CVC Income & Growth — Uncertainty creates opportunity

The post-pandemic economic rebound was progressing nicely with good tailwinds, albeit with the shadow of inflation lurking. However, inflation has reared its head in 2022 to a greater extent than anticipated (see Exhibit 1) and this has been made worse by events such as the Ukraine war and China’s COVID-19 lockdowns. The result is the prospect of higher interest rates than initially forecast by markets at the beginning of the year and a deterioration of macroeconomic conditions.

The European Central Bank (ECB) hiked interest rates by 75bp on 8 September and signalled that it could raise rates by another 75bp in the next meeting. The Bank of England (BOE) is expected to raise rates by 50–75bp when it meets next week (the market is pricing in 50% for 50bp and 50% for 75bp). The overnight index swaps are currently pricing in policy rates of 2.4% and 4.3% for the ECB and BOE respectively, by mid-2023 (Exhibit 4).

The debate continues regarding how much of current inflation is transient and how much will feed into more permanent expectations. Refinitiv-collected consensus for 2023 inflation for the eurozone currently stands at 4.2%, with 6.7% for the UK. The trend (Exhibit 2) has been clearly upwards.

At the same time, we are starting to see some inflationary pressures weaken (food prices have dropped for the last five months according to the United Nations’ Food and Agriculture Organization). There is also little doubt the cost pressures on the supply chain will drop as issues start to resolve. The impact of the Ukrainian crisis is difficult to predict, especially in relation to natural gas prices.

We note that the Citibank Europe Inflation Surprise Index (Exhibit 1) has been coming down from its peak, however the surprise bias is still for higher inflation.

The stage is set for a significant decline in real wages, which, along with higher interest rates for companies and consumers, will have an impact on economic growth.

The US economy is already in a technical recession, and this could likely occur in Europe as well, possibly felt more in 2023. Companies are being hit with the double penalty of more challenging operating conditions and higher (and tighter) funding costs.

Fitch Ratings sees default rates of 2.5% and 3.0% in its base scenario in European leveraged loans in 2022 and 2023, according to its ‘European At-Risk Leveraged Credit’ report from June 2022. This climbs to 4% and 5% for 2022 and 2023 in its ‘severe’ scenario. However, we note that Fitch does not expect a severe near-term recession that would lead to ‘wholesale credit downgrades’, unlike the pandemic impact in H120.

In its report, ‘Global Credit Conditions Q3 2022’ (28 June 2022), S&P Global Ratings (S&P) identified top risks including the impact of supply shocks on inflation and earnings, geopolitical risk and funding market dislocation as central banks raise rates to fight inflation. It rated these risks ‘high’ and ‘worsening’. S&P forecasts European default rates to ‘double in Q1 2023, potentially reaching 5–6% in a downside scenario’.

We expect all this bearishness to have an effect on issuance, although companies that come to the market will likely have to offer interesting yields to investors to be successful.

The ICE BofA Euro High Yield Index has more than doubled since August 2021 (from 292bp) when there was greater optimism as the COVID-19 recovery progressed and leveraged loans proved resilient during the pandemic. The index reached 668bp in early July 2022 and was 575bp on 2 September 2022. As part of the risk-off mood in the market, the US dollar has now reached euro parity and the £/US$ pair is now trading at $1.15 (from $1.41 in June 2021).

Credit quality is likely to be aided during the current downturn by consumers’ high stock of savings, low unemployment and the relatively robust corporate balance sheets coming into the slowdown.

Markets indicate central banks are likely to remain pragmatic by fighting inflation while keeping the economies ticking over. Central banks (particularly the ECB) might be comfortable with inflation running a bit higher than in recent years (when it was very low) as long as the signalling to the market is done well and they are not perceived to be falling behind the curve in fighting inflation. The ECB will be mindful of potential fragmentation in borrowing costs within the euro area, as reflected in market expectations of lower forecasted ECB policy rates than in the UK.

Typically, a leverage loan default has a 60–75% recovery rate. Therefore, in a scenario of 5–6% defaults this would result in about 1.2–2.4% actual losses. This suggests the market may have overdone the correction given the current yields of some investments. CVC IG’s portfolio has a YTM of 13.8% (euro hedged) and 15.7% (sterling hedged). There seems to be significant room for investment upside in CVC IG’s shares on this basis.

CVC Credit Partners is a subsidiary of CVC Capital Partners, a global investment manager with nearly US$133bn of assets under management (US$34bn in credit) at September 2022, specialising in private equity and private debt. CVC Capital Partners employs more than 250 investment professionals across 25 offices worldwide, with 64 focused on credit investments. The investment manager maintains a database of more than 4,000 credits from which it selects investment opportunities for its various portfolios based on in-depth fundamental analysis.

While acknowledging the current economic and market headwinds, the manager sees most of the significant decline in asset prices explained by ‘market technicals (supply/demand imbalance)’ reasons rather than ‘fundamentals’. This allows room for significant corrections as sentiment improves.

CEC also points out in its commentary that ‘inflation prints continued to surpass to the upside across the world but some macro indicators including jobs data, food and commodity prices and housing activity signal that we may be close to peak inflation levels’. Furthermore, CEC believes that ‘as fears of a recession mount, the market is starting to discount a less hawkish policy at some point in the future’.

As such, although it remains cautious, CEC is taking advantage of current market dislocation to add high-conviction names to its portfolio, both in the performing credit and credit opportunities books at attractive yields. It expects markets to remain volatile due to the ‘macroeconomic and geopolitical uncertainty out there and a lack of liquidity in markets’. The CEC internal estimate is for defaults of 1.5–2.5% for Europe in 2023.

CEC views leveraged loans as containing a ‘partial hedge’ against inflation since most of these assets are at floating rates. It continues to see the fund as ‘comfortably positioned’ for ‘an unstable macroeconomic and geopolitical backdrop’. The performing credit book is expected to deliver good income, while credit opportunities ‘continue to be a great focus of the team amid volatile markets’.

CEC’s base strategy is to target a broadly balanced allocation across performing and opportunistic instruments. This strategy has continued following the fund’s change of name to CVC Income & Growth. However, the company no longer discloses the weights and yields in these buckets, focusing instead on the total fund yield. In the last month that the split was disclosed (June 2022) it was 53% credit opportunities and 47% performing instruments.

CEC has now started to disclose the yield of the sterling and euro hedged portfolios. Exhibits 7 and 8 show the evolution this year and the significant increase in the portfolios’ yields resulting from not only the falling asset prices (although this is the key impact), but also the benefit from the floating rate nature of most of its investments. The YTM in the euro portfolio has risen from 7.8% at the end of January this year (before the Ukrainian conflict started in February) to 13.8% at the end of July. It is a similar story in the sterling portfolio, from 8.6% to 15.7%.

The floating rate nature of these investments has boosted the fund’s current (cash) yield in the euro and sterling funds from 7.4% and 8.2% in January to 9.1% and 10.9% in July, respectively. These higher current yields give some space for the fund’s board to consider increasing dividends, in our opinion.

Exhibit 9 shows the portfolio breakdown by asset type and ratings. The ratings breakdown has been stable over 2022. However, in July 2022 the fund reduced its position in high-yield bonds as prices were stronger that month, cutting the exposure from 15% in June to 12%. Correspondingly, the leveraged loans weight increased from 56% to 61%. Defensive assets (first-lien loans, senior secured bonds and cash) make up 74% of the portfolio. However, we note that defensive assets comprised 88% and 85% of all assets at the end of December 2020 and January 2021, respectively. This reflects CEC’s view regarding investment opportunities in the current market dislocation.

As of end January 2022, 56% of the fund was in euros, 21% in sterling and 23% in US dollars.

Over the last 12 months, the most significant change in the country weightings has been the increase in the UK from 22% to 29% and a decrease in the weight to the Netherlands from 17% to 12%, as shown in Exhibit 10.

Exhibit 11 details the breakdown of the portfolio’s industry exposure, which continues to be broad, illustrating the diversified nature of CEC’s portfolio. Over the last 12 months, the more significant move has been the increase in beverage and food to 8% from previously not separately stated and the reduction of travel and leisure from 10% to 6%.

CVCG and CVCE shares have delivered total returns over the 12 months to 2 September 2022 of negative 6% and 5%, respectively. The NAV returns have been 7% and 8%, respectively, over the same period.

Although CVC IG has outperformed over the longer term, it has underperformed over the last 12 months, as shown in Exhibits 13 to 15.

We note that as CVC IG’s portfolio consists of both loans and bonds (sourced from Europe and the United States), none of the indices presented in Exhibit 14 is a perfect comparator.

Exhibit 16 compares CVC IG’s performance to the sector average and two of its closest peers. CVC IG has outperformed the sector average across the various periods shown except over the last 12 months. CVC IG has outperformed NB Global Floating Rate Income and underperformed Axiom European Financial Debt Fund. We note that even these two peers have differences; for example, Axiom focuses just on debt from financial institutions, which is usually more subordinated than CVC IG’s investments and, unsurprisingly, Axiom’s fund has had greater volatility in its performance.

CVC IG’s ongoing charge is above average for the sector but we note that it does not charge performance fees like some of its peers (which in the current market conditions are presumably not being paid). CVC IG’s dividend yields are currently below the sector average.

Although CVC IG does not charge a performance fee or use leverage (as shown in Exhibit 16 in the data from Morningstar), they are both applied at the investment vehicle level as discussed later in the note.

CVC IG raised its target annual dividend from 4.5p for CVCG and 4.5c for CVCE to 5.0p and 5.0c respectively in April 2021. This increase was underpinned by CVC IG’s strong portfolio performance and better market conditions at the time. This change came 12 months after CEC had reduced its target from 5.5p/5.5c to 4.0p/4.0c due to the pandemic. At the time, the board said it would retain the 8% total return target and that it planned to raise the dividend when market conditions justified it. CEC had already raised the dividend to 4.5p/4.5c in September 2020.

Dividends are paid quarterly in February, May, August and November. A scrip dividend (the facility to receive additional shares rather than a cash dividend payment) was suspended in October 2019 due to limited interest from shareholders.

CVC IG operates a contractual tender system and a conversion facility between sterling and euro share classes, both now done on a semi-annual basis, and may issue shares from treasury in response to market demand. The chart below is for sterling shares (CVCG); repurchases include tendered shares and repurchases, and allotments include share conversions and the placing of treasury shares.

CVC IG’s conversion facilities minimise NAV discount/premium fluctuations. Since inception, CVCG shares have traded at an average discount of 1.1% to cum-income NAV until end-February 2020, before the COVID-19 crisis, with the discount widening in more distressed environments. During the COVID-19 crisis, the discount was as high as 38% on 19 March 2020. The discount then declined to between 2% and 6% as confidence rose while pandemic concerns ebbed. However, the greater market turbulence this year has seen the discount in a 5–10% range since March.

CVC IG was launched in June 2013 and is a Jersey-domiciled, London-listed, closed-end investment company with a focus on opportunities in leveraged credit. It invests solely in a Luxembourg-based investment vehicle, CEC, via preferred equity certificates (PECs). CEC has an actively managed portfolio of sub-investment-grade debt assets with an annual turnover of c 100%, which also involves trading within an issuer’s debt structure (ie assets with different maturities, currencies and seniority). Its portfolio is divided into two main pools: performing credit (assets acquired at close to par with the intention of generating returns from recurring interest payments/coupons) and credit opportunities (discounted assets with revaluation potential).

The investment manager is sometimes involved in restructuring activities to unlock the revaluation potential of credit opportunities investments. Returns come from a mixture of income and capital appreciation, with target aggregate gross returns of 8–12% pa (4–7% pa from the performing portfolio and 7–20% pa from the credit opportunities portfolio). Around 5% pa is expected from the income component. The investment vehicle focuses mostly on senior assets in the capital structure of the issuer: first-lien loans and senior secured bonds (73% of NAV at end-July 2022).

The portfolio is skewed towards floating rate assets and issuers domiciled (or with the majority of operations) in Western Europe. CEC invests in large-cap companies (minimum EBITDA of €50m), which had a weighted average EBITDA of more than €300m and which we believe still provide higher secondary liquidity and stronger credit fundamentals, leading to lower default rates in times of economic downturn.

At the AGM on 18 May 2022, shareholders approved raising the limit on investing in collaterised loan obligations from 7.5% to 20%.

Pieter Staelens is the portfolio manager. He is a managing director of CVC Credit’s Performing Credit team based in London and joined CVC in 2018. Before joining CVC, he worked at Janus Henderson Investors in London, where he was involved in various high-yield strategies and a credit long/short strategy.

There is no gearing at the CVC IG level, but the investment vehicle may gear up to 100% of net assets. At end December 2021, the investment vehicle had borrowings of 30.3% of NAV (December 2020: 27.7%). The manager disclosed that it changed its leverage facility in July to a different bank, and it was refinanced at a lower (undisclosed) cost of capital. It was previously at 1.35% plus Euribor.

CVC IG is a self-managed fund that delegates investment management to CVC Credit Partners, which also manages the investment vehicle. We calculated the ongoing charge at an annualised 1.6% in FY21 versus 1.5% in FY20. This included an annual management fee of 1.0% pa, charged at the investment vehicle level. CEC’s operating expenses are not accounted for in these ongoing charge calculations and instead are reflected in the value of PECs held by CVC IG. A performance fee (subject to a high-water mark) of 15% of excess returns may be paid at investment vehicle level if total annual returns exceed 5%.

In April 2021, the board voted to reduce the management fee from 1.0% to 0.9% of NAV, effective 1 May 2021. The new fee structure allows for further step-down reductions if assets under management (AUM) increase beyond certain levels. The current ratchet marks are €500m, €750m and €1bn AUM. The management fee drops by 5bp at each point with a floor at 0.75% pa.

CVC IG is a Jersey-domiciled, closed-end investment company with an unlimited life. However, the company intends to wind up in 2031 (subject to the investment manager’s decision to extend it). CVC IG’s board would also be required to propose a continuation vote if the average discount to NAV exceeded 10% over any rolling 12-month period or if net assets fall below €75m.

CVC IG has two share classes: sterling shares (CVCG, 133.6m shares in issue) and euro shares (CVCE, 107.7m). CVCE shares carry one voting right compared with 1.17 for each CVCG share. The company actively manages its capital structure to reflect investor demand by running a quarterly tender facility, a monthly currency conversion facility, and purchasing and selling treasury shares. CVCG shares are hedged back to euros to eliminate exchange rate volatility.

Before the exceptional market turbulence in March 2020, investors could every quarter tender up to 24.99% of shares for repurchase at a price close to NAV. In April 2020, the board won approval to allow this quarterly limit to be reduced to a minimum of 10%. However, so far, all requested tenders have been executed. This was further changed in the May 2022 AGM and the tender has been moved to a semi-annual basis with a 25% annual and 15% semi-annual limit.

CVCG shares can be converted into CVCE shares and vice versa and following the same AGM this can be done on a semi-annual (previously monthly) basis. To facilitate this, CVC IG actively trades its treasury shares and may issue new shares to meet investor demand, which effectively minimises the discount (since CVC IG’s launch in June 2013 it has averaged 0.1%).

There are no loans at the CVC IG level although, as previously mentioned, the investment vehicle itself uses gearing.