Chenavari European Regulatory Capital Strategy (Chenavari Credit Fund – D1 Share Class)

Best Performing Regulatory Capital Debt Fund

Originally published in the April/May 2013 issue

Founded in 2008, European credit specialist Chenavari investment strategy is led by Loic Fery, CEO & Co-CIO and Frederic Couderc, Co-CIO. Chenavari manages over $3.8 billion AUM and focuses on identifying and profiting from the full range of opportunities presented by European credit markets. Key strategies include long/short corporate, credit, asset-backed securities, real estate debt, direct lending, and regulatory capital. Each of these strategies have produced solid returns since inception and each presents a unique and compelling way to profit from continued and, in many cases, accelerating de-leveraging in Europe.

The European Regulatory Capital strategy (also nicknamed "Toro2" fund after Chenavari ABS team who manage the ABS Toro I funds) launched in 2011 and focuses on transactions aimed at improving banks’ regulatory capital, which banks must hold to satisfy requirements laid down by the Basel rules. The new Basel III rules are being phased in over three years until 2015, and will in many cases increase banks’ capital requirements while at the same time applying a stricter definition of capital. Local regulators can sometimes set even stricter rules, as Sweden and Switzerland already have, for example. These forced increases in the capital that banks must hold is occurring at a time when it is extremely difficult for banks to raise capital thus presenting a compelling opportunity for specialist managers such as Chenavari.

As banks are being forced to bolster their solvency ratios, they are in many cases hesitant to offload assets or exit business, thus “risk sharing” regulatory capital transactions with dedicated credit managers such as Chenavari present a compelling solution. The bank will always retain some degree of ongoing risk, and risk sharing models vary, and in all cases the bank retains many times the exposure of Chenavari. Sometimes Chenavari will take a first loss risk, and on other deals Chenavari might be exposed to mezzanine risk that sits in between the most senior and junior credit risks. In summary regulatory capital transactions provide investors with the unique opportunity to investing in high-quality portfolio of credit exposures that are core to the banks' business and achieve above market returns by helping banks meet these changes in the regulatory capital environment. Chenavari’s extensive network of relationships with banks and brokers helps to source primary deal flow, and also secondary transactions, which are generally not available via public markets. The Chenavari Structured Finance team of ten professionals has spent years looking at bank balance sheets, which also helps them to identify potential deals. Chenavari also has important legal expertise for structuring bespoke bilateral deals.

Profits of 36.94% were reported in 2012 with no down months. Returns came mainly from trading, with capital appreciation and carry also positive factors. Mortgage underlyings made the biggest contribution, and were nearly all residential rather than commercial. Corporate loan-related transactions were also profitable. Corporate credit risk can be wrapped in a collateralised loan obligation (CLO) securitisation or it could involve counterparty valuation adjustment (CVA), but in all cases Chenavari’s fundamental research will be analysing the credit risks associated with the underlying corporate names. Geographically the UK and Germany are currently the largest weightings. This is partly a function of local regulators’ open-minded approach to approving transactions that can boost banks' capital ratios. The proliferation of “bad banks” can also generate investment opportunities because bad banks may still have some assets that are interesting investments at high enough yields.

Senior Portfolio Manager and Chenavari partner Hubert Tissier de Mallerais says the outlook for the strategy is encouraging. Politicians across Europe are clearly concerned that smaller companies are being starved of finance, so Chenavari’s SME (smaller and medium enterprises) deals are well tuned to politicians’ commitment to keep capital flowing in a time of austerity and weak economic growth. Chenavari continues to see a strong pipeline of attractive deal flow. The fund is to deploy currently uninvested cash (approx 20% of fund NAV) in a few compelling unique deals closing in the near term. The strategy can also redeploy coupon income, pay-downs, and proceeds of asset sales to make new investments.

The current Chenavari vehicle is open to investments until the end of 2014, and then it can begin returning capital to investors. Its hurdle rate under performance fees is at least 2% over LIBOR, and can be higher for larger investments. The "Toro2" strategy has very little holdings overlap with Chenavari's other funds, which redemption terms range from monthly liquidity 30 days (L/S Corporate Credit) to quarterly liquidity 6 years lock up (European Direct Lending into real estate and SME).