Since its inception more than a year and a half ago, brokerage firm Pali Capital's CDO structuring business has provided new options for middle market insurance companies, smaller banks and wealth management firms that focus on alternative investments. Pali has done this by developing CLO vehicles and credit default swap (CDS) CDOs that better fit the needs of middle market clients. These investors, not often coveted by larger banks, tend to have shorter duration and lower risk expectations.
"We decided to go after another set of potential buyers," said Luis Marino, managing director and head of fixed income sales and structured finance at New York-based Pali, explaining that his firm didn't want to compete with big banks for CDO structuring business. Instead, Pali decided to meet demand from the middle market for CDO vehicles with shorter maturities, less leverage and more flexibility.
Pali complements its in-house sales force by working closely with portfolio managers, independent advisors and wealth managers, Marino said. "Quite often, the best ideas for a new vehicle come from these prospective partners and clients," he noted, pointing to Pali's significant reliance on reverse inquiry.
Shorter maturities are particularly important to Pali's clients. "In all of the deals we have issued so far, the longest maturity is seven years," Marino said. Pali's synthetic CLO (which is being managed by Princeton Advisory Group), Canal Point I, has a maturity of seven years and is callable in the third year. Pali's other CDO vehicles have five-year maturities, Marino said. This is while traditional CDO investments have maturities of at least 10 to 15 years. "The maturity is a big factor for our buyers," he said.
Indeed, so is leverage - Pali's CDOs use five to seven times leverage on its equity tranches, on average, while more traditional structures use 12 to 15 times leverage, said Marino. "And because we use lower leverage, the manager has a slightly wider ability to manage the portfolio," he added, explaining that the lower leverage releases managers from worrying about a CDO failing its leverage tests.
Pali's clients thus far have also been particularly fond of the more stable returns the firm's CDOs offer compared with traditional CDOs. "On a risk-reward basis, for example, our loan deals have been paying investors a coupon of 13% with [internal rate of return (IRR)] expectations of 11% to 13%," Marino said. "Comparative deals that we have seen on the Street being marketed with much higher leverage are offering investors 15% for the equity. So in a highly levered deal you could end up with a slightly higher return, but also with a greater probability of a low or negative IRR if the credit cycle turns against investors," he continued. "Pali transactions are meant to allow investors to sleep at night and produce positive IRR across a wide range of return expectations."
In addition to Canal Point I, Pali currently has one other loan CDO in the market - Whitebark Pine I, managed by Boston-based CypressTree Investment Management. In the last year and a half, Pali has issued five CDO deals in total with a notional value in excess of $1 billion. The structuring group, led by Tom Carter, has participated in secured loan, asset-backed securities, emerging market and CDS transactions.
CDS structures
Much like its loan CDOs, Pali's CDS vehicles are also designed to provide desirable returns with low risk. "The strategy is very simple," Marino said. "What we do is start with a zero-to-three tranche of 150 issuers in the portfolio and we create a global investment grade portfolio that has positive correlation to the Dow Jones CDS Index." These transactions have been managed by Duane Park Advisors, which was recently formed with Pali support.
Pali's newest CDS vehicle, Duane Park III, a five-year CDS-based note with an expected IRR in the 16% to 18% range, is set to be issued in October. Duane Park Advisors currently manages the Duane Park I and Duane Park II vehicles.
Pali, established in 1995, was first instituted as an equities- and derivatives-focused broker-dealer largely serving the hedge fund community. More recently, however, the firm has worked to build a fixed income platform that includes the structured finance business as well as a new special opportunities and distressed debt team (HYR, 8/7/06). Pali's flagship offices are located in New York and London.
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