Harch Capital Management Inc. (HCM) is a newcomer to the ever-so-attractive collateralized debt obligations (CDO) sector and is preparing to take the industry by storm, said Michael Lewitt, chief operating officer and general counsel - with a collaterized bond obligation (CBO) transaction set to launch sometime in June.
The anticipated deal, expected to be managed by Goldman, Sachs & Co., will be a privately placed transaction in the $300 million to $500 million dollar range, with mixed assets of 80% bonds and 20% bank loans.
"I think that we'll probably go out with a smaller size deal and end up upsizing it," Lewitt said. "It's really going to be based on how much equity we can raise. Right now we have a portfolio with about three-fourths of the assets identified."
The Florida-based company recently came to market with its first collateralized loan obligation (CLO), a $425 million transaction, dubbed Harch CLO-1 Limited, which was completed in the 144A arena. Lewitt expects that the company's future deals will also be completed in the 144A market because it "makes things easier from an issuer standpoint."
With two new deals in consecutive quarters it seems as if HCM is set to begin issuing with a vengeance, but apparently market conditions, in the end, will determine whether the company is poised to become regular issuers in the rapidly growing CDO market.
"I think that we're going to try to be," Lewitt said. "I think that up to a point we are going to continue to issue them and I think that it just makes a tremendous amount of sense. Lets put it this way: it makes sense when spreads are very wide because your financing costs are low and money is locked in. When spreads are tighter it might not make as much sense."
Lewitt also stated that the company doesn't "really have a timetable" for performing these transactions.
"The key thing for us is when it makes sense," he explained. "There are just other issues that we have to deal with internally in terms of staffing and so on. But if spreads stay this wide, I wouldn't be surprised to see us come back to the market again because it is just very opportunistic."
The Road to CDOs
HCM opened for business in late 1991, spending its first couple of years managing a large equity portfolio for the Drexel Burnham Employee Partnerships. The birth of its hedge fund came along in 1994.
"We just felt that we had been managing separate accounts up to that point and we felt that that would be a good vehicle to enable us to raise a large sum of money and also to have pretty free reign on how we managed it," Lewitt said. "Separate accounts have pretty specific requirements generally and with the hedge fund you pretty much tell people you can do whatever you want to do. We started only in bonds and now we do bank debt, so it's just sort of a freer way to manage money."
Lewitt doesn't speculate that the company will be branching out into other sectors beyond bonds and bank debt. "We don't really have the expertise to do other things," he noted.
Although HCM is a new issuer to the sector, Lewitt says that the company has been "studying the structure for five or six years" so that it could get comfortable with the sector and gain a level of expertise. In a sense, HCM has a formulated gameplan when approaching each new deal, with the main emphasis being on buying seasoned bonds.
"We don't like to buy new issues, we never have," he said. "So we're really trying to buy seasoned bonds that have a track record of having debt outstanding, therefore the companies have business plans that are established."
While most market players seek out CDOs to diversify a portfolio, HCM prefers a "less diversified" approach, mainly because there are several industries that the company is not interested in investing in. Its first deal, the CLO, had a lower diversity score and a higher ratings factor than your typical CLO - meaning that it was higher quality and more focused.
"We didn't go for having one of every industry," he pointed out. "That was something that held us back from doing these for a long time, the concern that we would be forced to buy things that we didn't want."
HCMs' upcoming deal will reflect these focused guidelines, with the deal straying away from certain industries but containing seasoned paper.
Small But Strong
Being a new issuer and smaller than its competitors, HCM does encounter several obstacles when wanting to perform business transactions.
"From the people that did invest, the most common complaint that we did get was that we were too small a company," Lewitt said. "The second issue was that people felt that we were more recognized as bond managers and bank loan managers."
To help alleviate this issue, the company plans to adjust its staffing along with its growth, Lewitt said.
"We're never going to be a mega-company," he said. "We don't have junior analysts running around doing research. All of the senior guys do their own work here and that's not going to change. But I think that we'll get some more help, particularly on the support side."
The High-Yield Connection
While Lewitt predicts a healthy future for CDOs, the long-term ramifications for the high-yield market may not be quite as positive.
"The growth of the CDO market has really enabled the high-yield market to grow tremendously," he said. "Because of the diversity requirements, its allowed a lot of deals that ordinarily wouldn't have found buyers to get done, which I think is a negative. You are seeing a lot of these deals go bust now."
On the other hand, the explosion of the CDO sector has put the ownership for these bonds in stable hands, which can be construed as an advantage. It will take time, however, to determine who can best manage these securities.
"I think [this market] will continue to grow," Lewitt said. "What will happen is that we'll have a whole bunch of managers rush out and it will end up being a "waiting out" factor, as some managers will end up being more successful than others."
Lewitt added that CDOs have really replaced the mutual funds as the main drivers of the high-yield bond market. On the bank-debt side, it has had even more of an effect. CLOs have spurred the issuance of institutional debt, because CLOs can only contain institutional tranches of bank debt.
"I think that it has exposed a lot more institutions to this market," Lewitt said. "Over time it should be a healthy development, but there will be a shakeout. A meaningful number of deals have been downgraded."
The biggest danger, Lewitt said, is when someone goes out and raises a $1 billion deal without already having the assets, and they first have to go out and buy them. Additionally, due to deteriorating underwriting standards and other problems, some players have bought poor-quality paper.
"I think that the main thing that equity investors are going to find with this thing is that the returns are not what were advertised - that the recovery rates on bonds and bank debt are overstated and the default rates are understated," Lewitt said. "People really need to pay attention to who their manager is."
A Sector of Risk
For a company that just entered the ABS battlefield, Lewitt feels that his company brings to the table an army of seasoned professionals that will give the company a competitive advantage.
"We have nine seasoned people who have seen all sorts of markets," he said. "We literally have guys that go back 25 years in this market. I think in terms of experience and knowledge of the market, nobody really matches up with us. We've been very successful in focusing on what we call "event-driven investments", which are investments with positive-event risks where the bonds get redeemed early at a premium."
Looking at it from the CDO perspective, Lewitt feels that HCM has a more conservative investment philosophy than others.
"I think that our track record has been better than a lot of other guys... we have consistently shown that we can make money in bad markets and endure risks," he said. "This asset class is just filled with risks. Everywhere you turn there is something else that can go wrong. I think it takes a lot of years to figure out what to avoid."
