The Lyxor Chenavari UCITS fund has again received The Hedge Fund Journal’s UCITS Hedge performance award for best risk adjusted returns in the long/short corporate credit category over 3, 4 and 5 years ending in December 2021. This liquid strategy managed by Chenavari UCITS team maintained positive returns in 2021, navigating the new environment of higher interest rates and wider credit spreads through credit selection, hedging and tactically trading to optimise risk adjusted returns.
Chenavari’s private credit and specialty finance strategies seek low double-digit annual net returns over a multi-year time frame, taking advantage of both the cyclical upswing in yields, and the structural need for banks to deleverage. Chenavari first raised capital for illiquid opportunities in 2011 and has recently launched a vehicle which allows the team to access granular pools of assets, through three types of investments – significant risk transfer transactions, portfolio acquisitions and new lending.
In the second and third quarters of 2020, Covid resulted in spreads 250 basis points wider than pre-Covid: that is when we step into these transactions.
Hubert Tissier de Mallerais, Partner and Senior Portfolio Manager, Chenavari
Chenavari runs in total close to USD 6 billion as at April 2022, across liquid credit, illiquid credit and structured credit including its own CLOs.
The European bank deleveraging story continues, with the latest potential triggers including accounting and banking regulations; Covid moratoriums ending; the ECB tapering asset purchases, and some banks’ Russia, Ukraine and related interests. The private credit strategy focused on specialty finance will obtain exposure to old and new lending books from three angles: buying portfolios of seasoned loans from banks, providing significant risk transfer (SRT) capital to banks through risk-sharing regulatory capital solutions, and financing credit originators such as FinTechs and specialty lenders which originate new loans.
Chenavari is highly selective in all three areas. While European banks’ portfolio divestments are mainly non-performing loans (NPLs), Chenavari solely invests in the niche market of performing loans portfolios, which can sometimes include some historically stressed situations that have been restructured and are now “re-performing”. In bank risk-sharing transactions, Chenavari has also been picky, selectively participating in the market, and sometimes stepping aside when spreads compress too far. In credit origination strategies, careful selection is also needed to avoid some pitfalls that have tripped up neophyte alternative lenders in what is a newer strategy for credit markets but where Chenavari has an almost 10-year track record.
Chenavari runs in total close to USD 6 billion as at April 2022, across liquid credit, illiquid credit and structured credit including its own CLOs
Chenavari has been active in risk-sharing transactions for over a decade since 2011, and in portfolio acquisition, buying its first portfolio in March 2013. Banks commenced selling junior risk on portfolios before the GFC, after which regulation increased their need to deleverage. Basel II in 2008, then Basel III, then Basel 3.5 and now Basel IV due to be implemented in 2023, all placed constraints on risk weighted assets. Banks have sold mainly NPLs, and their remaining lending has been refocused on core areas, leaving some borrowers including SMEs neglected. The latest incarnation of banking regulation is not a revolution, but it could have a significant impact on certain banks: “Basel IV sets a minimum for risk weighted assets and limits the maximum capital benefit that can be obtained from using internal modelling rather than standardised modelling. This means that some banks using the internal modelling approach will move closer to the standardised approach,” says Benjamin Jacquard, Head of Private Credit.
Another factor spurring banks to de-risk is IFRS 9, which forces earlier recognition of expected losses on portfolios, making stressed, distressed or reperforming loans more capital intensive for banks to hold. But “Stage 2” loans, which have higher credit risk without being impaired, can offer a happy medium between return enhancement and acceptable risk, provided careful underwriting is carried out. “Reperforming loans have been restructured to offer the same cashflows as a performing loan. The judgment call for investors and regulators is whether the restructuring is sustainable,” says Hubert Tissier de Mallerais, Partner and Senior Portfolio Manager. These sorts of loans could land in both portfolio sales and risk-sharing regulatory capital deals: “We have seen Stage 2 loans in loan portfolios sales. We have not yet seen them in regcap transactions but expect we will do so very soon,” says Tissier de Mallerais.
Alignment of interest between investors and banks is important and the amount of risk retention varies: “Under Capital Requirements Directive (CRD) 4 rules, banks need to retain a 5% slice of regcap deals, which can be a vertical part of each loan or a random selection of similar loans of the whole structure. We welcome banks keeping a higher proportion of risk, but also recognise that this is not always realistic or practical where they are under pressure to deleverage,” says Tissier de Mallerais.
Gaps left by banks can be filled by non-bank FinTech and specialty finance lenders, but a disconnect exists between their angel investors’ return targets, geared towards the growth of the lending company, and realistic return expectations from the lending activity. “The non-bank lenders are typically backed by private equity and venture capital firms with very high target returns and costs of capital, while their core business of lending and loan origination does not generate enough return for them,” says Tissier de Mallerais. A double digit return with the right structure and leverage is sufficient for Chenavari’s closed-ended vehicles however. “We look for firms with good underwriting, where we can provide capital and senior funding for a structured warehouse SPV,” he adds.
Illiquid private credit strategies have adapted to changing environments over the years. Back in 2011, markets were still hungover from the GFC, and were reeling from the European sovereign debt and Greek crises. “This resulted in very different discount rates and credit spreads, which have subsequently compressed a long way. Yet premiums remain for structuring, complexity and illiquidity,” says Tissier de Mallerais.
In most cases, to attain its net target returns, Chenavari seeks a junior position in existing structures, creates new structures which also have implicit leverage, or acquires loans at a discount: “For new lending warehouse transactions with credit originators, we will typically be at the bottom 10 to 20% of portfolios. For portfolios of loans, we will acquire them at a discount and we can typically finance them still at 40 to 50% of original par value. For SRT deals, our investment will generally be in the most junior 7% of the capital structure,” explains Tissier de Mallerais.
However, Chenavari cannot always deploy capital with optimum risk/reward to every strategy, in every year. The three sub-strategies follow their own broad pan-European cycles and can also move asynchronously between countries. Chenavari is opportunistic in seeking the most attractive risk-adjusted returns, by rotating around the strategies and moving between countries.
Ireland remains an attractive mortgage market. It has consolidated from 10 to 3 or 4 banks, as foreign lenders such as Bank of Scotland, KBC, Rabobank, Danske Bank and others went bust or exited.
Hubert Tissier de Mallerais, Partner and Senior Portfolio Manager, Chenavari
Chenavari has selected about 1% of the deals on offer in SRT and invested a total of EUR 1 billion in these deals over the past decade against deal volumes around EUR 10-12 billion per year. “We see most of the flow in this space and are very selective, as a bank transaction is often rejected on a relative value basis in favour of better deals. Spreads became much tighter in 2014-2015, and in 2018. When non-core, “tourist” investors from large US credit, multi-strategy or even global macro funds start deploying large amounts of capital in regulatory capital solutions, spreads can come down for a while before some shocks or stresses widen them out again. In early 2016, Brexit and concerns around China widened out spreads, and then again in the second and third quarters of 2020, Covid resulted in spreads 250 basis points wider than pre-Covid: that is when we step into these transactions” says Tissier de Mallerais.
Where SRT is the most transparent and market sensitive strategy, the cycle cannot be pinpointed as precisely for portfolio loan sales and alternative lending since there is less transparency about overall market pricing. “We know where we bid, win and lose deals, but we do not see all deal pricing,” admits Tissier de Mallerais. Nonetheless, only about 10-15% of deals looked at will make the grade. “We review 10-20 portfolio loan sale transactions annually and invest in 2 to 4 of them. They mainly come direct from banks but can occasionally be tertiary transactions that other asset managers originally acquired from banks,” he points out. Less than EUR 500 million of Chenavari capital is actually invested in loan portfolios acquired from banks, which seems tiny given that annual volumes can range between EUR 50 and EUR 100 billion, but it is worth remembering that these figures represent the capital invested by Chenavari rather than the amount of loans acquired as financing is usually involved so the amount of loans acquired is much larger.
Chenavari is similarly choosy in alternative lending: “We look at 20-30 opportunities in the space in any given year and invest in 3-4. Some of them could be renewals of existing transactions. One example would be Irish mortgage lender Dilosk, which is active in buy to let and residential mortgages,” says Tissier de Mallerais. Some FinTech lenders including peer to peer lenders might have seen losses because their expertise was more in technology than in credit risk assessment. Chenavari proceeded cautiously: it was not the very first mover in this space and has taken some years to build substantial exposure. Spread compression on regulatory capital deals provided the original impetus for diversifying into loan origination in 2013. Since then, credit originators financed by Chenavari have originated more than EUR 10 billion of loans, most of the time in granular asset-classes such as residential mortgages or consumer loans. A large of part of Chenavari investments were made in the past few years, with an acceleration in in 2020-2021. “In the past 10 years, the ramp up of non-credit origination strategies was slow because most alternative lenders started after the GFC, and we, the credit ratings agencies who rate their securitisations, and the public investors who ultimately invest in them, all want to see between 4 and 5 years of track record,” explains Tissier de Mallerais.
Chenavari has historically taken some private equity stakes in loan origination platforms and loan originators, such as Buyway in Belgium, Qander in the Netherlands and Creditis in Italy, which are affiliates. Different vehicles may not pursue similar investments however, in order to avoid potential liquidity mismatches with the relevant fund’s target duration.
Chenavari applies ESG policies at firm and investment levels. At corporate level, a scheme to offset carbon on flights illustrates ‘E’ green credentials; diversity and inclusion under ‘S’ are demonstrated by several women in senior roles – including Global Head of Marketing, Ally Chow; Head of Investor Relations, Kirstie Sumarno; and Chief Compliance Officer, Jackie Jordan, as well as circa 80 staff including 15 nationalities and languages while the dedicated Head of ESG, ESG committee and annual sustainability report show an ESG governance framework. Chenavari is also collaboratively engaging with the wider industry, with its Head of ESG sitting on the European Leveraged Finance Association (ELFA) ESG Committee.
At investment level, Chenavari are UNPRI signatories, but the degree to which ESG aspirations are currently manifest varies by strategy. The liquid UCITS strategy, and leveraged finance, have relatively extensive ESG policies, including a mix of third party ESG ratings (from Sustainalytics or Moody’s) and proprietary ESG scores for all investment holdings. On the illiquid side, challenges include data gaps and legacy exposures in portfolios of loans and other credit structures because many loan originators, third party asset managers and Chenavari itself have recently introduced or expanded their ESG policies. For instance, Chenavari’s proprietary ESG scoring and its negative screening ESG Exclusion Principles covering thermal coal, controversial weapons, tobacco; controversy scans, have been phased into various new CLOs at dates between 2019 and 2021. The direction of travel is clear, but practicalities mean that different investment strategies are adopting ESG policies at their own speed.
The CLO arbitrage remains as securitisation has weathered rising rates and wider spreads, since in theory all rates in the structure should move up in parallel. “Prior to Russia’s invasion of Ukraine, senior lending spreads for AAA tranches had increased by 10-15 basis points between end of the summer and January 2022. Even after the war started, AAA spreads have only increased another 25 basis points circa. Taking inflation, rate rises and Ukraine together, the overall increase is still much less than was seen around the Covid crisis,” says Jacquard. Beyond CLO activity, Chenavari is very active in securitising new loan warehouses originated through credit originators across Europe. “The economics of securitisation are favorable now. As we understand precisely how credit origination is performed and know what to expect from the portfolio in terms of risk performance, we then regularly sell senior and mezzanine tranches that yield less than our funds’ hurdle rate, and keep the more junior tranche, such as equity and junior mezzanine tranches, yielding more,” says Tissier de Mallerais.
Recently, in 2021 deals were done taking junior exposure to consumer loans, mortgages and SME loans in Sweden, Germany and Switzerland, as well as some global loan books. Over 11 years, Chenavari has invested in most countries in Western Europe, including Spain, Portugal and Greece. The pipeline remains very much pan-European, and still includes the UK, which is especially important in some segments, making up over half of online alternative finance or “marketplace” lending in Europe. In fact, some books of loans acquired are global, because that is how big banks group their large corporate exposures. Chenavari closely monitors where each country is in its economic cycle. For instance, Ireland was one of the first to recover and Greece one of the latest.
Certain markets are structurally more appealing for some areas of credit however, such as Ireland for mortgage lending. “We need to understand the domestic dynamics. Ireland remains an attractive mortgage market. It has consolidated from 10 to 3 or 4 banks, as foreign lenders such as Bank of Scotland, KBC, Rabobank, Danske Bank, Ulster Bank and others went bust or exited. And since the GFC, local risk weighted regulatory capital requirements set by the Central Bank of Ireland are more than 2.5 times higher than elsewhere in Europe, so mortgage spreads also need to be wider. Price comparison sites show the cheapest Irish mortgages cost 2% compared with below 1% in other countries such as France. Standard owner-occupied mortgages pay 2 to 2.5% for a 3-to-5-year fix. Buy to let mortgages in Ireland offer even higher yields, of between 3.7% and 4.2%,” explains Tissier de Mallerais.
UK self-employed mortgages are another market segment that could also be contemplated as a source of yield pickup. In contrast, Dutch prime residential mortgages are an example of a sub-asset class that currently fall short of Chenavari’s return target. “The yields are relatively high because the mortgages are long dated and the yield curve is upward sloping, which also increases the amount of interest rate hedging needed. Our modelling suggested we might only get to mid to high single digit returns. Nonetheless, we could revisit the space in the event of stress,” says Tissier de Mallerais.
The monetary policy and interest rate backdrop is of varying importance for different strategies and countries. At some stage, higher borrowing costs could start to impair credit quality. “We are thinking about how companies will adapt to higher rates after many years of very tight credit spreads. Interest rate normalisation should start to affect the credit profile and default risk, which would require much higher spreads on equity tranches,” points out Jacquard.
In contrast, interest rates could be less relevant for other segments. “SME, consumer and mortgage borrowing is not very sensitive to rising rates, because mortgages are fixed rate in most countries outside the UK. SME lending is very country specific – and sensitive to when Government Covid support ends, so we would need to build a matrix for each country,” says Tissier de Mallerais.
Overall, the opportunity set is compelling. “The pipeline is stronger than we have seen in five years. It is broadly spread over countries and specialty finance asset classes, and we also expect some repeat transactions with our credit origination partners,” says Tissier de Mallerais.
Loïc Fery, Founder and CEO of Chenavari concludes, “To summarise, Chenavari originates private credit granular loan portfolios from two main channels. On the one hand, European banks, from whom we acquire or risk transfer portfolios of performing loans. On the other hand, specialty finance originators with whom we partner across Europe to originate new loan origination programs. In most cases, we then transform these portfolios made of granular private loans into bonds through securitisation: Chenavari funds seek to capture the positive premium arising from that transformation of private credit portfolios into ABS”.