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More than Trups: Hildene's expansion into CLO investments paying off

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Hildene Capital Management made its mark in the CDO space a decade ago when founder and president Brett Jefferson jumped into Trups.

Distressed assets are Hildene's investment niche, and in the aftermath of the financial crisis there was plenty of anguish in approximate $40 billion volume in outstanding collateralized debt obligations of trust-preferred securities of mostly community and regional banks.

While many institutional investors took a bath on Trups CDOs when large swathes of banks (28% in 2010, according to FDIC data) defaulted. Hildene bought up CDO securities on the cheap, and had net annualized returns of 21.5% a year for the firm's initial Hildene Opportunities Fund I, now with $2 billion in invested assets.

The guiding strategy of Jefferson and his team came from a simple surveillance of the financial industry landscape: despite the impact of the crisis, it seemed more than likely that a large portion of the 8,000 banks in this country would stay afloat and satisfy their Trups obligations. “In a time like that, you need to cut through the fear and noise and think about likely outcomes,” Jefferson told Asset Securitization Report.

Hildene (along with EJF Capital) remains a top investor in Trups, but in 2011 the Stamford, Conn.-based firm expanded more broadly into distressed structured credit investments with a second fund, Hildene Opportunities Fund II.

The fund (now sized at approximately $850 million with net annualized returns of 14.5%) made notable investments in pre-crisis CLOs as those deals wound down to maturity, but Jefferson and his co-chief investment officer, Dushyant Mehra, have now expanded the firm outside of its distressed-credit specialty: investing in the highest-risk equity securities of post-crisis CLOs.

Both sat down with ASR to discuss their distressed-asset strategy and what they see ahead for buying opportunities in 2019.

Delving into investing strategy, how do you determine an asset is mispriced?
Brett Jefferson: Back when I was at Marathon [Asset Management] from 2002 to 2006, I was buying assets in the single digits and that strategy paid off. Later I bought billions of dollars in Trups CDOs – some in the single digits [to par], some 20s, some 30s – and it all paid off. But that was in a distressed environment. In a time like that you need to cut through the fear and noise and think about likely outcomes; in the Trups asset class at that time, everyone thought all the banks were going to fail. We would look at deals, and ask ourselves, are all of these banks going to fail? Because you had 8,000 banks in the country, and if you’re looking at one deal and saying that’s a representation of the universe, you would have to expect 3,000 banks fail. But we only had 500 banks fail.

Now that we’re not in a distressed environment, it’s more of a hunt to find mispriced assets. Let’s take for example a CLO during a selloff in the loan market. Let’s say you’re looking at the CLO’s equity tranche, which happens to be 10 times levered and the loans selloff to 95; you’ve lost 50%. If the NAV of the equity is now 50 points lower, you have to ask yourself, is it really 50 points lower? Because loans mature at par, they don’t mature at 95. So, at the end of the day, it doesn’t matter what that CLO is worth today, you have to think about what it’s going to be worth when the assets mature.

Dushyant Mehra: You have to be cognizant and recognize what the value of the option is and what the probability is of that coming true or not. You have to make a call as to whether you’re going to get paid for the risk you’re taking.

What are mispriced or undervalued options in the CLO market?
Jefferson: From a technical perspective more so than a fundamental one, I think the volatility of the underlying loan market is going to create opportunity in the CLO space. We’re also seeing managers struggling to get deals done in periods of volatility, and believe opportunities will emerge due to managers getting hung with certain positions and needing to get out.

Mehra: Three years ago, given it was late in the cycle, liquidity and volatility were increasing, and so we pivoted our Hildene Opportunities Fund II into the same [CLO] asset classes, but into sectors of those asset classes which we believed would offer the shortest duration, either by returning principal in a short period of time or by having really high cash-on-cash yields, or a mix of the two. That’s important, because as volatility increases, we’re creating intrinsic liquidity by returning cash sooner. You are taking reinvestment risk, but in a highly volatile market, so you are ultimately able to play offense while the rest of world is playing defense.

Markets are getting more illiquid as dealers’ balance sheets have decreased. It’s happened in the loan space and in structured products – we’re really seeing this shift across the board.

Looking at Hildene Opportunities Fund II, in what assets classes did you find opportunities in 2018?
Mehra: In general, we try to find opportunities in markets which are less trafficked, and as a result, not well understood. In markets which are more heavily trafficked, like CLOs, we try to find “nichier” and smaller opportunity assets that are mispriced within the market. In CLOs, what has paid off for us in multiple years, is focusing on the cash flow component of CLO equity. For example, in 2016 and 2017 we became one of the largest holders of 1.0 CLO equity as the asset class was disappearing. In 2018, we recognized that the refi and reset optionality in CLO structures was not priced well, and, given the rising rate environment, we thought that optionality would be a worthwhile opportunity to buy into. Accordingly, we bought 2012-2013- vintage CLO equity at the end of 2017 and well into 2018, primarily to drive the reset and refi options, which helped our CLO investments outperform.

In addition to CLOs, another asset class in which we invest is REIT Trups CDOs, a niche part of the market, which is not well trafficked and massively undervalued. These assets have a structure that, even today, we believe trades at a substantial discount to the value of the underlying assets. Over the past two years, we’ve sought to grow our exposure to REIT Trups CDOs, and the asset class was our biggest performer in 2018. We are also finding opportunities in other pockets of financial credit-backed instruments, including banks and insurance Trups CDOs, ABS assets, bank TARP and single-name credits.

Is the focus on Hildene’s investments in post-crisis CLOs also concentrated on equity positions, like with the CLO 1.0 deals you bought into?
Mehra: Pre-crisis equity was definitely a key driver of our returns in 2015, 2016 and 2017. However, in 2017, our focus shifted to opportunities we were finding in 2.0 post-crisis deals. Similar to how we approached CLO 1.0 deals, in post-crisis CLO deals we also focused on equity positions. We like to focus on equity as we believe there are more opportunities to differentiate. In our view, it’s almost impossible to differentiate yourself in CLO mezzanine except under specific circumstances – like being the liquidity provider in times of market distress or taking advantage as a bond rolls down the credit curve post the end of its reinvestment period. In general, CLO equity is one place where we believe we can differentiate ourselves, as we can evaluate manager performance, behavior and incentive structure. We can evaluate documents and structures, which eventually affect CLO equity performance more than anything else.

And was controlling interest included in your CLO equity purchases?
Mehra: Sometimes, but not necessarily.

Are you planning any more issues from your earlier CLO platform that was active from 2012-2014?
Jefferson: That platform was a joint venture which we created and ultimately sold. Today, we manage about $6 billion of Trups CDOs. These are static deals, so it’s more like servicing deals with no new asset selection.

How much shelf life is left in Trups?
Jefferson: We believe Trups have about an eight-year average life; however, some have a shorter life than others. While there may not be as many opportunities as there were 10 years ago, we still believe there are a lot of opportunities within the asset class.

Any asset classes you’ve shied away from?
Jefferson: We typically steer clear of on-the-run crowded spaces. Take, for example, CMBS – that’s a big market and one which we’ve typically avoided. We do, however, invest in REIT Trups, which have the same assets that would be in CMBS [deals].

Mehra: Student loans are another example. We don’t necessarily invest in student loan securitizations up and down the capital stack. It’s not an asset class we actively trade in, but we invest in certain specific pools of student loan securitizations, where there is a technical element presenting an opportunity. We do not shy away from a sector as a whole; it’s more about understanding the breadth of the sector, the liquidity of the sector and finding niche opportunities within a sector.

What are your thoughts on opportunities ahead for the rest of 2019?
Jefferson: We believe there will continue to be opportunities in the CLO market, particularly given the volatility in the loan market. We also believe there will be opportunities to add-on positions in Trups.

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