Jim Wiant, ceo, partner and portfolio manager of Capital Four US, answers SCI's questions

Q: Capital Four launched its first US CLO last year. What were the motivations behind expanding into the US market?
A: If you look at Capital Four’s history and its path to growth, since 2007 the firm has meaningfully extended its investment capabilities beyond just European high yield. The firm now covers a wider range of investment capabilities in Europe – having broadened its investor base, and then importantly expanding its geographic base too. Even prior to the contemplation of establishing the US effort, Capital Four has been increasing its efforts and focus on global funds which could broaden the investment scope beyond Europe and looking towards US issuers.

Prior to the formation of the US platform, the firm saw a real need and interest in being able to provide even stronger global capabilities to its investors. Capital Four has been managing around US$2bn-US$3bn in US issuers - of its total US$18bn - on a consistent basis. By extending those capabilities and having a senior team in the US, we were able to not just grow the business, but better serve our existing investors interests in managing and investing in these global vehicles that have exposure to the US markets.

As the US business gets started, I think the emphasis will initially be on loans and in performing high yield. Establishing the CLO platform in the US is of the greatest importance to us – Capital Four’s CLO business began in 2019 in Europe and is currently working on its fourth CLO.

This is coupled with the fact that the firm has a strategic investor, Northill Capital – which has provided significant equity capital in the launch of both the European and the US CLO businesses. This strategic equity enables us to get the business off the ground and to scale, quickly, with our core strategic focus in mind. 

Q: Currently, what are your primary areas of focus for the new CLO business?
A: When I look at the backdrop of the current investment opportunities in US loans, there has been a dramatic recovery following the pandemic period. We’re probably now at a point in the cycle where it feels like risk is maybe being undercompensated.

We are speaking to an environment where it pays to construct more conservative portfolio structures and then be in a better position, should you get more volatility more broadly within the market. We’ve obviously seen this volatility in equities and in US high yield; however, because of their floating rate nature, loans so far have been quite immune to this volatility.

So, it’s not just about being conservative for conservative’s sake, but being able to create the flexibility, should you encounter volatility – and to take better advantage of that. Then, in the meantime, continuing to make smart credit decisions and being effective in terms of the trading of the portfolio, so we are able to create incremental equity return.

Q: What have been the main challenges you’ve encountered during your expansion into the US market?
A: We have been fortunate in several ways. First, the amount of support which the US business has had from the broader capital franchise has been incredible – both from a capital and a resources perspective. While we are a newer effort, and currently only eight people in size, the amount of resources we can tap in to - from research to operations and portfolio management – really helps us to work as a global operation. Even when I look at CLO 1, because our European analysts have been following US credits for so long, a quarter to a third of the portfolio is actually coming from investment ideas from them.

Another important factor is the decision the team made to base the expansion with real capital and build strong capabilities from the beginning. This has served us very well.

Sometimes, businesses take the approach of first establishing satellite offices before fully committing to growing its business in a new market or region, whereas we decided to invest in a strong and highly capable team from the beginning. Our team averages at about 17 years of experience - most of our investment analysts have been in their sectors for more than a decade and have invested in both the CLO and high yield markets before.

The market, as well, has also been quite accepting of us. I’ll attribute this to being a recognition of the success that Capital Four has already attained in Europe, with the hope being that the US business will follow in those footsteps. Because of this, and the experience of myself and the team, we’ve been able to attain the right credibility – which is critical when you’re marketing a CLO.

Q: How are you expecting the Libor to SOFR transition to impact your US business?
A: It’s interesting, because I think if you were to fast forward 18 or even 24 months, it’s going to appear to have been a non-event. By that point, your assets will have largely migrated over and your liabilities will obviously be in SOFR, so you’ll be back in that natural state of consistency.

I think in this current initial period, there could be some mismatches. First would be how the CSA looks – this bridge from Libor to SOFR.

There has been a lot of uncertainty and discussion about what range that could be and whether that was going to steer more towards the benefit of equity or liability, which could lock up the market for a little bit. However, we’ve spoken to credit analysts in investment grade liabilities and in equity investment teams, and although there’s only been a couple of deals that have come through so far under SOFR, this isn’t an area of any major meaningful concern to either party.

It seems as if there is potential to have a relatively seamless transition and because we are bringing our own equity for the first several deals at Capital Four, it makes us a little less exposed. We want the right equity return for our investors, but for us it’s really about building franchise value and establishing a platform.

So, if we’re going to build conservative portfolios and establish the right track record, if that equity IRR pencils out in our particular case at 12% or 11.5%, there’s going to be some third party of equity investors that won’t be interested. However, for us, we are interested in establishing ourselves and building the business the right way for the long run.

Q: Have you differentiated your approach to the US CLO market versus your existing CLO business in Europe?
A: This is one of the things that has been critical in establishing our US platform. There was about a year of discussion, which followed a pre-existing eight-year relationship with the team at Capital Four, making sure that the way we think about our investment philosophy - about building businesses in general - is aligned. It is important when you’re trying to build a global franchise that all parts of the business reflect the same investment philosophies – because investors expect to see similar portfolio composition and trading strategy between the different regional CLOs.

Q: What are the primary areas of focus for your European CLO business?
A: I think about it in a couple of ways. If you look at successful entrants in the CLO space – and I think this applies to Europe as well – you will find managers who show the ability to ramp conservative portfolios to be able to demonstrate strong performance have been rewarded with lower liability levels much faster than before. Five years ago, as a new entrant, you would have been put at the back of the line in terms of liability levels because it was very much a hierarchy – it was based mostly on scale.

The biggest managers, even if they were mediocre performers, would’ve gotten the tightest spreads – and the newer managers got the opposite. There was a long road for the newer managers to get from one to the other, and because they had higher liabilities, it would force them to form their portfolios accordingly.

Now, I think there’s a path towards getting your liabilities tighter, which gives you a much better strategic footing in the CLO space. So, I think it links up well because the market environment speaks to it, and because of how current liability investors think about younger managers.

In 2022, I think the other areas to be mindful of are inflation and supply chains. How that’s going to play through businesses could define some of the winners and losers here.

We also have to understand what aspects of these risk are analysable. If you can assess for a company that there could be headwinds on the cost-side and it could bring margins from 20% to 16%, I’d much rather be able to box that and ask if we have the appropriate capital structures, for example.

However, when you’ve got something that could be a potential headwind, which could lead to a potential impairment of your loans, where it’s more difficult to analyse or more out of your control – like the price of a commodity. I think those are more concerning to us, and so that’s an important touchstone - particularly within the loan space - to avoid.

Q: How do ESG considerations fit into Capital Four’s CLO business?
A: If you look at the history of Capital Four, I think it speaks to not just a lot of European but particularly Scandinavian investment managers, ESG has been a consideration for longer than a decade. It has been embedded from a cultural perspective long before it was important to investors, or the introduction of increased regulatory scrutiny. Not only is the business broadly well positioned, but the US business especially has been integrated into the existing ESG infrastructure.

There has been an increasing emphasis on ESG across credit broadly, with CLOs being no exception. I think you’re seeing a transition in Europe – which is unsurprisingly further along than the US – of migrating from just an exclusion basis ESG policy in these five or six industries.

Which, if we are being honest with ourselves, isn’t eliminating many potential loan issuers. So, moving towards a more ESG-integration approach may ultimately lead towards firms actually differentiating themselves by having their portfolios geared towards rewarding performing companies from an ESG perspective. In addition, this isn’t just the companies that are the greenest of the green, but the ones that are also making positive steps in that direction.

Today, we manage ourselves consistently from an ESG perspective. Within Europe, our CLOs do not just have exclusions but have actual ESG scoring integration in the indentures and the reporting of our internal ESG scores.

The US is currently predominantly an exclusion-based market, but that does not mean in a few years it will not be different. In the US we are moving forward, and in Europe we expect very soon to be managing some of our portfolios as light green under the European Sustainable Finance Disclosure Regulation.

Effectively, this means the organisation is being run under those principles. So, the US market is at a different starting point, and is perhaps on a slightly flatter trajectory than the pace of change in Europe. However, I think it’s clear the direction that the business is going, and I think the CLO market will follow.

Q: What are your expectations for the future of the market and Capital Four’s role in it?
A: From a credit perspective, we expect defaults to remain quite modest here. There’s a lot of liquidity and, in general, companies are performing quite well.

I think we saw a lot of companies demonstrate their ability to deal with rising costs quite well, either through cost containment efforts or by raising prices – although this can lead to inflation. So far, however, credit issuers have managed okay.

In the high yield space, I expect it’s going to be driven by what’s happening with the expectation on rates. You’re seeing a variation between equity and high yield and what is occurring broadly in the loan market, which has proven to be much more resilient.

I don’t think it’s resilient in an absolute sense, because there are Libor floors which can create a fixed-rate component which would mean rising Libor could hurt your liabilities. Maybe some of your assets float, and some others don’t, but it won’t be a massive area of concern.

I think the CLO market has shown in the US, across a trillion dollars, that it has fully made the transition from a cottage industry dominated by a narrow set of players to being a who’s-who in credit. Regardless of your roots, having a CLO strategy has become the standard.

Last year was a record year from an issuance perspective, and I’d expect 2022 to also demonstrate a strong level of growth. I think we’ll see that continue to develop going forward. The industry has gained a broader acceptance and investor base – both at an equity and a liability level – and there continues to be an interest in supply from managers that view it as a high strategic area of focus.

Claudia Lewis