orthogonal addition to most credit portfolios but in terms of marketing and branding, systematic credit is relatively new and Blackstone can now lend additional brand recognition to what was a relatively small and independent firm.
Blackstone Credit sees significant opportunity in the liquid strategies that DCI has historically been active in and continued emerging market corporate issuance will likely open additional opportunities for the team.
There could even be scope to roll out hybrid products. “For instance, Blackstone Credit’s fundamental views could lead to strategies with sector over-weights or under-weights using SSG for security selection,” says Smith, though no imminent hybrid launches are slated. “We need to live together for a while but anything is on the table in terms of hybrid approaches that may combine purely systematic or purely discretionary strategies. Much analysis and testing will be needed to determine if we go for single funds side by side or a more integrated approach.”
DCI’s market neutral strategies are less scalable but strategically very important. They are flagship strategies providing the purest version of alpha.
“Blackstone has often managed very specific customized mandates with many constraints,” says Smith. SSG can continue to refine customization of mandates for risk or ESG constraints. One avenue for asset raising is insurance companies and other firms bound by solvency regulations. SSG analytics can be particularly useful for insurance companies optimizing regulatory constraints. “For instance, we can provide credit rating mappings to Moody’s or S&P. This enables insurance companies to use their internal models for NAIC ratings in the US – or indeed Solvency II risk budgets in Canada, Europe and other countries that follow the Solvency II regime,” says Kasta. “One client with a long only bond strategy wanted to optimize – by maximizing alphas subject to minimizing capital charges under Solvency II. Our analytics mapped out an efficient frontier of capital charges, which differentiated our approach from competitors,” he adds.
ESG integration is a large focus on the liquid credit side at Blackstone, and this is something that SSG has made significant advancements in. “We are quite excited about our ability to introduce ESG constraints, just like Solvency II capital charges, as a constraint to be optimized. We can quantitatively show investors how they could dial up or dial down the trade-offs. For instance, we are optimizing based on ESG criteria, such as carbon footprint intensity data. For example, we believe we can run a high yield portfolio with 25 to 50% less scope 1 and scope 2 emissions, without seeing much alpha decay,” says Kasta. On top of SSG’s firm-level ESG screens, clients can change or tighten constraints easily to customize to their own needs for example, adding in scope 3 emissions.
Blackstone Credit has historically reviewed the impact of ESG factors on investment risk and performance but has begun to do so in a more structured manner as data quality improves: “We evaluate ESG risks when lending to companies across all sectors. ESG risks can impact credit quality and liquidity so we are fundamentally taking this into account. However, there is work to be done to standardize metrics in our market which drives the need for our own formalized process,” says Smith.
Smith’s near-term view on the opportunity set for credit investing is broadly constructive: “Our overall fundamental view on credit is fairly positive, though valuation is most in question. We are focused on finding higher spreads on shorter duration assets. We have been very positively surprised by resiliency and recovery in portfolios, aside from travel and leisure sectors directly impacted by the Covid crisis. Central banks remain supportive and capital markets remain open so that issuers can reduce costs of capital and extend maturities. Even some companies who should not have access are able to refinance – one firm just issued a large bond with use of proceeds being to repay interest on other debt. Equally, we are aware that as the tide of liquidity goes out, we will see which companies can and cannot stand on their own. But we do not see a surprise rise in defaults”.3