SCIO Capital’s SCIO Opportunity Fund has received The Hedge Fund Journal’s Alternative & Private Credit 2021 award for Best Performing Fund over 3 Years in the Asset Backed Securities – Europe (AUM < $100 million) category. The awards were powered by Preqin data.
Since inception in June 2010, the SCIO Fund Composite has annualised at 11.5% net return, with a 2.3 Sharpe ratio over a range of open- and closed-ended funds for the past eleven years.
Before launching SCIO in 2009, co-founder and CIO, Greg Branch, worked in credit on the sell side for 16 years. An early mentor was mortgage-backed security and derivatives trading pioneer, Ellington Management co-founder Laurence Penn, who inspired Branch on both professional and personal levels: “I worked with Larry briefly in the early 90s when he was running CMO derivatives trading, and I was the new kid on the desk. Larry is a brilliant man (he represented the United States in the 21st International Mathematics Olympiad), but more importantly a genuinely kind, likeable and selfless person; this left an indelible impression on me early in my career”.
Private markets in general currently offer significantly better risk/return for those investors able to accept some level of illiquidity in their portfolios.
Greg Branch, co-founder and CIO, SCIO Capital
Another formative figure was Greg Lippmann, who was Global Head of Asset Backed Securities at Deutsche Bank where Branch was Head of Structured Credit Trading for Europe: “Greg Lippmann was a major influence and taught me a lot; a very smart guy who can think outside of the box – a rare commodity in an industry overrun with herd mentality”. Lippmann, who co-founded LibreMax Partners, became famous for the short sub-prime trade that The Big Short movie was based on.
SCIO’s investment strategy is long-biased where the downside is controlled through rigorous selection, structuring and risk management. SCIO opportunistically seeks strong risk reward, which could come from public or private credit markets, including asset-backed and mortgage-backed securities, structured credit and bespoke, bilateral deals: “Our funds’ ability to navigate seamlessly across both private and public markets is a major competitive advantage,” says Branch. After the firm launched in 2009, SCIO took advantage of post-GFC credit pricing and started investing in public credit markets, before pivoting to predominantly private credit after then-ECB Governor Mario Draghi’s famous July 2012 “whatever it takes” promise that was followed by a multi-year trend of compression in liquid credit spreads. In recent years, public markets have only offered intermittent and ephemeral opportunities: for instance, in 2015, and in 2020, when SCIO picked up some deeply discounted asset-backed securities and structured credit on the secondary market after the Covid crisis but was able to take a quick profit and redeploy capital into private deals that once again became more compelling as public markets recovered. SCIO’s ability to avail of these public market opportunities does partly depend on how much cash it has rolling off from maturing private deals and whether various funds have net inflows, as one fund did in the first half of 2020.
“Private markets in general currently offer significantly better risk/return for those investors able to accept some level of illiquidity in their portfolios. The disconnect in risk/reward is so large that investors should only look at public credit if they need daily liquidity,” says Branch. Yield pickups relative to equivalent or mapped credit ratings are often presented to illustrate the relative value case but that is not how Branch would draw comparisons, partly because he has always been sceptical on credit ratings. His calculus is more case by case: for example: “SCIO finances MBA loans with historical cumulative default rates inside of 5%, compared with 20-30% for many types of US student loans. Our stress tests suggest that an economic depression similar to the one experienced in 1929 would be needed to lose money on these loans, thus we are underwriting to a very severe recessionary scenario. Yet the MBA loans deal offers a double-digit yield,” says Branch.
Since inception in June 2010, the SCIO Fund Composite has annualised at 11.5% net return
SCIO is not hedging against depression or recession scenarios but did have some hedges for two standard deviation events when it was invested in public credit markets pre-Draghi. Currently SCIO is not hedging either the portfolio or individual positions. “The best hedge, we find, is to underwrite conservatively and thus avoid basis risk between the portfolio and hedges,” says Branch. SCIO is underwriting to historical scenarios and stress tests such as normal and sharp recessions or the Lehman collapse, and hypothetical scenarios such as an Italian referendum leading Italy to exit the European Union. The lowest-realised IRR on an individual private loan since programme inception in 2013 has been around 7% and to date there have been no realised losses: “We do not like to take a loss on anything,” says Branch. SCIO has not yet had to go through a workout process: “Deals are structured in bankruptcy remote entities that allow for acceleration and enforcement out of court,” says Branch.
SCIO concentrates on shorter-term opportunities providing “point to point” finance since these command higher yields generally into double digits for the base case scenario. SCIO finds the sweet spot for deal sizes is between EUR 5 and 25 million: “These are too large for individual investors and too small for private equity and larger funds. We do not want to be competing with other funds for deal flow. A key SCIO principle is to target overlooked market segments. Being the only person in the room means you don’t need to compromise, either on structure or price,” says Branch.
SCIO’s advisory board also brings to bear extra know-how and market intelligence: “They have an invaluable wealth and depth of experience and insight across a broad range including asset management, business development and market research,” says Branch. SCIO rarely offers co-investment opportunities to investors because bespoke and niche opportunities are not always well suited to co-investments, and SCIO can usually absorb the entire deal.
SCIO often needs to be geographically opportunistic to maintain its return targets. Germany was at one stage the largest country allocation, but in 2021 there is none in Europe’s largest economy. “It is overcrowded and overbanked: ten-year mortgages on commercial property often yield less than 2%. We can look across regions and invest in Finland, Poland or Ireland for better yields,” says Branch. Countries do need a legal framework that SCIO feels comfortable with.
We are in uncharted territory: debt to GDP is at the highest-ever peacetime level, and the last expansionary cycle pre-Covid was already longer than any other cycle.
Greg Branch, co-founder and CIO, SCIO Capital
SCIO is normally more than 90% invested and cash has averaged 5-10% over the past three years: “Cash kills returns, and we would stop taking subscriptions if we could not find opportunities,” says Branch. Sourcing private deal flow was not always easy in the early years however, and this partly explains performance differences between vintages of the closed-end funds; those that took longer to deploy capital had some periods of subdued returns. “When we started doing private credit several years ago, most deals came from banks. Today that has changed, with the majority sourced directly or via intermediaries,” says Branch.
Now that SCIO has enough assets to fund nearly all its niche deals, a network of relationships, a growing presence on social media, and a reputation for moving faster than the banks, the firm rejects far more deals than it accepts.
SCIO can afford to apply very strict and selective criteria. Collateral could be hard assets or financial assets such as mortgages or loans, some of which might be securitisable. Mainstream lending is an example of a space that is generally not of interest: “We avoid it not because we consider it a bad business model or because we don’t see value in it but rather because there is more competition in that market segment. There are market segments within SME lending, for example, which are overlooked that we do find appealing,” says Branch. Similarly in risk retention capital SCIO avoids mainstream deals but might find value in certain segments: “We have done risk retention, not in CLOs as that market is relatively well bid, but rather in smaller ABS deals,” he points out.
SCIO is inclined to avoid binary risks and excessively volatile collateral: “As debt is risk-asymmetric, long-term success hinges on focusing on downside protection. As such, we avoid strategies where the underlying assets display considerable amounts of volatility. Shipping would be one example of this,” says Branch.
SCIO has also eschewed some other more volatile industries, having had no exposure to travel, leisure and retail ahead of Covid: “Retail has been under pressure for years in a growing economy. It was obviously not a great sector to lend into, particularly late cycle,” says Branch. SCIO could also turn down deals where there is insufficient data to assess risks.
SCIO is a UNPRI signatory, and its ESG approach excludes some industries such as coal. As well as negative screening, some deals have a positive social impact: “Social housing, co-living and student loans are a few examples of ESG positive loans currently in our portfolio,” says Branch. The lending with SME Capital also has a positive impact in financing smaller firms.
These deals tend to require bespoke and complex structuring, where SCIO’s deep expertise allowed it to swiftly move into private credit. “Owing to our highly-experienced investment team with 24 years’ average experience in structuring, modelling, risk-analysing and trading, transitioning to private markets several years ago was rather straightforward. We also engage best-in-class external legal counsel, ensuring four-eye oversight on every deal,” says Branch.
SCIO does not use leverage at the fund level, nor are most deals implicitly leveraged through being junior parts of a capital structure: “Many of our recent deals are senior bridge facilities with hard subordination, so they are less than 100% leveraged. On our mezzanine positions, the amount of subordination varies based on the asset type. Most deals are heavily overcollateralised, unitranche or have some degree of subordination, though this may not always apply since every deal is unique. It depends on the asset class and deal structure, so is hard to generalise. Deals do not always fit into an easy bucket, and we underwrite every risk separately,” says Branch. In addition to seniority, SCIO likes to see other stakeholders putting their money where their mouth is: “SCIO always requires skin in the game in order to align interest,” says Branch.
Assets have an average duration of around one year. The breakdown in July 2021 was approximately 40% below six months and 80% below 18 months.
Assets have an average duration of around one year. The breakdown in July 2021 was approximately 40% below six months and 80% below 18 months. The relatively short duration means that SCIO, unusually, runs similar strategies in both closed-end and open-end fund structures, the latter of which was set up to cater for demand from high-net-worth individuals and family offices, many of which are long-time SCIO investors. New deals are shared between both funds, but there can be historical differences due to the timing of launches: “Many of the recent deals are shared between the two funds. However, as the new fund is only 15 months old, prior loans would typically be found in the older fund,” says Branch.
The open- and closed-end funds value assets in the same way and with the same frequency. Valuation agents used include Oxane Partners and Prytania, which have strong expertise in private credit valuations. Markit would typically be used for public assets. The SCIO Opportunity Fund saw a small and temporary performance reversal in March and April 2020, based on mark to market prices for liquid assets and lower mark to model valuations for illiquids: “The discount rates used to value private credit widened out and development loans extended maturity dates. The largest markdown was on a small legacy CLO position down 50%, but it quickly recovered and has already been repaid,” says Branch.
Branch does not doubt that the credit cycle is very mature: “We are in uncharted territory: debt to GDP is at the highest-ever peacetime level, and the last expansionary cycle pre-Covid was already longer than any other cycle. We are likely very late cycle, and as such SCIO has tightened its lending parameters accordingly. The catalyst for the next downturn is anyone’s guess, but come it will, and so we must prepare now. Forewarned, as they say, is forearmed. When the next proper recession comes, lenders without proper protections and loan covenants will be left high and dry, as institutions will do what they need to survive”.
Yet the opportunity set remains compelling for SCIO’s highly selective deals since European banks continue to neglect the smaller and medium sized deals where SCIO finds its best opportunities. “Fortunately, our deal flow is not reliant on bank deleveraging, but rather more a function of bank consolidation and their focus on larger clients. This has resulted in a funding gap, particularly for smaller structured loans, which SCIO exploits to great effect,” says Branch.