Blackstone Loan Financing (BGLF) has released its annual results for the year ended 31 December 2022. Key takeaways are that while performance was supported by robust distributions, the discount to NAV remains wide and the board launched a shareholder consultation in January to look at this. Conclusions were announced in March and steps will now be taken. These include a continuation vote in 2024 if there is no significant improvement
Performance
During the period, BGLGF delivered a total return per ordinary share of 5.22% on a Published NAV basis, ending the period with a NAV of €0.9081 per share. The return was composed of dividend income 8.83% and of net portfolio movement of -3.61%.
On an IFRS NAV basis, the Company returned a total return per ordinary share of -19.19%, ending the period with a NAV of €0.6784 per share (the difference between the Published and IFRS NAV return is the differing valuation bases, with the main driver being the discount rate used).
During 2022, BGLF’s performance on a Published NAV basis was supported, through its investment in BCF, “by robust distributions from the underlying CLO and loan portfolio”. CLO distributions have continued to benefit from refinancing and reset activity during 2021/2022 as well as the absence of CLO CCC basket breaches, which could cause diversions of cash flows away from CLO equity. However, the portfolio (primarily the loans directly held by BCF and those CLOs that have exited their reinvestment periods) was not immune to broader loan market movements, noting that European and US loans returned -3.3% and -1.1%, respectively.
Quarterly dividends – potential 12.5% increase for 2023
BGLF paid four dividends to ordinary Shareholders during 2022, totaling €0.08 per share, which is at the upper end of the 2022 dividend target of €0.07 – €0.08 per share. The increased dividend paid in the fourth quarter is a result of the strong continued and expected cash flows of the underlying portfolio. Looking ahead to 2023, BGLF’s Board has announced an “elevated dividend policy” that targets a total annual dividend of €0.08 – €0.09(6), which represents a potential 12.5% increase to dividend per share.
Discount management and shareholder consultation
The share price discount to Published NAV widened from 15.75% on 31 December 2021 to 26.77% on 31 December 2022. The share price discount to IFRS NAV narrowed from a discount of 13.43% on 31 December 2021 to 1.98% on 31 December 2022. During 2022, the Company repurchased 16,406,180 shares for €11,478,926 at an average discount of 22.95% using available cash with the goal of reducing the volatility and quantum of discount. As of 31 March 2023, the share price discount to Published NAV was 18.95%.
On 26 January 2023, BGLF announced it would undertake a Shareholder Consultation on potential policy amendments in light of the prevailing and persistent discount to NAV at which the Company’s shares trade, with a view to broadening investor interest in the Company’s shares and maximising Shareholder total return. An announcement was made on 17 March 2023, covering the following results of the Shareholder Consultation:
- It was discussed that there are times when reinvestment by the Company into BCF may be unattractive but direct investment in primary market CLOs managed and controlled by the Portfolio Adviser may still be attractive. The Board believes such flexibility to be in the interests of Shareholders and will propose a change to the Company’s investment policy to allow such investment to be put forward at the time of the Company’s AGM expected to be held in July 2023.
- The Board will continue to monitor the situation and consult with Shareholders and if there is no significant improvement in the discount, the Board will consider putting forward a continuation vote alongside the AGM in 2024. In the period between now and the 2024 AGM, the Board will continue to use all tools at its disposal, principally its buyback policy, in an effort to mitigate the share price discount to NAV while taking into account the market environment for CLOs.
- Shareholders expressed concern that the mark to model approach, whilst reflective of the hold to maturity nature of retention assets, was not a good benchmark for assessing current market risk and therefore whether the Company’s shares are trading at discount or premium to the risk of the underlying assets. The Board is considering these points and believes there is merit in adopting a mark to market valuation methodology for the monthly published NAV at a time when the NAV derived from both methodologies are broadly aligned.
Portfolio Adviser’s Review – Bank loan market overview
“The global loan market started 2022 in a fundamentally good position following the strong economic recovery in 2021 that generated record supply and healthy risk adjusted returns across the asset class. However, the resurgence came to a halt in February with Russia’s invasion of Ukraine and as the market realised that inflation would be more persistent than originally thought. Supply chain issues remained as a major headwind for issuers although they eased as the year progressed. Loans were also caught up in the UK’s LDI pension crisis which swept through global credit markets.
“Despite the barrage of headwinds, investors generally viewed loans as a safe haven against the most pressing concern of 2022: rising inflation and interest rates. The Federal Funds rate started the year off at 0.00% to 0.25% and by year-end, reached 4.25% to 4.50%, representing one of the most aggressive tightening policies in history. Similarly, the ECB hiked base rates in the Eurozone from (0.50)% to 2.00% during the year. The S&P 500 recorded its worst annual return since 2008 at (18.8)% as a result. By comparison, loans outperformed other debt and equity markets in 2022, generally due to their floating rate nature. Total returns for European and US loans ended the year at (3.3)% and (1.1)% respectively versus high yield at (11.6)% in Europe and (11.2)% in the US. Average prices for the European and US leveraged loan indices fell to €91.56 and $91.89 from €98.71 and $98.39 at the end of 2021, respectively.
“Loan outperformance came against a thin primary pipeline and global loan volume stood at just $505 billion (€473 billion) in 2022, roughly half of that during 2021’s record breaking year. Issuance was weighted toward higher quality issuers looking to term out maturities.
“Turning to fundamentals, many companies reported ‘better-than-feared’ earnings in 2022 after strong refinancing activity post COVID-19 left balance sheets in good shape. Still, rising credit concerns pushed spreads across European and US loans (represented by 3-year discount margin) wider by 248bp and 213bp to 661bp and 652bp respectively as the year progressed. Rolling 12 month loan defaults ticked up in the second half of 2022, ending the year at 1.1% in the US and 1.9% in Europe, although these remain within the 10-year historical averages of 2.2% for both regions(9).
“Looking ahead to 2023 and despite kicking off the year with a more constructive market tone, we expect ongoing volatility as credit markets adjust to the higher-for-longer narrative and digest the recent bank failures of SVB and Credit Suisse. We expect credit fundamentals to remain solid and for corporates to continue to access debt capital markets to both refinance and raise new debt. Interest coverage ratios have remained stable through all signs of volatility in the market and reported earnings could continue to deliver.”
Portfolio Adviser’s Review – CLO market overview
“In stark contrast to the prior year, throughout 2022, the CLO market experienced numerous headwinds but nonetheless, ended the year with robust primary issuance of €28 billion in Europe and $129 billion in the US. 2022’s CLO issuance volume marked the third largest year on record(10) , following a record year of issuance in 2021 and brought the total outstanding volume of CLOs globally to nearly $1.1 trillion(11). That was despite technically driven volatility at the top of the CLO debt stack, due in part to LDI-related weakness. Reduced demand from US and Japanese banks(12), the dominant buyers of CLO AAAs(13), was another factor.
“Underlying the full year headline issuance volume, the running spread between assets and liability costs (known as CLO arbitrage) came under pressure in the second half of the year, due in part to the sustained high cost of liabilities as some dominant buyers of CLO AAAs remained side-lined following the LDI-related, technically driven secondary market sell off in CLO AAAs. While the impact of a diminished spread arbitrage on CLO equity performance can be offset to some degree through the purchase of discounted loans, capturing that price arbitrage during periods of volatility requires access to warehouse financing that remains open and available for use, which is not always the case across all managers. Issuance in 2022 skewed heavily to larger, more established managers and demonstrates advantages of greater access to warehouse financing in order to better achieve an attractive equity arbitrage.
“Within the broad market, the weighted average cost of capital for new issue European CLOs widened by 134 basis points to 324 basis points and similarly by 132 basis points to 311 basis points for US CLOs over 2022. The higher cost of debt resulted in a lower net interest margin, to CLO equity investors of new issue deals. However, as noted above, the expected return in new issue CLOs is based on buying loans at discounted prices, thereby benefitting from the ‘pull-to-par’ effect, in addition to the traditional return from net interest margin.
“Though volatility creates a challenging environment for primary CLO creation, it also provides opportunities for more seasoned vintages of CLOs to improve performance through portfolio rotation into higher quality and or wider spread loans, which highlights a key benefit of the CLO structure and its long term, non-mark-to-market financing, particularly for those CLOs which have longer remaining reinvestment periods.
“Despite that rating downgrades outpaced upgrades, CLO fundamentals remained resilient throughout the year, underscoring the impact of active management on the portfolio quality and robustness of CLO structures. Commonly used measures of CLO portfolio quality showed improvements as managers have been taking advantage of the volatility in order to improve quality, as measured by reduced exposures to CCC-rated assets and stable WARF levels. Caa-rated buckets in European CLOs finished 2022 at 3.1% on average, down from 3.6% at the end of 2021, and in the US, Caa-rated buckets ended the year at 3.7%, compared to 4.1% at the end of 2021. Similarly, WARFs ended the year at 2892 in Europe and 2833 in the US, below the 5-year averages of 2924 and 2897, respectively.
“While volatility and technical factors have become a more constant market feature, we believe that we are at the start of a period of transition where the CLO primary market and CLO formation will continue to be more heavily influenced by fundamental credit performance as well as liability performance, as measured by rating stability and liquidity.
“Additionally, looking forward, returns across floating rates assets, including senior loans and CLOs, should continue to benefit from further central bank rate hikes in 2023. We expect the focus from managers to be on preservation of capital through active risk management.
Portfolio Adviser’s Review – Portfolio update – BCF
“From the beginning of the year, BCF’s CLOs were well insulated from dislocations related to rising inflation and interest rates. At Blackstone, we first identified inflation as a potential issue in 2021 by observing labour and input costs in our portfolio companies. Our belief that inflation would prove stickier than many expected influenced much of the trading within our portfolios over the past year. We leveraged our expansive network of CFOs to discuss corporate fundamentals and expectations, providing valuable insight. At the same time, we continued to stress test the issuers in our portfolios with higher forward looking base rates. Each quarter, our credit research team re-underwrites each loan and provides guidance on the timing and expected probability of defaults or downgrades to CCC on a loan-by-loan basis. While our view on the credit environment has shifted to a more cautious perspective and our expectations of downgrades and defaults have risen in the past year, these increases are modest and remain well within CLO limits. To date, higher default and downgrade assumptions have not caused any of BCF’s CLOs to experience a disruption of cash flows and our analysis shows this to be the case even in stressed scenarios.
“For the first half of the year, much of the focus within BCF’s loan portfolio was on exiting tail risk names amidst the mounting macro headwinds. Our investment focus has shifted to rotate up in quality to protect against rating risk, credit risk and price migration, turning to issuers from defensive sectors in what we call ‘good neighbourhoods’ with secular tailwinds and robust cash generation.
“As the year progressed, volatility continued to be a central theme, catalysed by a shock to the UK gilt markets following the UK government’s proposed mini-budget announcement. In our view, the general re-pricing of risk created a buying opportunity and a compelling relative value opportunity for cross border issuers. Simultaneously, BCF continued to pare back exposure to lower quality assets to get ahead of any downgrades and preserve distributions within the CLO portfolio. Consistent with this approach, BCF’s industry concentration is led by a 16.7% weighting towards healthcare at year-end, a defensive sector with strong pricing power, beneficial given an environment of interest rate rises and inflationary pressure. By comparison, sectors with elevated risk to consumer spending, such as leisure/travel entertainment, remain outside of the top five industry concentration.
“As of the end of 2022, BCF remains a defensively positioned portfolio of 675 loan issuers diversified across 29 sectors and 26 countries. The portfolio remains concentrated around B1-B2 rated issuers and holds 4.6% Caa-rated assets (at the facility level), which is broadly flat from the start of the year. In line with the market, the portfolio’s average loan price declined to around €90 and $98 from €98 and $100 at the end of last year. Assets priced below €/$80 increased from 0.5% at the start of the year to 6.4% at the end of December. We see minimum refinancing risk in the portfolio as loan maturities are generally wrapped around 2028.
“BCF’s portfolios demonstrated strong collateral quality metrics compared to the market and peer managers in 2022. With respect to defaults during the year, the BCF portfolio maintained a lower default rate of 0.54% compared to the European and US loan indices of 1.90% and 1.10%(15), respectively. According to data available at the end of January(16), Blackstone’s CLOs outperformed the peer average amongst the largest managers in terms of IDT cushions and other similar tests(17). The IDT is the ratio of a CLO’s assets to its liabilities and is a widely used measure of portfolio quality. A breach of the test diverts cash flows, which would have otherwise been paid to equity holders to protect debt holders and the ‘cushion’ is the margin of safety to the breach level. These are important tests that ensure equity distributions are well protected, the Company’s income is well supported and dividends remain well covered. To note, the Company’s year-on-year dividend cover increased from 1.32 times to 1.63 times at year-end 2022.
“Even with challenging market conditions for CLO origination, BCF invested in five new issue CLOs in 2022, three in Europe and two in the US, bringing the number of originated CLOs within the portfolio to 49 spanning 9 vintage years, reemphasising the wholesale exposure investors experience through this vehicle. Given interest rate movements throughout the year, the expected return for recent new issue deals is in part based on the pull-to-par effect, with underlying assets being bought at a discount. This is in addition to the traditional return from spread arbitrage (as explained previously), which were temporarily squeezed toward the end of the year due to a timing mismatch between the base rates used for assets and liabilities, and we expect this to normalise over time as interest rates stabilise. Despite this, CLO distributions remained robust and have maintained uninterrupted cash flows from each CLO since inception. BCF’s weighted average remaining reinvestment period was 1.9 years at the end of 2022, providing ample runway to actively reinvest in loans, taking advantage of both lower prices and generally wider spreads in the current environment.
“Looking forward, BCF will, as always, prioritise managing its portfolio to effectively navigate through the market turbulence, while opportunistically issuing new CLOs when we believe the economics are attractive. We will continue to leverage our wealth of resources and experience across numerous credit cycles to invest in a prudent manner that is supportive of CLO returns to investors.”