Kempen’s hedge fund solutions franchise has continued to mature since The Hedge Fund Journal last profiled the offering in 2013. Assets have grown to over $1.3 billion, from a mixture of steady performance, net inflows and the launch of a new multi-manager solution in structured credit: Diversified Structured Credit Pool (‘DSCP’). Kempen’s team is expanding. Alongside the two co-heads of Hedge Fund Solutions, Remko van der Erf and Michiel Meeuwissen, Kempen hired industry stalwart, Igor Puljic in 2013, who was previously Deputy CIO at Key Asset Management, as Senior Portfolio Manager, and Jeanne Spronck, who wrote her thesis on hedge fund replication, managed futures and alternative risk premia, as Portfolio Manager in 2016. Kempen is currently seeking to hire a fifth hedge fund manager selection specialist. The four-strong full-time hedge fund team are supported by an advisory board of five, which has recently added Mark Smith, formerly an event-driven and merger arbitrage manager at Gruss. The hedge fund specialists also draw on expertise elsewhere in Kempen. There are 17 other manager selection professionals, covering traditional strategies, private debt, real estate and private equity; equity and credit analysts looking at single securities; trade execution, fund structuring, operations professionals; a risk team of eleven, and legal and compliance.

If Kempen’s team keeps growing, its roster of hedge funds has moved in the opposite direction. “The number of managers has shrunk to around 21, as we have further increased portfolios’ concentration,” says Meeuwissen. Retaining Aksia for a full operational due diligence (‘ODD’) second opinion – on top of Kempen’s own ODD – is one change that Kempen implemented in 2013. Kempen’s team shadowed Aksia’s ODD routines and determined that the process was thorough and high touch. A further augmentation of Kempen’s process is using RiskMetrics HedgePlatform for risk aggregation (with some managers also offering Open Protocol Enabling Risk Aggregation). Separately from risk aggregation, Kempen continues to obtain full position transparency electronically (or upon site visits for some ‘old school’ managers).

Indeed, Kempen’s own ODD emphasises the crossroads between investment due diligence (‘IDD’) and ODD. Valuation and liquidity classification are hot IDD/ODD overlaps (where Kempen has noticed the same instruments classified as level 2 and level 3, under the valuation hierarchy, in different fund audits in some instances). Valuation of level 3 instruments is naturally a focal point of DD, and Kempen has a sharp eye for ‘stale pricing’ where some managers have been remiss in not updating valuations frequently enough. “Best practice is not to charge any fees – either management or performance – on level 3 assets until they are realised,” argues van der Erf.

Fees and non-fee costs
Kempen’s own multi-manager fees are 0.75% for quarterly liquidity (and 0.55% for a longer lockup), with no performance fee, for its commingled funds of hedge funds investing across multiple strategies. A concentrated book, with average ticket sizes of $60 million, helps Kempen to negotiate lower fees from managers, which can be obtained in various ways: early bird, founders’ or other share classes, or rebates for loyalty or allocation size. Kempen reveals that fee discounts can get typical management fees down from 2% to 1.5%. Kempen’s average holding period of six or seven years puts the firm in a strong position to have a fee conversation with a manager. The Dutch are, stereotypically, as thrifty as the Scots, and Kempen also encourages managers to negotiate competitive terms from service providers, such as administrators. “Eighteen basis points is more than you get for an outsourced CIO mandate and seems too high for administration. A manager got the cost down to ten basis points after we pointed this out,” says van der Erf. Indeed, non-fee expenses are often overlooked but can include hefty line items. Kempen takes a pragmatic approach: “While there are other expense types that we do not like managers to charge to their funds, there are no hard and fast rules to disqualify a manager; expenses should all be seen in the context of their activities and Kempen engages in a constructive dialogue rather than voting with its feet,” explains Meeuwissen. Kempen finds that credit and distressed strategies tend to have somewhat higher non-fee costs, partly because legal advice can be an inherent part of strategies that involve creditor committees, restructurings and insolvencies, etc. Distressed debt and structured credit are typical of the more complex, specialist strategies that appeal to Kempen.

Kempen Orange Investment Partnership’s top ten holdings, as disclosed in its annual report, are Anchorage, Pharo Gaia, One William Street, Tybourne, Boussard & Gavaudan, OZ Credit Opportunities, Bridgewater, Nokota, Silver Point and LibreMax. Kempen has made good strategy allocation decisions in having a high structured credit weighting, and has also identified outperforming managers within out of favour strategies, such as macro and CTAs. Though many discretionary macro managers complain that it has been harder to make money in the QE era, Pharo has profited, amongst others, from an early long stance in emerging market currencies, and a contrarian long position in the Euro in 2017. Kempen has also identified a relatively strong CTA: its only hedge fund manager based in the Netherlands is trend-following CTA Transtrend, which was profiled in The Hedge Fund Journal this year to mark its 25th anniversary.

Performance
Kempen’s commingled products that invest across multiple specialist strategies and managers (Kempen Orange Investment Partnership, and Kempen Non-Directional Investment Partnership) have performed well since they launched 2005/2006. Recent performance is between top decile and top quartile in the Mercer and InvestHedge databases, according to Meeuwissen, who acknowledges that during bull runs, the lower equity beta of these products means they may not keep pace with US multi-manager products that run more equity exposure.

Bespoke tailoring
But investing across multiple strategies and asset classes does not suit all investors. “We have a close relationship with clients (pension funds, private banks, family offices and insurance companies) and their needs have led us to launch bespoke, high conviction portfolios focused on specific strategies, such as structured credit,” explains van der Erf. Some 40% of Kempen HFS assets are now in bespoke strategies. For instance, Kempen runs two separately managed accounts for medium-sized UK and Dutch pension funds with assets between $3 and $6 billion (the largest pension funds often have their own in-house teams investing directly into hedge funds). The UK mandates fit in with the wider Kempen strategy of growing its international footprint, including its market share inthe UK, after acquiring the UK clients of fiduciary services provider, MN Services.

DSCP: Structured credit at competitive fees
Since 2009, Kempen has steadily increased its allocation to structured credit and has generated strong returns. Kempen has carved out its structured credit hedge fund allocation, and calculated that it delivered annualised returns of 10.1% and volatility of 4.3%, between December 2009 and March 2017, as shown in Fig.1.

In response to investor demand, Kempen has launched Diversified Structured Credit Portfolio (DSCP), a multi-manager fund that allocates to long-only structured credit funds operating in ‘crossover’ territory (average credit rating between BB and BBB) and are managed by hedge fund firms. Mentioned funds generally do not use any leverage. And as of late 2017, the fund’s target returns (4-6% net) are expected to come mainly from clipping coupon income, while good quality paper mainly trading in the 90s provides additional scope for gains from pull-to-par capital appreciation. Though the opportunity set in late 2017 is attractive in relative terms, the extraordinary opportunities that arose from dislocations over the past eight years (particularly in 2009, 2011 and 2015) are rarely present right now. But they might yet recur.

Quarterly liquidity and fees
Kempen has been opportunistic in adding to its structured credit investments upon selloffs, for instance in 2011 and in late 2015/early 2016. Because such routs may be seen again – and Kempen is cognisant that liquidity can dry up during these episodes – Kempen maintains its preference for quarterly liquidity (even though some managers in the space will offer weekly or monthly liquidity). “Commercially, we might have put out a more liquid offering, but we want to be able to withstand a crisis or even take advantage of it,” explains van der Erf.

The fees are commensurate with the return expectations. Kempen always thought that fees of 1.5 or 2 and 20 were too high for long exposure to structured credit, such as CLO equity, and resolved to launch a long only product with much lower fees. Kempen’s fee is 0.35% and the three managers are running dedicated funds initially created specifically for, and effectively seeded by, Kempen, which pays an average fee of 0.6% indefinitely (while other investors would generally pay 1%). No performance fee is charged at either level. With non-fee costs of only around 0.10% in a relatively low cost AIFMD-compliant Luxembourg RAIF (Reserve Alternative Investment Fund) vehicle, the total expense ratio is not much more than 1%. The vehicle is open to professional investors. For now, there are USD and EUR share classes, and a GBP share class can be added in response to demand. Kempen also runs an allocation within a separately managed account in the same strategy, on a pari passu basis.

Yield pickup and complexity premiums
At its simplest level, structured credit in late 2017 offers a better risk/reward than many other credit sub-asset classes. Structured credit provides a yield pickup, relative to corporate debt of the same credit rating, typically of around 200 basis points, as shown in Fig.2.

Structured credit offers competitive yields across all credit ratings, as shown in Fig.3.

Joseph Naggar, the Senior PM, Partner and Executive Committee member of GoldenTree, which manages one fund that DSCP is invested in, explained why he views structured credit valuations as anomalous: “In most parts of the credit markets, valuations are at post-crisis tights, but in structured credit, a ‘BBB’-rated CLO tranche offers a spread of 400, which is still above pre-crisis levels.” One explanation could be memories of sub-prime NINJA loans inside pre-crisis RMBS structures: structured credit was at the epicentre of the GFC. “But the next crisis or recession will not be the same as the last one,” says Naggar, who was interviewed by van der Erf, at the Legends4Legends conference held in Amsterdam in September 2017.

Kempen and Naggar view the yield pickup as a ‘complexity premium’, amongst others. Returns in structured credit may be higher because fewer managers have the capabilities to invest in it. According to Kempen, only around 40 managers worldwide are geared up to trade the structured credit market, which is sized at $2.8 trillion in the US alone – twice the size of the US high yield market. “Technology is crucial as you cannot manage portfolios without it. You need powerful technology to model and monitor cash-flows, waterfalls and thousands of bonds with different nuances. You cannot analyse these one by one,” explains van der Erf. “GoldenTree were one of the first and are still one of the largest clients of Amazon’s AWS cloud computing division,” continues Naggar. Structured credit investing also requires extra qualitative research, with one example being the quality of service providers. For instance, van der Erf observes that “in sub-prime auto loans one particular issuer can be particularly weak but another one can be much stronger. You need to know your issuers and how they originate loans as the quality of the collateral is crucial – and can make or break a deal.”

Investor segmentation
Another reason for higher yields is differences of opinion over credit ratings. “Some paper rated below ‘CCC’ is less risky than a ‘BBB’ rated paper. For instance, sub-prime mortgages dating back to 2004, now tend to be below 10% of the original balance with average loan to value ratios of the order of 40-50%. These are not likely to default,” opines van der Erf. “Ratings inefficiencies create imbalances between supply and demand: as capital charges on sub-IG rated tranches are extremely high for insurance companies, they are excluded,” continues Meeuwissen. Regulatory rules around banks and insurers’ capital and solvency, such as Basel, Solvency II, and Volcker, also mean that large swathes of the asset class are off limits for many potential buyers. Another potential group of investors is ruled out because structured credit has not yet been packaged into ETF or index products. Furthermore, little of central banks’ QE programmes have been directed at structured credit.

Diversification through specialist managers
If the level of returns is expected to be higher, the pattern of returns is also different from other parts of the credit markets. As a considerable part of structured credit is floating-rate related, it has less interest rate duration risk than fixed income bonds. Structured credit can offer some degree of diversification from equities and bonds – and from other credit sub-asset classes – as each collateral type in structured credit has different return drivers and sensitivities. DSCP can invest in CLOs, RMBS, CMBS, consumer ABS (autos, credit cards, student loans), and other ABS such as CDO TruPS.

Kempen has identified specialist managers with core expertise in particular sleeves of structured credit (GoldenTree is focused more on CLOs, LibreMax more on RMBS and consumer ABS, and One William Street on CMBS and RMBS, per Kempen). The portfolio has roughly equal weightings to the three, each of which manages several billion in structured credit. The key portfolio managers – Joseph Naggar at GoldenTree; Greg Lippman at LibreMax and David Sherr at One William Street – have an average of more than 20 years’ structured credit experience.

Margin of safety
From launch in April 2017 to September 2017, the strategy annualised at around 6%, which is within its target range (of 4-6% per annum unlevered) for a “fundamental risk profile that Kempen judges to be close to investment grade,” says Meeuwissen. In the language of value investing legend, Benjamin Graham, there is a wide ‘margin of safety’. Stress tests suggest that default losses would need to be worse than those seen in the early 1990s or GFC Great Recession of 2008, before the type of paper owned started to incur losses. Kempen cites a generic trade example from LibreMax, who have modelled a 5.75% yield for a CLO bond rated ‘BBB’ and estimate that defaults would need to hit a cumulative 14% per year, every year the bond was held, before the bond saw impairment. In fact, the highest US loan market default rate over the past ten years has been just 8.2%.

Moreover, active, specialist CLO managers have been adept at avoiding a high proportion of defaults. (This is not only seen in loans. In general, active credit managers are far more likely to outperform long only indices than are equity managers).

Preferred areas of structured credit
DSCP’s portfolio is balanced mainly between investment grade, and sub-investment grade, bonds, with any unrated holdings deemed to have an acceptable risk profile. Notwithstanding the inefficiency of credit ratings, Kempen expects to be exposed mainly to BBB and BB rated tranches – below the AAA and AA but certainly above the equity. “DSCP would not do CLO equity even in a crisis situation. A CLO with ca. 5% exposure to Toys R Us recently saw its CLO equity tranche lose roughly half of its value,” warns van der Erf.

Kempen’s structured credit managers also have significant exposure to non-agency US residential mortgage backed securities, based on strong fundamentals from US house prices and the job market. However, yields in this area are starting to compress, as mainstream asset managers move into RMBS.

CMBS can offer much higher yields, but careful security selection is essential. Some retail-oriented CMBS assets are threatened by internet retailing, and certain synthetic CMBS tranches have become popular short trades; most notably CMBX series 6. But a huge variety of underlying collateral can be found in CMBS and Kempen likes to invest with managers that are doing detailed diligence on tenants, borrowers and individual properties. For instance, single hotel properties can end up paying low double digit yields for loans. The boom in prime US office valuations has meant loan to value ratios are low and credit investors’ innate caution means that yields can still be as high as 8-9%.

Certain niches in structured credit, “such as trust preferred CDOs, backed by junior debt of US regional banks, trade at the lowest levels in the whole world”, GoldenTree’s Naggar points out. He recently acquired mezzanine paper at 50 cents, which has appreciated to 65, and offers a substantial safety cushion: “Defaults of 24% two years in a row would be needed for the instrument to start losing money. The peak level of defaults in the global financial crisis was 7%,” explains Naggar. Consumer credit card receivables also offer a high margin of safety: “Certain mezzanine tranches could withstand defaults of 19% per year, without losing money; current default rates are running at 3-4% and they peaked at 17%.”

Elsewhere in consumer ABS (which includes credit cards, student loans and auto loans) there can be security-specific opportunities. Student loans remain unique in the US in that they cannot be discharged in bankruptcy (fears that Hillary Clinton would let students write off their debt are now on the backburner). This means that defaulted loans can come good later on if graduates’ fortunes improve, and some graduates enter into settlements with lenders. “Note that such settlements would provide a windfall gain to the trust as loans are generally written off to zero upon delinquency,” points out van der Erf. Once again selection is key as the student loans market is a rather bifurcated one. “Student loans issued by the private sector (banks and other financial institutions) are of better quality with lower defaults than those offered through federal programs, which tend to be need-based. Private student loan programs are credit-based with better underwriting (e.g. focus on higher quality universities), and co-signing by parents can provide a high degree of guarantees. Historical defaults in the private student loan segment (ca. 10% of the market) have been a fraction of the government ones,” explains van der Erf. Even in sub-prime autos, where default rates are forecast in the high teens, it is possible to find tranches that have a huge cushion of loss absorption from more junior tranches. “It is also about how a deal performs versus initial expectations. If the newspapers are full of subprime auto delinquency rates of up to 20% – but the modellers assumed a 24% default rate to underwrite a bond initially – then it is still on track to perform,” illustrates van der Erf.

Generally, the US agency mortgage market does not offer a way to express a credit view. But one DSCP manager (LibreMax) has exposure to a specific type of Fannie and Freddie notes – Credit Risk Transfer (CRT) notes that are junior/mezzanine notes backed by high quality collateral. “CRT notes are beneficiaries of the strong US housing market that is characterised by rising home values, low unemployment and rising wages; all on the back of a solid and growing US economy. A potential resurgence of inflation would be a positive for these notes as it would further improve LTV ratios,” explains van der Erf.

Areas to avoid
Just as important as where Kempen’s managers are investing, is where they are not – and may never – invest. A few examples follow. For now, Kempen has limited exposure (around 16%) to European ABS, which is mostly European CLOs and a tiny bit of UK non-conforming mortgages, partly because European RMBS has less secondary market liquidity. Kempen’s three managers have nothing in Asia, where Japanese RMBS trade at very tight spreads. Kempen has tailored its manager mandates to be all about credit risk and managers are not encouraged to take significant duration or prepayment risk. For this reason, most Danish MBS is off limits. Kempen would naturally not invest in exchange-listed closed end funds that can run balance sheet leverage of 10 or more times as its managers are restricted to 25% leverage (and “even that 25% gearing can only be utilised during market sell-offs so that managers can take advantage of forced selling should it occur,” van der Erf adds). Kempen is well aware of the investment thesis for a popular hedge fund trade in Fannie and Freddie preferred stock, but views the story as being too binary.

Bermuda-bound for ILS deep dive
“We are constantly striving to stay relevant to our client base,” says Meeuwissen. In the wake of a clutch of severe hurricanes, a trip to Bermuda is scheduled to update research on the insurance linked securities (ILS) space. Kempen is less interested in CAT bonds than in the private markets for reinsurance and retrocession contracts, which can offer higher yields. The attraction of these annual renewalcontracts is partly the chance to reset afresh at zero each calendar year. Kempen is no stranger to ILS, having been invested between 2008 and 2014. Kempen took profits on the allocation after determining that spreads were not enough to compensate for the risks. Kempen is in no doubt that climate change impacts sea temperatures and therefore damage done by hurricanes, and will be delving into managers’ models in these areas. Kempen will be diving into the data, but with three four-hour meetings per day over two days, there will be no time for scuba diving.

Outlook
Spreads keep grinding tighter and may compress further. A shrinking supply of some types of structured credit bodes well for the technical outlook. Despite this, GoldenTree, for example, finds adequate liquidity in structured credit. “At GoldenTree we trade $2-5 billion in the asset class per year and sometimes $100 million in a day,” states Naggar.

In addition, Naggar says that “while new issue in structured products are down by 60% from pre-crisis levels, the new issue market in ABS, CLOs, and other structured credit creates $300-500bn of new product per year.”

Structured credit can certainly be vulnerable to market panics, but could prove more resilient in future than it was during the GFC. Post-crisis, the investor base of structured credit has shifted from leveraged investors such as prop desks and off-balance sheet vehicles that were key players pre-crisis, to ‘real money’ investors such as pension funds, asset managers and insurers that are not using leverage.