Special situations can often involve significant credit market beta risk; leverage; an illiquidity premium; default risk and distressed situations; and esoteric legal systems, but Cladrius is not generating returns from these sorts of premia. Rather Cladrius is earning a complexity premium on legal and structural features that become relevant when certain events occur like a financing or exchange offer, in the context of documents predominantly drafted in New York, Delaware and English law. Ruggere finds these opportunities across the credit quality spectrum – not just in low rated and unrated corporate securities that distressed funds typically trade. Notably, the average credit rating on Cladrius’ investments is BBB minus (low investment grade) inception to date, with some recent investments on issuers as high as A-rated. Recent returns have been multiples of what a buy and hold strategy would have made in equivalent rated investment grade corporate credit, which has generated approximately flat returns in the first eight months of 2021, and only yields around 2%.

The portfolio is approximately market neutral in crude cash terms and also works out neutral based on more advanced measures that consider duration, credit quality and beta on each side of the book. “The objective is to eliminate all market variables to isolate the convexity of covenants and structural features in what remains as an inefficient investment area,” says Ruggere, who featured in The Hedge Fund Journal’s 2019 ‘Tomorrow’s Titans’ report on rising star hedge fund managers. 

Many market neutral fixed income or credit strategies need to do some heavy lifting by using substantial leverage to extract returns from relatively small discrepancies in areas such as yield curve trades. Cladrius has a leverage facility but does not use it. The book averages around 100% long plus 100% short, which given the market neutrality, also means that shorts effectively finance longs. “Philosophically we do not believe in leverage. There is enough alpha in the strategy to run 200% gross exposure, which is where our balance sheet is fully deployed,” says Ruggere.

The strategy is not picking up illiquidity premia either. It may sometimes own an older bond issue with tighter covenants and short a newer one with fewer or no covenants, but this is not analogous to a long less liquid “off the run” versus short more liquid “on the run” fixed income arbitrage type trade. “The capital structures tend to be multi-billion dollar and liquid, and the fund assets are small enough to be nimble. The portfolio is all level 1 and level 2, exchange or TRACE (Trade Reporting and Compliance Engine) traded instruments that all have CUSIPs and ISINs. There are no level 3 or “mark to model” assets,” says Ruggere. 

Moreover, default risk should be the exception rather than the rule. Defaults are not the driver of returns, as is the case for some special situations and distressed funds. Events that cause legal and structural features to become immediately relevant range from bull, bear, to just plain idiosyncratic events. The Cladrius strategy is mainly corporate paper but occasionally finds opportunities in structured credit and equity instruments like convertibles, preferreds, and equities.

Covenant arbitrage

Legal alpha is perhaps the best way to summarise the strategy, though trades have many moving parts beyond pure legal analysis. Ruggere cross-trained at NYU School of Law while studying for his MBA and he finds legal covenants in bond indentures are a rich canvas for alpha generation. The current credit cycle is one of the longest ever, and has seen an explosion of corporate debt issuance – firstly of “cov lite” debt with few covenants, which recently moved on to debt with no covenants. The fact that many capital structures also contain paper with tight covenants creates what Ruggere sees as the big secular opportunity for the mandate. “Historically a capital structure contained two categories of covenants, ‘good’ and ‘bad’. We essentially had two choices in terms of contractual and structural quality differentials. Now for the first time in my career, we now have a third choice in the form of ‘no’ covenant bonds – which is an entirely new category. This creates what I view as an unprecedented quality differential, and with the overall growth of the market, leaves us with the most fertile investment opportunity I’ve seen. This quality differential really allows us to create investments that have meaningful convexity into hard idiosyncratic events provided our underwriting and trade construction is on point,” says Ruggere.

Covenants could be triggered by multiple corporate events such as re-financings, restructurings and takeovers. This legal and structural complexity is often compounded by how covenants interact with structural or regulatory features; different corporate entities or jurisdictions, and divergent interpretations of covenants under various events and scenarios. “Whether covenants permit a company to extend its liquidity runway for example can often be misunderstood, as there can be legal and practical loopholes to consider and understand. For example, we recently invested in a situation that had perceived loopholes, but the company ended up paying us a consent fee and up-tiering our bonds from unsecured into second lien in return for us agreeing to eliminate our covenants. In another recent case, a company pursued a coercive exchange offer, we held out because we believed the layering risk was misunderstood, and the company has now offered us better terms by issuing warrants that can be stapled to certain classes of bonds,” explains Ruggere. 

An eclectic strategy repertoire

“The bull market in M&A combined with a steady stream of refinancings creates more opportunities and events that can be pursued from multiple angles,” says Ruggere. Cladrius has developed eight broad strategy groups: capital structures in transition; credit M&A; equity linked convexity; financings; litigation; regulatory driven; securitization and special situations. Some trades can cover more than one sleeve and several of them can be further sub-divided into other niches. 

Cladrius will often take an active role to drive its own idiosyncratic outcome. Cladrius recently collapsed a discount between a trust and its collateral, which involved working with counsel and a trustee to receive a pro-rata share of the underlying collateral based on certain provisions and triggering events in the governing documents. Occasionally, Cladrius has hired counsel to lead a process and create a blocking stake, but bilateral deals are more common. Cladrius sometimes awaits court judgements or out of court decisions around events, but also expedites outcomes by negotiating bilaterally with issuers. The objective might be to get a direct redemption or a sweetener, such as a make whole, up-tier or consent fee, which might be offered in return for consenting to a contractual amendment. Companies that need to surpass a certain threshold of bonds to eliminate covenants might pay a premium directly to those bondholders who get them over the critical level. The incentive, which might make a bond more senior, is not always extended to the broader class of bondholders as was the case in a recent investment realization by Cladrius. If companies make a “low-ball” offer to all holders, Cladrius may hold out for something better.

It can take time for corporate events, and associated negotiation with issuers, to follow through, and the average holding period is 12-18 months. Some investments, such as one under the litigation category, have still not yet fully come to fruition. 

Some of the strategies are post-event. Cladrius generally gets involved in merger related investments after they have closed, and is not speculating on deal break risks such as antitrust risk. “A common scenario is that large companies want to conform and clean up covenants on acquiree bonds that they inherit after an acquisition for various legal and economic reasons,” says Ruggere. Though this might sound like an administrative formality, the returns from Cladrius’ merger arbitrage trades have often been multiples of what could be made from plain vanilla merger arbitrage spreads in the equity. 

Opportunistic strategy allocations 

The opportunity set for different sub-strategies ebbs and flows. In 2020 Cladrius took advantage of a rescue financing opportunity that generated a double-digit coupon – but was structured in a manner that created long volatility and short credit optionality. A volatility arbitrage strategy around equity linked convexity was added in late 2020 to capitalize on dislocations in a particular asset class that has allowed Cladrius to earn 8-12% annualized yields by selling upside volatility on some instruments. Cladrius can forage amongst more exotic convertibles such as mandatories and reverse convertibles, as well as other equity-linked instruments such as warrants and rights.

Capital structures in transition has become more active since Covid led to more refinancing. Some regulatory themes around bank capital might have a defined timeline and will be replaced by others once the trade has played out. 

Cladrius does not typically short for macro directional views or portfolio hedging, since the trades are already somewhat hedged, though some of the strategies construct synthetic puts that provide some optionality: “Alpha shorts have been less active in 2021, but in the previous fund, Dhallion, one third of performance came from the short-biased side of the portfolio,” says Ruggere.

Cladrius also revises strategies based on unprofitable trades: “We run the business unemotionally to ferret out egos,” says Ruggere. Cladrius documents losing trades and learns lessons from them, which might inform position sizing, or lead to a different tolerance for optionality costs: “Sometimes we get paid for options, sometimes they are free, and sometimes we pay for them. I liken our mandate from a risk management standpoint of having the profile of a collection of options, where downside is protected and limited to the premium paid – while still having convexity. We are in some ways synthetically creating this return profile via our capital structure arbitrage mandate, with the difference being the options we synthetically create have no or low theta in many cases,” says Ruggere. 

The strategy is also geographically opportunistic. Cladrius usually has most exposure in the US, followed by Europe and Latin America/Asia. 

Technology and counterparties

Credit markets have been much slower than equity markets to move towards electronic trading and execution, but technology can be used in different ways to inform the research and analysis process. Cladrius is harnessing artificial intelligence to increasingly automate the process of screening, sourcing and prioritizing relevant information around corporate reporting and credit events: “The ultimate objective is to write repeatable algorithms and create a black box computer program in a structurally complex mandate where we can exploit alpha, in a consistent and repeatable way. That’s the cornerstone of our highly process oriented culture,” says Ruggere. Artificial intelligence can be used for some tasks such as highlighting differences between indentures. This is an iterative process that improves over time. Ruggere believes technology will be a big differentiator in the investment business: “The investments we have made in our proprietary sourcing and screening technology have been a key strategic priority for us from a business strategy standpoint,” says Ruggere.

As assets have grown to more than USD200 million, Cladrius has been growing the team, adding prime broker counterparties and ISDAs. Goldman Sachs has been added to JP Morgan as lead prime brokers. Ruggere envisages capacity of around USD1 billion for the main strategy: “We want to make sure the fund is appropriately sized to ensure we optimize capital for our investors, of which we are one. We are taking a very long-term view and look to build a best-in-class firm over the long term with a core group of high-quality capital partners that share the same view”. The two seeders, M.D. Sass and Fir Tree (Ruggere’s former employer), remain invested.

He could also contemplate using the firm’s expertise to launch opportunistic themed funds or a less liquid strategy. Ruggere believes this is a better way to take advantage of opportunities that may arise without sacrificing the integrity of the main fund.

Late cycle credit

Some observers characterize the credit markets as being artificially inflated by liquidity and central bank purchases, and playing a game of “extend and pretend”. These pose risks for long only investors but are not necessarily a bad outcome for the Cladrius strategy. Ruggere recognizes that credit spreads leave very little room for default related losses but does not expect many actual defaults because the maturity wall, which has already been pushed out by refinancing, is also being further delayed by covenant-lite issues that allow firms to extend their liquidity runways.

Companies have more options and more levers to delay defaults and extend their liquidity runway due to weak covenants. They might start with secured financing, then up-tier via an exchange offer, and then offer consent fees. “Due to the weak covenants, there are effectively many more events along the way between stress and distress than in the past and each event presents an opportunity,” says Ruggere. More events between stress and ultimate default may artificially reduce defaults, but they also create a busier timeline for regularly running up against covenants. “There are also more unofficial out of court restructurings because companies do not need to file for bankruptcy,” he points out. Ruggere does not have a strong macro opinion on credit valuations. He does however expect that volatility could pick up, which could add further opportunities to the busy corporate event calendar.