Volta Finance (VTA) has published its annual results for the year ended 31 July 2023, during which its NAV per share has grown to €6.45 at 31 July 2023, an increase of 3.7% on the €6.22 recorded at 31 July 2022, and the dividend has been maintained at 8.0% of NAV, equating to a yield of 10.2% based on the share price of €5.08 at 31 July 2023. However, the share price fell by 3.1% to €5.08 at 31 July 2023 from €5.24 a year previously. Whilst VTA’s chairman, Dagmar Kershaw, comments that this is disappointing, it is against a backdrop of significant widening in investment trust discounts and widespread falls in share prices and VTA has not been immune (its discount was 21.3% at the year end).
Kershaw comments that the CLO market is pricing effectively as shown by the NAV (VTA’s CLO assets are valued using specialist, external market pricing providers and not internal models), but observes that the investment trust market is suffering a torrid period and that, in his view, VTA’s share price does not appear to take into account the strong cashflows and regular income that the portfolio is generating – annual cashflows are running at 21.2% currently and higher interest rates have flowed through to cashflows, as CLOs are predominantly a floating rate asset class. The board believes that VTA offers excellent value at these pricing levels.
Kershaw says that the underlying assets in VTA’s portfolio continue to perform well. Defaults in European and US leveraged loans remain at historically low levels of 1.5% and 1.75% respectively and the forecasted uptick in default rates is proving slow to materialise. Whilst defaults have increased slightly from their artificially low, COVID-19-liquidity era days, CLO portfolios are as yet showing few signs of stress and are largely in compliance.
CLO issuance has been muted in recent months as the cost of debt issuance has risen, but market expectations are for $80 – $100bn of issuance across the US and €18 – 20bn of issuance across Europe in 2023. Kershaw says that there are few liquidity or maturity issues worrying CLO managers so many are choosing to wait until the arbitrage is more in their favour.
Key messages from the investment manager
Macro review
- Over the financial year, the macro picture has been more constructive than most market participants’ views:
- US GDP proved to be resilient, led by strong consumer spending and active US labour market at the same time as the Biden administration pushed forward the re-onshoring / nearshoring of activities;
European markets have been pricing the Ukrainian conflict as a regional issue (i.e. a low contagion probability to other European countries seems to be priced in for now); - China reopening post Covid lockdowns has not resulted in additional global growth. To the contrary, lower demand from China propped up recession in Germany;
- The fight against inflation from central banks has been ongoing but has not yet ended with the US Federal Reserve increasing rates from 2.25-2.5% to 5.25-5.5% while the European Central Bank moved rates from negative to 3.5-3.75%; and quantitative tightening also begun with the Fed reducing its balance sheet by circa 45% down to $7.5Trn as well as tighter lending standards.
Over the period, despite the banking turmoil in Q1 2023, appetite for risk assets increased with S&P500 returning close to 13% while bond markets kept on being volatile. The US HY market benefited from circa 100bps of spread tightening in addition to attractive carry while loans benefited from the greatest post GFC price appreciation, partly driven by their floating rate nature and the increase in base rates.
Loan asset class review
Regarding the loan asset class, the last 12 months were a bifurcated year as fears around loan and warehouse overhangs on bank balance sheet materialised through Q3 2022 but then receded as GDP kept on being resilient despite the elevated inflation figures and the higher cost of borrowing: in a nutshell, US loan prices started the year at 93.47%, moved down to 91.7% at the end of September before rallying to 94.14% at the end of the financial year. The same holds true for Europe which moved from 91.95% down to 88.13% on October 13th and ended the year at 95.27%. Forward yield on leverage loans went from 8% up to c.9-10% fuelled by higher rates with 1st lien loan discount margin kept around 500bps. Primary loan issuance activity kept on being thin with little M&A and refinancings to energize market activity.
Looking at fundamentals, companies fared better than expected: top line and EBITDA growth were kept in positive territory, helping the default rates stay below historical averages: at the time of writing, rolling last 12 months default rate in the US stands at 1.55% while it is at 1.27% in Europe. It is true that EBITDA growth is now coming close to nil while interest expenses are going up paving the way for further loan downgrades as well as future defaults, in line with mixed results from companies through Q2 23 earnings season.
Nonetheless, the ‘higher rates for longer’ is, in our view, now mostly priced in as any firm with reduced interest coverage ratio or with any short term need for Capital Expenditure (CAPEX) is now on the radar screen of our CLO managers. According to our understanding, many companies have also been partially hedging their floating rate debt liabilities, providing some headroom through the past period.
Clearly, another key topic regarding default rates is the maturity wall: given that the leverage loan universe is fully covenant-lite, outside of bank Revolving Credit Facility lines, monetary defaults mostly occur at a time where companies start having liquidity issues and are running out of cash. A large part of the double-digit default rate during the GFC was due to companies hitting into their maturity wall. As a result we see positively, as anticipated, that this maturity is currently being pushed away either through loan-forbonds takeout or through amend-and-extend activity: only $24Bn of loans are still due to mature in 2024 (€4Bn in Europe) compared to $143Bn in YE 2021. As a reminder, amend-and-extend processes are market activities through which the existing lender base agrees for extension of the maturity of a corporate loan in exchange of additional spread concession and without any change to the existing documentation. These types of ‘cashless’ rolls are beneficial to CLO equities as 1/ it reduces near term default risk – everything else being equal, 2/ keep the CLO invested and 3/ increase marginally the weighted average spread of a CLO portfolio.
In addition to the help of the bond market in refinancing some high quality issuers of the leveraged loan market, the increased size available in Private Credit to finance individual borrowers also proved to be beneficial to the loan market. On top of underwriting overhang deals sitting on banks’ balance sheets in 2022, Private Credit lenders have been shopping in a sub-segment of broadly syndicated loans, namely ‘B-‘ and ‘CCC’ rated issuers. Some of the latest examples are Hyland Software ($3.4Bn deal), a Thomas Bravo deal refinanced by Golub, Ares, Blue Owl & Oak Hill (source: Bloomberg) or Finastra ($5.3Bn deal) where Vista is getting a unitranche refinancing done through multiple different direct lenders. In the medium term, the current dynamic questions the approach private equity and companies will retain in order to address the cost/benefits of both markets.
All-in, based on the above, we still expect loan default rates to reach 2.5-3% at the end of this year and to increase slightly over 2024 as a result of the combined impact of minimal GDP growth, higher cost of capital and some maturities coming due.
Alongside increased default rates, recovery rates were put under pressure compared to historical norms: according to BofA, “the average recovery rate for 2023 bankruptcy related defaults has declined meaningfully to ~25% on average” while long-term historical 1st lien recovery rate has been in the 60-70% context . The loan market being covenant-lite, the last few years saw sponsors being creative trying to find out ways either to push the can down the road before triggering any default (to the point where liquidity of the company is in questions), to carve-out some value from the collateral package or distress funds to look to prime existing lenders when the company needed additional financing. While lenders are adapting to such loopholes in loan documentations, CLO managers have been trying to adapt through additional documentation protections alongside ability inside new CLO to participate in restructurings as a way to protect value for CLO Equity investors. Still, we find that some of the recently very low recovery rates are linked to ‘zombie’ companies as “60% of Bankruptcy filings this year have occurred in borrowers who are either filing for bankruptcy the 2nd (or even 3rd time) or have gone through an out of court restructuring earlier” 3. We still believe that generally CLO managers will be in a position to mitigate the par burn through thorough documentation review, active engagement into workouts and with Private Equity sponsors as well as active trading. As a result, we still believe that a long term average of 50-60% recovery rate should be the norm when running prospective scenarios.
Turning to loan prepayments, the disconnect between buyer and seller valuations when looking to buy or sell a company kept M&A activity as well as LBO refinancings at pretty low levels (close to levels only seen through the GFC). This droves the loan market into net negative issuance and is now providing support for loan prices.
CLO Market review
Through the financial year, the CLO primary issuance felt by c.40% in the US and 30% in Europe due to CLO AAA tranches widening from c.165bps in the US market to c. 235bps at the end of Q4 2022. The latter widening was led by multiple factors including:
- Lack of appetite from US banks given retail investors turning from bank deposit into Money Market Funds as well as large unrealized losses stemming from fixed rated assets held on their books (both aspects resulted in the regional bank meltdown and into the SVB collapse)
- Denominator effect sharply reshaping investor target allocation as illiquid assets increased mechanically on the balance sheet compared to liquid bond portfolios following their decline in value
- Capped appetite from Japanese investors given increased costs to hedge dollar investments back to Yen
- This put pressure on CLO arbitrage (difference between CLO assets yield and CLO liabilities yield) and while ability to buy loans at discount still enables to provide a double digit internal rate of return, attractive arbitrage became more difficult to secure as secondary market prices were volatile and leveraged loan primary market pretty limited.
but also to an increased number of CLO coming out of their reinvestment period: we currently estimate that c.40% of existing CLO being outside of their reinvestment period by year end. The resulting amortization of AAA tranches should provide money back to investors with ability to renew CLO activity at tighter spreads later down the road.
Regarding CLO Equity payments, the 1st half of the year was impacted by 1-month/3-month basis on Libor in the US, reducing payments to 12-14% payments annualized depending on vintage while the 2nd half improved to c.16-20%. Surely, the move from Libor to SOFR that will show in Q3 cashflows is likely to have some negative impact but the impact of higher rates should be a mitigant factor alongside side many loans now including a Credit Adjustment Spread.
From a CLO debt perspective, CLO debt prices followed the same pattern as leverage loans, helped by increasing rates, though as it is often the case with a little bite lag: CLO BBB and BB tranches moved respectively from 7.5% and 12% forward yield to 8.7% and 13.5% as of July 2023 according to JP Morgan Pricing Direct.
Through the last few months, CLO AAA tranches started rallying as arranging banks were able to syndicate transactions to multiple buyers while some could also anchor a good chunk of the AAA tranches. Lower down the capital structure, mezzanine tranches kept on tightening as well with European CLO mezzanine debt tranches outperforming (given a lower starting point resulting from the
Ukrainian war). We believe that the current technical of the loan and CLO markets should imply further spread compression over the medium term.
Portfolio review
As at 31 of July 2023, Volta’s portfolio is 92% made of CLO with the rest of the portfolio being mainly invested in regulatory capital transactions. It corresponds to 85 different investments and over 1750 different issuers. In terms of projected yield, based on end of July 2023 prices, the projected yield in EUR of Volta’s invested assets is 21.8%. Focusing on Volta CLO investments, it is split across 33 different CLO managers.
The Company continues to pivot towards pure CLO investments benefiting from the high cash flows associated with a larger CLO equity bucket. We view this strategy as offering transparency and simplicity to our Shareholders relative to an allocation mixing different and sometimes less transparent asset classes. Over the last 12 months, the Company invested c.€39.9m (17.5% of its YE 2022 NAV) into:
- 3 warehouse investments for a total amount of €19.4m equivalent. In the US, we favoured short term warehouse investments on already ramped portfolio as a way to participate in the CLO Equity primary market. In Europe, we planned a patient ramp with the manager in order to be able to seize opportunities both in the primary and secondary loan markets. This should translate into an attractive CLO Equity investment for Volta in the next few months.
- 2 US CLO Equity in the primary market for a total amount of $7.1m that are resulting from the above warehouse investments. Those transactions will be able to be refinanced with 1-1.5 years with a lower cost of capital.
- 1 US CLO debt for $3.76m with a target return of 13.5% and benefiting from a 1.5 year non-call protection.
- 3 European CLO Equity in the secondary market for a total amount of €2.6m. These purchases were made on an opportunistic basis with a focus on the deals benefiting from the longest reinvestment possible with clean portfolios
- 7 European CLO debt tranches for a total amount of €7.8m as we viewed European CLO debt tranches being cheap to US CLO debts. 6 of these 7 purchases were made in the primary market.
At the time of writing, we receive an early prepayment on a bank Balance Sheet transaction, further reducing the exposure to this asset class down to c.3% (including cash). This cash will be reinvested either into CLO tranches or into the funding of our current warehouse commitments.
Regarding our ESG journey, we are glad to report that all investments made through the year includes some industry exclusions and engagement of CLO managers into ESG discussions. The average ESG score of Volta’s purchased assets through 2023 stands at 7.35 (10 being the highest grade and 0 the lowest) while we rate the overall CLO book invested by Volta at 5.09.