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Feb 21
Opportunities & Pitfalls in the Credit Markets

​​Thursday, February 8, 2018

Speaker: Bennett Goodman, Co-Founder, GSO Capital Partners and Senior Managing Director, The Blackstone Group

1.    GSO Capital Partners overview.

  • Blackstone's global credit platform with over $97bn in assets under management – one of four Blackstone's principal investment businesses.
  • Focused primarily on non-investment grade corporate credit market (Junk-rated Universe)
  • Credit strategies: direct lending, stressed/distressed debt, mezzanine lending, long only (high yield and leveraged loans), event-driven, and energy-focused funds.
  • Less liquidity does not necessarily mean increased credit risk.

 

2.    Market outlook

  • Short-term (1-2 years) outlook is generally constructive:
    • Favorable macroeconomic outlook due to tax reform, lighter regulatory touch, repatriation of capital from overseas, employment is high.
    • Expect 2.5% - 3.0% US GDP growth.
    • US consumers are in good shape.
    • Public markets remain open and liquid.
  • Longer-term outlook gets hazier. In our view, the main risk to the markets has less to do with macroeconomic risk but more with trade policies and in particular geopolitical risk.
  • Markets are fully valued – 8 out of 10 major stock indexes around the world have P/E multiples that are higher than their 15-year average. We view that valuation as a source of collateral protection.
  • The artificial stimulus of accommodative global coordinated easing monetary policy is creating distortions.
    • Currently the US 2-year Treasuries are traded at 2.12% YTM well in excess the main European countries as ECB buying sovereign debt building its balance sheet – here we see a potential for a broad change in the next couple of years.
    • Currently European unsecured high yield bonds trade at 3.7% yield, while US senior secured bonds trade at 6.3% - our advice: short European high yield go long US senior secured debt.
    • The spreads are also impacted – today a typical leveraged loan trade at 420bp over the Libor (vs 15-year average of 530bp); high yield bonds are even more pronounced trading at 390bp over Treasuries (vs 600bp).
  • Default rates has been pretty low since 2011 and may remain low into 2019 - JP Morgan's forecast of 2.5% default rates is well below the historical average of roughly 4%.
  • Given the historical data, we suspect the next distressed cycle is likely to come over the next few years.
  • Historically (over the past 17 years) high-yield bonds provided attractive returns in 12-24 months period after the high-yield spreads crossed 700bp, averaging to 8.0% and 22.2% return in the next 12-month and 24-months period, respectively.
  • Liquidity in the leveraged finance markets:
    • Ever since the financial crisis the capital allocated to market making has evaporated – comprised a tiny 0.3% of $1.27trln market as of end-2017, down almost 90% in volume since the crisis.
    • At the same time the HY market size has doubled (from about $0.6trln in 2008) over the same period of time.
    • We expect that situation to change, and expect the liquidity to be provided not by the largest players, but those investors that have capital to put to work when that change happens.

 

3.    Where are the opportunities?

  • Direct lending - senior secured loan to a middle market company can provide an attractive alternative to public markets:
    • Higher levels of income compared to many traditional fixed-income investments - yield 8%-10% vs 6.3% leveraged loans.
    • We typically got lending with 2.5x interest coverage, 1.5x interest coverage after CAPEX, less debt/cash flow multiple compared to public market deals. We got covenants!
    • Relatively low interest rate risk due to floating rate structure.
    • Relatively low credit risk due to seniority in capital structure.
  • Energy
    • Banks reduce their exposures to energy sector due to regulatory pressure.
    • Additionally, the market 'hates' E&P right now: energy stocks trading close to 52 weeks low, every energy IPO done in 2016 is trading below its issue close despite the fact that oil price has increased.
    • The capital availability for energy companies is constrained - that is generally a good time to think about investing.
    • At the same time the capital needs are accelerating: CAPEX for shale gas companies, M&A activity is picking up.
    • Hard assets, divisible acreage, optimistic CEOs and multiple strategic buyers in any given shale gas play.
    • In middle market we are focused on senior secured debt (more defensive), in energy sector we don't mind having more junior position - we can structure a convertible debt or preferred warrants where we get equity like returns but take credit type risk.
  • Mazzanine lending.
    • In 2017 we allocated $1bn into our mezzanine fund but ended up with more than $2bn worth of deals all at a very good terms.
    • Large scale capital commitments are scarce – very limited number of institutions can write a $1.0bn check today.
    • Sellers of assets need certainty of funding – the seller will not take you seriously unless you have committed funding.
    • Mezzanine financings provide speed of execution and certainty (no need for roadshows or rating agency presentations).
    • In return, a provider of mezzanine financing gets well compensated – in our mezzanine structures we are commanding 9%-10% coupons at a time when high yield bond market is yielding 6%-6.5%. Current illiquidity premium of 350-400bp is well above the historical norm of about 100bp – this creates an incremental return without increasing credit risk.
    • We are able to mitigate risk better by negotiating credit agreements. 

Q&A:
1. With regard to the energy sector you have talked a lot about producers, what do you think about pipelines?

  • We like midstream MLPs because they are hard assets, they operate with long-term contracts, and they are basically a unique monopoly.
  • Most MLPs trade around 7.5%- 8% dividend rate which is excessive compared to utilities' 2-3%. The growth prospects for midstream MLP pipeline companies are far greater than for utilities.
  • There is a probable $800bn of capital needs for additional pipelines given the development of shale gas in the United States. Those CAPEX projects have an average 12% rate of return. MLPs cost of capital is about 7%-8%. The industry thus provides the volume and a good risk-reward opportunity.
  • Why are they trade the way they trade? MLPs are dominated by retail investors and they tend to trade MLPs based on oil price trends; in 4Q17 we also saw a tax related selling. We believe the institutions will eventually come in to that assets class and the excessive dividend yield will come down.
  • Drawbacks: complexity of partnerships, tax consequences.

 
2. You gave a lot of examples about the kind of premium you were able to command over the public markets because of the features that you offer to the issuers. But at the same time one of the trends that we have observed is an increased allocation to private equity and private debt space. In theory that would mean more competition. Can you talk a little bit about the challenges and how the marketplace within the private space has changed as we have seen the growth in capital flows towards that space?

  • Indeed, a lot of capital has been raised through a direct lending around the world, and the market has become more competitive, e.g. our Libor+7% pricing was Libor+9% three years ago, a lot of deals are Libor+5% or Libor +6%.
  • In order to be in the space you have to have a competitive advantage:
    • We believe scale matters.
    • We offer to any of the company we are lending to participate in Blackstone Group Purchasing Program which negotiates better pricing for different products and passes that advantageous rates to our borrowers (e.g. Blackstone is the second largest user of Fedex services after Amazon).
    • We compete on who is the most valuable partner – on average every portfolio company that signed up to participate in that Group Purchasing Program saves 2%-6% in EBITDA annually through the cost saving.

 
3. What do you think about emerging markets debt?

  • We don' like it. Mostly because we don't understand it.
  • That is an incredibly different business: main difficulties are sovereign risk, the notion of a lack of a law, currency risk etc.
  • It is a different story for EM equity where you can buy a growth story. As for credit, the risk and reward (high single digit coupon) that you get are incomparable. 
 
4.  In direct lending how do you feel about your competitors underwriting standards?

  • Our principal competitors are "good players", but there is always someone (in any industry), likely a new entrant, who wants to "break the rules" trying to establish a market share.
  • Culture is very important.
  • Having everyone share a perspective on risk and reward is the key.
  • Stay disciplined to your core tenants.​


5. When do you think deleveraging will occur? What do you think of government loosening regulations on financial institutions?

  • I believe that many aspects of Dodd-Frank Act will either be amended or repealed. Trump's administration is very focused on getting the banks lend again with the biggest emphasis on a "local community bank" that suffered the most from imposed regulations (as they did not have resources to absorb compliance costs). Government is focused on loosening regulations to get local community banks back to having double digits ROE. I don't see the regulatory changes to have dramatic effect but on a margin it would be better for the banking community.
  • Concerning deleveraging, it is hard for us to define what is going to cause a lot of selling pressure in the next couple of years. If I had to pick one area it would be the high yield market. Structurally it is comprised of mutual funds and ETFs that provide daily liquidity to their investors. As rates go up, prices go down, you start seeing loses in high yield bond funds, and that could accelerate selling pressure. In the last three weeks, as we saw interest rates move up we did not see prices deteriorating that much in the high yield bond markets, however the redemption report showed a $2.7bn outflow from the market which caps yet the third week in a row when we see $2-3bn outflows.

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