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Promising debt trust doesn't match up to equity funds
James Carthew casts his expert eye over investment trusts operating in the debt sector.
It has been a while since I wrote anything about investment trusts in the debt sector. In January 2011 I had a quick look at the HarbourVest Senior Loans Europe (HSLE) trust and NB Distressed Debt fund.
Back then, HSLE’s shares were trading at about 96p and they are now 77.5p – a bit worrying at first glance, but this is misleading as HSLE has already started making returns of capital to shareholders. In October this year, shareholders got 9.78p per share by way of a B share issue and HSLE’s shareholders have also had 6.15p worth of dividends over that time, so what was 96p is now about 94.4p per share – not great but not a total disaster.
HSLE aims to generate income and maintain capital by providing senior debt finance for European private equity backed companies. It listed in May 2010 and raised just over £100 million. It was expanded twice: via a £26.7 million C share in April 2011 and a placing in February 2012, which raised £12.1 million. Following the return of capital, the market cap is now just under £110 million.
The structure is a Guernsey-domiciled fund with Luxembourg subsidiaries. The subsidiaries hold the loans – 17 of them at present. The portfolio is diversified geographically with just over half the assets in the UK and the balance in EU loans. It is also diversified by business sector. As the name suggests, the loans are at the top of the capital structure of the companies they are lending to so HSLE has the first charge on the company’s assets.
For reasons I have never been able to fathom, shareholders are not told who HSLE has been lending to (whether this is the manager, the borrowers, other lenders or the private equity companies that insist on this anonymity, it seems to me that someone just wants to cover up any potential mistakes). Instead, HSLE publishes a table that details the various characteristics of each loan.
There is one unusual loan in the bunch. This was made to a company in Sweden; it matures in 2015, pays interest of just 250 basis points (bps) over Euribor (the European inter-bank lending rate) and was acquired in the secondary market at a discount. Otherwise, most maturities range from 2016 to 2018 with the weighted average maturity in 2017. Margins range from 375bps to 525bps and the weighted average margin is 458bps. Most loans represent around 4x the borrowing company’s earnings (Ebitda).
HSLE promised that after an initial period of two years (which ended in June 2012) it would return capital to shareholders as loans matured rather than reinvesting it. In August one loan was repaid four years early. This freed £12.7 million to fund the capital return. It will be interesting to see how fast the rest of the portfolio runs off. In the year to 30 June 2012 three of HSLE’s loans were repaid early. Two were repaid early in the prior period.
HSLE does not hedge its euro exposure; it would be impractical for it to do so, given the illiquid nature of the portfolio. This has had an impact on the net asset value (NAV). In its first reporting period, to end of June 2011, this was beneficial as the euro/sterling rate moved from 1.17 to 1.11. As we know, since then the euro has been weak. To counter this, the manager increased the proportion in sterling loans early in 2012. Over the year to 30 June 2012 forex moves cost the fund about £4.4 million. The exchange rate hasn’t moved by much since then.
The rest of the decline in the NAV relates to changes in the valuation of the underlying loans. If HSLE held the loans to maturity and was repaid in full then mark-to-market changes in the value of loans ought to be of very little consequence to shareholders. The managers have chosen to crystallise one loss by selling on a loan, however. There is not much scope for them to recover this now we are past the end of the reinvestment period. In theory this is an attractive market. Many banks are unable or reluctant to lend to the sector and this is boosting margins (the February placing got away on the back of this story).
The current portfolio yield is 5.15%. The base fee of 1% on invested assets is okay but ongoing charges are around 1.8%. HSLE managed to pay 3.18p of dividend over the past year and may be able to squeeze that up a little from here if they can keep overheads under control.
The question is: is this an attractive enough yield for new investors? The managers will be keen to keep the fund going and will be looking to raise new capital, especially if the pace of capital returns is maintained.
The forex issue could be addressed – I wonder whether new euro assets could be covered by a separate euro class of shares; making it easier for shareholders to hedge the forex exposure themselves if they want to.
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