It’s about leverage
For GSC’s US loan team, liquidity is nice. But what really matters is choosing low levered loans and working with the borrowers.
By Michael Peterson

Creditflux - June, 2008 -- Tom Inglesby believes he knows what it takes for a lender to work with a corporate borrower that hits troubled times. Some 10 years ago he was a manager in a private equity fund with an investment in a software company that turned sour. He fired the management, installed himself as chief executive and worked to turn the company around.

Then he hit a problem in the shape of a tenacious work-out officer from the company’s biggest lender, a Japanese bank. The banker put Inglesby through the wringer, dogging his every step and making sure he did everything – including threatening legal action – to prioritise the company’s obligations to its senior investor.

In 2001, Inglesby became head of the CDO team at GSC Group. He figured that, in order to maximise recoveries, a good work-out officer would be a key member of his team, so he hired his old sparring partner from IBJ, Harvey Siegel.

There is no better illustration of the GSC corporate credit group’s approach than the fact that Siegel not only remains employed by the firm but is one of its pivotal figures. This is despite the fact that over the last few years of low defaults, he has not had many loans to work out. “Harvey has had a few years of dropping grapes in his mouth,” jokes Inglesby. “But he is getting busier.”

The group’s philosophy is to minimise its expected losses by lending to the right kind of borrowers and working out the loans that encounter problems rather than selling them. In recent years, many liquid loans to big companies did not fit the bill. “We think the best way to gain value is to purchase assets that have low leverage and good covenants,” says Inglesby. “We don’t pay very much attention to companies with perceived high asset values or loans with liquidity. If a loan is liquid that is nice. But we favour loans that have less liquidity and have low leverage in terms of debt to ebitda.”

Besides Inglesby, who still heads the group, and Siegel, there are several other key figures in the corporate credit group at GSC (the firm also has a separate business that focuses on ABS.) The head of portfolio management is Seth Katzenstein, a former Salomon Smith Barney analyst who joined GSC around 10 years ago.

Primary origination of loans is headed up by David Thompson, while John Kline is responsible for buying loans in the secondary market. The group also employs several assistant portfolio managers and traders and a team of 10 credit analysts who are organised by industry.

The team currently manages nine corporate CDOs, almost all cashfl ow CLOs. It also manages a permanent capital vehicle in the form of a business development company, GSC Investment Corp, which is listed on the New York Stock Exchange with the ticker GNV.

In 2000, the original GSC CBO team started out by purchasing high yield bonds, but soon got caught in the disastrous default and recovery rates of high yield bond issuers in the early years of the decade. “It seemed like in every default we would lose 75% of our money, which struck me as a bad deal,” recalls Inglesby.

That is when the group switched from bonds to loans and, in particular, loans to mid-market companies. The company acquired a portfolio of these loans made to smaller companies from Siegel’s old firm (including a loan to the company that Inglesby had been trying to turn around when he met Siegel).

That portfolio of mid-market loans became the core of GSC’s fourth corporate CDO, the GSC Partners Gemini Fund. That deal has performed spectacularly well, winning Creditflux’s award for best performing seasoned corporate CDO last year as a result of its 1.43 “par plus” ratio (a measure of annual equity distributions less par erosion).

But the Gemini fund is not the deal that Inglesby is most proud of in terms of performance. The one he is really pleased about is GSC’s fi rst deal – one of those troubled CBOs. GSC CDO Fund I was launched in early 2000 and consisted of weak single B bonds on average. Like other CDOs of its vintage, the transaction was out of compliance as a result of defaults in 2001 and 2002.

 
GSC’s Siegel, Inglesby and Katzenstein (left to right),
pick up their award for best seasoned CLO
(for GSC Partners Gemini Fund) at Creditflux’s 2007 Manager Awards

However, when the deal was liquidated last year, debt investors were repaid at par, and the deal was even able to return some money to equity investors (equivalent to a 3% return on equity, while also distributing restructured debt and equity securities in six companies).

After the Gemini deal, GSC’s subsequent CLOs kept a strong midmarket flavour. Mid-market companies are typically defined as those with $50 million or less of earnings before interest, tax and depreciation (ebitda). However, a more practical definition of mid-market loans are those in which a small number of firms, rather than a big syndicate, are the investors. Often referred to as members of the club, they have close links with the private equity sponsors of these companies.

The mid market assets have very little liquidity in the secondary market, but they do typically offer lower leverage and stronger covenant packages than broadly syndicated debt. “As a function of the illiquidity of that market, mid-market loans have stronger covenants – there has never been a covenant-lite mid-market loan – and a better capital structure than broadly syndicated loans,” says Inglesby. “The level of debt to ebitda has often been a turn or more less than for a broadly syndicated loan.”

The lack of liquidity in these assets means their prices were never bid up in the same way as mainstream leveraged loans and their documentation and leverage never became as aggressive. As a result, these assets are still hard to source, though GSC was able to buy a block of them recently at around 84 cents in the dollar.

GSC is not a pure mid-market specialist though, as some loan managers are. It also buys broadly syndicated loans when it likes the terms. At the beginning of this year, for example, it became one of the few CLO managers to complete a deal, closing GSC Investment CLO 2007, a deal consisting entirely of syndicated loans.

However, in the broadly syndicated market GSC’s focus remains sharply on leverage levels and thorough underwriting procedures. “There are several principles that are deeply ingrained in our group,” says Inglesby. “We need assets with real cashfl ows, you have to meet the company and you need to go through a standardised review process. I fi nd that most of the loans that we do not approve get kicked out very early in the process.”

By early 2007 the group found that it was kicking out most of the loans that came its way. “We can’t say we saw the crash coming,” says Inglesby. “But we saw how terrible the structure, pricing and documentation of the loans were and we took the opportunity to reduce assets under management.” As a result, the firm called two of its early CDOs (CDOs I and III) in that tight spread environment. GSC Partners CDO Fund III, a 2001 CBO, delivered a 19.3% net IRR to its equity investors.

The firm reckons its approach has paid off in terms of performance. Defaults in its portfolio have been below the market average, except for 2004, when it suffered 2.3% defaults compared to a market average of 1%. Recoveries in recent years have averaged 93%, a figure that includes the 2004 cluster of defaults.

GSC’s US corporate credit team’s emphasis on higher spread loans is reflected in its performance. Excluding the group’s first three deals, which were initially composed predominantly of high yield bonds, its deals have generated annualised cash distributions to equity of 19.7% since inception.

With most companies still recording earnings growth, Inglesby does not envisage defaults this time being as high as in the last economic downturn. Still, he reckons that his work-out specialist will have to put in more hours in the next couple of years. Siegel’s expertise could make a big difference to the recoveries GSC gets on default. “Harvey’s job is to maximise absolutely the primacy of the first lien loan, and force managers and owners to support the company with third-party financing,” says Inglesby. “In return, he can offer limited relief from covenants.”

Though Siegel threatened to sue Inglesby’s company all those years ago, litigation is not normally part of his approach. “Harvey doesn’t brandish litigation,” says Inglesby. “His main tool is offering managers the incentive of keeping control of their company, and managers like to stay in control.”

Reproduced from the June 2008 issue of Creditflux. For more information visit www.creditflux.com. Creditflux is for information purposes only and does not constitute investment advice. All content is the copyright of Crediflux Ltd. and unauthorised copying is strictly prohibited. © Creditflux Ltd 2008.

IMPORTANT NOTE: The performance information reported in the above article reflects the returns and cash distributions to holders of the equity or subordinated notes of the relevant CDOs or CLOs.  The performance numbers do not reflect changes in the market values of the assets held by these vehicles.  The article discusses the performance of a select class of vehicles managed by GSC Group.  The performance of other vehicles or funds managed by the firm may differ materially.  The performance information is also current only as of the date of the article.    Past performance is not necessarily indicative of future performance.  Investments include the risk of loss.

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