Through the cycle returns 

Both DSC Meridian strategies have an all-weather performance objective of targeting double-digit net returns through a full cycle, though they target higher returns during the recovery after periods of corporate distress, and then position the funds more defensively when risk premiums are lower. The firm has so far met its objectives since its 2018 launch and made profits in very different years, due to their nimble portfolio construction. “At the top of the cycle, when spreads are tight and defaults are low, we prioritize capital preservation, liquidity, secured instruments and alpha shorts. At the bottom of the cycle, when spreads are wide, we target capital appreciation and focus on long opportunities in stressed and distressed securities. Beginning 2020, credit markets had been in one of the longest benign cycles ever, so we were defensively positioned, running a low net exposure. By March, our shorts kicked-in and we protected capital, which allowed us to pivot the portfolio and focus on very attractive long opportunities caused by the Covid pandemic,” says Chowdhry. 

Some key distressed trades in 2021 involved debt of two Latin American airlines, acquired at prices in the $30s, which more than tripled to reach near or above par value ($100), and outperformed similar debt in developed markets. In one case, DSC Meridian was an active participant in the corporate restructuring serving on the creditor committee and driving the process. In the other case, DSC Meridian was a passive participant demonstrating the firm’s flexible approach to investing in distressed.

Triple digit returns were also made from some selective excursions into equities after the Covid shock. Chowdhry has always analysed the entire capital structure in search of the best risk/reward, and this sometimes comes from the equity. During the Covid crisis, a regional and school coach transport operator in Europe had bonds trading at 90 cents and yielding 4%, while its equity had dropped by 80%, offering a more asymmetric proposition. “We mainly look at equities through a credit lens and have the flexibility to invest across the capital structure to capture the best expression of the asymmetric risk/reward,” says Chowdhry.

The high yield ESG learning curve

ESG is currently seen as cyclically fashionable, but many investors and companies have had multi-decade long ESG objectives. In 2021, Investcorp-Tages seeded DSC Meridian’s second fund, a highly innovative ESG credit strategy, the Climate Action Fund. “We partnered with Investcorp-Tages because they have a strong reputation for seeding and ESG, including an A+ UNPRI rating,” says Chowdhry.

The climate action strategy shares the performance objective of the flagship strategy and has had similar returns. Neither strategy targets the mainly investment grade, ‘green bonds’ and ‘sustainability bonds’ that can exhibit a ‘greemium’ valuation premium but offers relatively low yields of 4-5%. Instead, DSC Meridian’s strategies are focused on US high yield credits currently offering around a 10% return target. Returns apart, the philosophy of the strategy does not restrict it to exclusively ‘green’ companies or projects. Part of the portfolio is aligned with net zero or other climate objectives, but the most exciting aspect is improving climate (and investment) performance of heavy emitters – and DSC Meridian has already had considerable success engaging with high yield issuers to proactively shape positive carbon outcomes. 

US high yield is a huge and often neglected climate and carbon engagement opportunity due to its disproportionately high carbon footprint and slow adoption of climate disclosures and decarbonization targets. “While US high yield issuers make up only 3% of the credit investment universe in the US, they contribute approximately 33% of carbon emissions. The key industries include energy, construction, power, steel, transport, airlines and cruise lines,” says Chowdhry. The arithmetic here is that US high yield issuers account for $1.5 trillion of debt outstanding and emitted 2 billion metric tons of absolute, annual scope 1 and 2 carbon emissions, as of February 2021 (as highlighted in DSC Meridian’s April 2021 ESG Spotlight White Paper, “Event-Driven Credit: Climate Impact Through Corporate Engagement”).

Additionally, these companies are at an earlier stage of their ESG journey than many large global companies: as of February 2021, just 15% of the 962 issuers in the MSCI US High Yield Index were disclosing scope 1 and 2 carbon emissions; fewer (14%) had set science based targets consistent with a 1.5 or 2 degree warming scenario and fewer still (11%) were currently aligned with such a scenario, (as flagged up in DSC Meridian’s May 2021 ESG Spotlight White Paper, “Crawl, Walk, Run: Fit-For-Purpose Solutions to Address Climate Change”).

Collaborative engagement 

This last white paper also sets out how different companies traverse their climate journeys and trajectories at different speeds. The “crawl” stage commits to a materiality assessment that will typically identify 5 to 10 ESG issues as being material. The “walk” stage involves consistent disclosures across regulatory filings, annual reports and sustainability reports. The “run” stage requires a commitment to net zero, which could include divesting higher carbon units and investing in decarbonisation, setting credible interim carbon targets, board engagement and financial incentives for senior management and other staff. DSC Meridian is also flexible about which reporting and disclosure frameworks such as CDP, SASB, TCFD or GRI are most attuned to different issuers’ plans. 

ESG disclosure and improvement 

The engagement book has so far achieved the highest return on capital: since the Climate Action Fund’s April 2021 inception, the engagement book has generally comprised about one third of the fund’s long exposure but has contributed over 50% of returns as some issuers announced ESG changes that were welcomed by investors. This corresponds with some equity research suggesting that ‘ESG improvers’, rather than firms already boasting the highest ESG scores, are the biggest alpha opportunity. So far, as of March 2022, the engagement book comprised 12 issuers out of 50 or 60 issuers the Climate Action Fund has invested in. DSC Meridian speaks with most of the companies in the portfolio about ESG and fundamental issues but classifies issuers as ‘engagements’ where there are specific climate outcomes identified and acted upon.

Some asset managers outsource engagement to one or more of proxy voting advisors, ESG ratings agencies, and others but DSC Meridian prizes one on one dialogue. “We work with companies on a collaborative and constructive basis. Activism is not only for equity investors. Real time engagement, directly with the company, is better than third party reports based on web scraping and annual reports, which can be over a year out of date. More and more investors are asking issuers for ESG data, which DSC Meridian believes is essential for assessing high yield issuers. We understand companies better and know where they are heading. We engage with companies on a wide variety of Key Performance Indicators (KPIs),” says Chowdhry. 

Engagement asks for both disclosure and action. “A short-term priority is simply asking companies to disclose scope 1 and 2 emissions and asking some firms to split their “dirty” activities from their “clean” activities through spin offs,” says Paula Luff, Director of ESG Research and Engagement. At some stage in the future, DSC Meridian might focus attention on scope 3 emissions, which are even more rarely disclosed. DSC Meridian is also educating firms about the rising price of carbon, which they expect could increase much further.

High yield companies could even be more receptive to ESG discussions, simply because they need to refinance every few years. Many companies appreciate the ESG input from DSC Meridian. Some high yield issuers are under-resourced in terms of having no dedicated Chief Sustainability Officer (CSO) and an average of only half of one full-time employee devoted to ESG, according to DSC Meridian research. A cruise line operator and a sand materials company have already provided written, positive feedback endorsing DSC Meridian for its ESG input. Most of the engagement is environmental, but there have also been discussions about health and safety issues, an example of a social topic.

Engagement has been mainly bilateral so far, simply because DSC Meridian are not aware of any other investors pursuing the same approach. “When we started our ESG journey 3 years ago, nobody else was doing it, so we could not borrow any ideas on engagement,” says Jay Blount, Director of Business Development. The firm is however open-minded about collaborating with other investors who share similar objectives. The aforementioned thought leadership white papers, and others on the DSC Meridian website, educate investors and the industry about DSC Meridian’s approach.

Alignment, credits and offsets

Some companies, including those using older or legacy technologies, need carbon credits and offsets to meet their net zero targets, which can be controversial where these measures are seen as substitutes for changing the core business. DSC Meridian views credits and offsets as interim steps along a decarbonization continuum. “If companies such as airlines or cruise lines cannot eliminate carbon from their core activity, based on current technology, then buying credits is better than nothing. Some US airlines are doing as much as they reasonably can now, including upgrading their fleet and investing in new climate mitigation technologies. This sets a good example for other airlines in Latin America or elsewhere,” says Chowdhry.

Legacy technologies not excluded

Since DSC Meridian is targeting large polluters for engagement, it would be irrational to avoid investing in them. “It is not an exclusionary strategy,” stresses Chowdhry. DSC Meridian will engage with both forward-looking companies and those in legacy technologies. No industries are necessarily off limits. Excluding or divesting from a high-emitting industry or issuer may make for a lower carbon portfolio, but it has no impact on real world emissions in DSC Meridian’s view. The manager prefers collaborative engagement to exclusions and is pragmatic about the limits of current technology. “Coking or metallurgical coal has no current substitute in the steel industry. We applaud new technology using hydrogen to make steel, but it is not yet being deployed at scale,” says Chowdhry.

Shorts combine financial and ESG criteria

Shorts can be based on financial or ESG risks or a combination of both. A highly successful short in a specialty finance lender was based on discrepancies in its disclosures, though its focus on high interest payday loans was also somewhat controversial since some investors perceive this as “predatory” or “usurious” lending. This specialty finance lender ultimately filed for bankruptcy in Q1-2022. 

Outlook

DSC Meridian’s base case is that low double-digit net returns could be achievable from a mid-cycle expansion of risk premiums. Chowdhry admits that it is tricky to judge the exact point of the credit cycle since a typical cycle lasts 5-8 years but the current one was interrupted by Covid: “Two years post-Covid it is reasonable to assume we are mid-cycle, and there are good opportunities because all asset classes have corrected: equities, investment grade credit and high yield have all had pullbacks and there is plenty of dispersion and volatility”. 

The biggest two risks Chowdhry sees would be an escalation of the Russia/Ukraine war to include NATO, and higher inflation, with the second one feeding into investible themes: “Current inflation of 7-10% is already starting to impact consumer sentiment, though high yield has been fairly insulated. High yield spreads have risen by 300 bps, but we are not yet seeing a rise in defaults. We are cognizant of supply chain and inflation risks and avoid both on the long side. We also own materials, mining and commodity companies that may benefit from inflation”.

Interest rate risk is a lesser concern. “Bonds yielding 10% with a 3.5-year duration do not have much interest rate sensitivity and are more sensitive to equity valuations. We are hedging interest rate risk and in theory could even over-hedge it, but we would rather take a bottom-up approach and pick alpha shorts than take macro views,” says Chowdhry. The portfolio currently has positive overall carry of 6%, including the negative carry from the short book. “The shorts are designed to offer an asymmetric risk reward. Trading near or above par, they have little or no risk if bonds are retired or called at par, but do have significant optionality on the downside,” he adds.

Both strategies offer discounted fees in their founders’ share classes until those share classes reach $500 million in assets under management.