Chenavari Embracing European illiquid credit opportunities HAMLIN LOVELL


I


n its first six years, Chenavari has grown assets more than one hundred-fold to $5.5 billion from the $40 million it started with in 2008. The size of assets easily secures Chenavari’s place in The Hedge Fund Journal’s Europe 50 survey each year, while the performance of various funds


has earned Chenavari THFJ performance awards. Initially a European credit specialist, Chenavari has now opened offices in Sydney and Hong Kong to cover Asia, adding to London headquarters near Buckingham Palace and the Luxembourg trading base and business continuity backstop. The firm has been on a hiring spree, including private equity specialists, and now employs 90 professionals with roughly half now on the non-investment side handling operations, compliance, and regulation. On top of that there are now several hundred more staff in hands-on, operational roles at Chenavari’s loan servicing affiliates, which are important for some of the less liquid strategies.


Chenavari covers the full spectrum of European credit assets: corporate credit, credit derivatives, credit indices, financials, structured credit, asset- backed securities, real estate debt, regulatory capital and direct lending, including specialty finance activities. The suite of products ranges from a London Stock Exchange-listed permanent capital vehicle, to liquid alternatives offering monthly dealing, hedge funds locked up for between one and three years, and less liquid investment strategies with private equity-style fund structures and five to seven-year terms.


Although the liquid trading strategies still make up two-thirds of firm assets, this feature focuses on two less liquid investment strategies pursued by Chenavari: regulatory capital and direct lending, both of which have a compelling and growing deal flow pipeline. Chenavari is already launching a second regulatory capital fund as its first one, started in 2011, begins to return capital to investors. That pioneering fund has twice won The Hedge Fund Journal’s Europe 50 performance award for Best Performing Regulatory Capital Fund. The new fund will be investing until the end of 2016 and harvesting out to 2019. Meanwhile, a Diversified Direct Lending Fund maturing in 2020 with opportunistic exposure towards SME Lending, Real Estate Lending and Specialty Finance Lending is open to investors, and a dedicated new Real Estate Direct Lending fund is planned to launch in Q1 2015, after Chenavari initial real estate debt fund started to return capital to investors. Dedicated managed accounts are also available for both strategies.


Both of the less liquid investment strategies are taking advantage of opportunities created by the daunting scale of the deleveraging being undertaken by banks mainly in Europe. Like all of Chenavari’s funds, these


Table 1 Regulatory Capital DR - € 2011


YTD -2.86%


2012 2013 2014


36.94% 3.08% 15.19% 1.84% 6.42% 1.24%


1.61% 0.69% 1.18%


JAN FEB MAR APR -0.05%


3.39% 0.25% 0.53% 1.85% 0.97% 1.12%


Source: Chenavari Investment Managers as of 30 June 2014 MAY


0.53% 0.07% 1.03% 0.64%


JUN


-0.02% 3.91% 0.02% 0.27%


JUL


0.38% 4.41% 1.53% 0.24%


AUG


-2.39% 2.96% 0.68% 0.61%


Annualized Returns: 15.14% SEPOCT


NOV DEC


-2.32% 0.74% -0.71% 1.00% 5.61% 0.96% 3.82% 1.92% 1.20% 2.56% 1.08% 1.24%


have a clearly defined mandate, hence there is no overlap of holdings between the two strategies.


The limited life, closed-end fund structure is common to both. It follows a familiar private equity model – cash is drawn down and invested over a ramp-up phase, inflows level off and then the fund returns capital to investors in stages over the run-off harvesting phase. Management fees are friendlier than at some private equity funds – they apply only to capital drawn down and put to work, not to committed capital. Chenavari only gets performance fees after investors have received their initial principal, and only then above hurdle rates of between 2% and 4% over three-month interbank rates, depending on the amount invested.


Can double-digit returns continue? So Chenavari must be confident of maintaining double-digit returns if they expect to earn a performance fee of more than 1.6% a year. The 12% return target looks close to what distressed debt has delivered, but Chenavari is keen to emphasize that they focus mainly on performing portfolios of loans, and expect to deliver positive IRRs, even at multiples of historic default rates! So far, their adverse default scenario stress tests have proved realistic. The track record has been flawless, with no significant impairments recognized on any deals, in either the regulatory capital or the direct lending strategies.


Therefore, the 4% hurdle rate alone may seem startling for some investors – it is not far from the yields to maturity on many high-yield bonds or senior secured loans, which, trading near or above par, now offer buy and hold investors no scope for capital appreciation on top of yields. Of course, the Chenavari managers are active traders who aim to beat passive investors through market timing and security selection.


Even buy and hold investors might expect to get double-digit returns from these performing liquid credit assets through explicit fund-level leverage, or implicit leverage – buying more junior assets that have higher exposure to default risk. Chenavari’s less liquid investment strategies have not historically used the first form of leverage, on the balance sheet of the fund, but some of their positions are using the


second type of implicit leverage. Just as the junior tranches of structured credit vehicles like CLOs and CDOs are implicitly leveraged, so too are Chenavari’s first loss and mezzanine regulatory capital deals and their second lien direct loans. However, Chenavari’s junior participations are different from “plain vanilla” subordinated instruments, because they contain risk mitigants designed to limit downside, which form part of Chenavari’s expertise at structuring bespoke deals.


So, both trading and efficient debt structuring have contributed to Chenavari’s historical returns from illiquid credit, but Chenavari has also extracted double-digit returns from originating or owning first lien/whole loans – not just riskier slices of loan books – and holding them to maturity. Double-digit returns have been attained partly because illiquid credit still seems be an oasis of historically high risk premiums – even after the rising tide of liquidity appears to have lifted nearly every asset class boat. Yields on many liquid credit assets, such as “high”- yield bonds or senior secured loans, are at all-time lows in absolute or nominal terms, although credit spreads over the risk-free rate remain well above pre-crisis lows. Illiquid credit assets have not ignored the tightening trend, and indeed Chenavari finds that yields on some deals have been compressed to levels that no longer meet their risk/return criteria. “In some recent cases, such as some German SME mezzanine loans, we would welcome shorting the risk if we could,” says Loic Fery, CEO and co-CIO of Chenavari. However, six years after the crisis, carefully selected illiquid credit assets continue to offer potential returns that are historically high – in absolute terms, relative to those on liquid assets, and versus similar US deals, hence the stampede of US private equity firms into the space!


The evolution of market environment has been such that “these 20%+ gross double-digit returns are unlikely to persist,” Fery freely admits, meaning that the net annualized returns of 16% since 2011 for the regulatory capital strategy might not be maintained. Indeed, 2014 returns to August are now only 5.77% for the Euro share class, but Chenavari’s strategies in the space are still targeting net double-digit returns over a five to seven-year time frame. “Given the opportunity set, a net target return of 12 to


9


Page 1  |  Page 2  |  Page 3  |  Page 4  |  Page 5  |  Page 6  |  Page 7  |  Page 8  |  Page 9  |  Page 10  |  Page 11  |  Page 12  |  Page 13  |  Page 14  |  Page 15  |  Page 16  |  Page 17  |  Page 18  |  Page 19  |  Page 20  |  Page 21  |  Page 22  |  Page 23  |  Page 24  |  Page 25  |  Page 26  |  Page 27  |  Page 28  |  Page 29  |  Page 30  |  Page 31  |  Page 32  |  Page 33  |  Page 34  |  Page 35  |  Page 36  |  Page 37  |  Page 38  |  Page 39  |  Page 40  |  Page 41  |  Page 42  |  Page 43  |  Page 44  |  Page 45  |  Page 46  |  Page 47  |  Page 48  |  Page 49  |  Page 50  |  Page 51  |  Page 52  |  Page 53  |  Page 54  |  Page 55  |  Page 56  |  Page 57  |  Page 58  |  Page 59  |  Page 60  |  Page 61  |  Page 62  |  Page 63  |  Page 64  |  Page 65  |  Page 66  |  Page 67  |  Page 68  |  Page 69  |  Page 70  |  Page 71  |  Page 72