The following is an exclusive interview with GSC Group's Seth M. Katzenstein, managing director and head of portfolio management and underwriting, U.S. collateralized corporate debt, and Alexander B. Wright, managing director and head of origination, U.S. collateralized corporate debt. GSC recently took time to answer questions on topics including investment strategy, CDO structuring and the market's future potential.
ASR: What is the typical structure of your CDOs? Do allocations vary by fund?
GSC: Our asset mix varies by fund; typically we focus on 90% to 100% senior secured loans in these vehicles with small baskets for high yield bonds. Our CLOs focus on middle market collateral. In 2002, we were one of the first movers into the middle market. We have a significant market position through relationships with most of the larger middle market underwriters, so we are viewed as a partner to those underwriters instead of simply an asset manager. There is a balance with broadly syndicated loans as well, but that platform has largely been built in and around middle market loans.
ASR: Have you been one of the many who've invested in some of the mega-deals we've seen of late? Or do you shy away from them?
GSC: We take a bottoms-up credit analysis approach to our transactions. We have participated in a select few of the "mega-deals" that have come to the marketplace but any in credit, whether it is a small company in the middle market or one of these big deals, we are looking at credit metrics. This includes leverage both ahead of and through the security that we are purchasing, based upon the free cash flow. That is the method we have used as a guiding tool along with a comprehensive credit analysis.
ASR: Are there any sectors or companies that you prefer to invest in and/or shy away from?
GSC: Because of our bottoms-up analysis, we focus on companies with strong free cash flow. We tend to avoid highly-levered industries, particularly where there is a lot of leverage ahead of our security. That will keep us out of some cyclical and capital-intensive industries such as commodity packaging or commodity chemicals. We also have concerns with industries or sectors that have reimbursement risk, such as certain areas of health care.
ASR: What specifically turns you off on a deal?
GSC: Excessive leverage as calculated by using free cash flow. We have not looked favorably upon bifurcated collateral packages that have surfaced in the last few months. Also, covenant lite deals are troublesome.
ASR: What do you look for in a deal? What are the specific aspects of a deal's structure that you want to see?
GSC: We look for earnings consistency in a company. We also look for transactions, particularly within the middle market sector, with financial sponsors.
ASR: Leveraged finance investors today have a variety of options, including second lien loans and mezzanine financing. How has this affected your investment in the loan market?
GSC: Managers have access to both mezzanine and second lien opportunities. Many managers we have seen have "barbelled" their portfolios because of the fact that the higher-rated loan assets have seen spread compression. Some select managers pursue second liens to barbell their portfolios and make their returns more attractive.
We have not adopted that approach in our business, instead we have structured funds that purchase different asset classes, and we have levered those funds in an appropriate manner to be resistant to any volatility that one might find in those asset classes as the economy ebbs and flows. We have a combination of funds that focus almost exclusively on senior secured first lien debt, and other funds that have oversized subordinate collateral baskets for both second lien and mezzanine to accommodate that type of purchase activity. We do not believe that "barbelling" portfolios is an appropriate way to manage the business, and so we created these funds to address that.
Our buy rates are conservative, both for term loans and subordinated collateral.
ASR: How would you describe your investment philosophy?
GSC: We are not buying the market and moving in and out of deals based on our risk appetite. We are really looking at a buy and hold strategy. Obviously there will be sells from time to time but again it's a bottom-up credit analysis based upon the free cash flow generation and other characteristics of the business.
ASR: What are your thoughts on the market as we head further into 2007? Do you feel that it will outpace 2006?
GSC: Liquidity in the leveraged loan market continues to remain strong, driven by the influx of new institutional investors and improved rate standardization. As well, the loan asset class has a lot of advantageous characteristics over high yield bonds such as floating interest rates, asset security and covenant packages which will continue to attract investors. At the same time, we may be starting to see some signs of the credit cycle turning - such as the frequency of amendments from companies in the market. Our current view is, absent any major events, we expect to see only a modest rise in default rates.
Second liens will also continue to form its own asset class driven mainly by the fact that they have attractive yields.
ASR: Have you made any recent additions to the team? Will you be looking to expand in 2007?
GSC: Within the collateralized corporate debt group, last year we hired three credit analysts and one in 2007. We are always looking to hire talented and knowledgeable investment professionals to expand the depth of our team.
GSC Group is an investment management firm that specializes in corporate credit, distressed investing and real estate with offices in New Jersey, New York, London and Los Angeles. As of Sept. 30, 2006, the firm had $18.3 billion assets under management across 35 funds and the collateralized corporate debt group had $6 billion under management across 14 funds including warehouses.
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