What is the history and background of your company?
Varden Pacific LLC is a San Francisco based investment manager that was founded in 2010, launched its flagship fund in April 2011 and currently manages over $200 million in its core strategy. Varden is focused on capitalizing on niche opportunities and residual dislocations within the structured credit markets, specifically within corporate-backed structured credit. The firm’s strongly held view is that for the near to medium term, corporate defaults/bankruptcies in Fortune-500 type companies will not exceed the levels realized during 2008/2009 – the worst since the Great Depression. A number of fundamental factors support this view including; cash on corporate balance sheets reaching a 20 year high, a low interest rate environment, strong free cash flow generation, access to capital markets, a lack of near term debt maturities and a slowly improving economy.
Over the course of the past 12 months what do you consider to be the most significant development in the OTC markets?
Credit markets over the last 12 months have experienced a material disconnect between the market implied probability of default as calculated from credit spreads and the probability of default as determined from fundamental analysis of balance sheet health, free cash flow from operations and near term debt maturity profile. Throughout 2011 and in to 2012, investment grade and high yield credit spreads are predicting a five year high yield environment that is a multiple of what occurred during the Great Depression. When analyzing credit spreads, one has to take in to consideration a number of factors. In addition to actual default risk, market observed credit spreads also incorporate a liquidity premium and some degree of counterparty risk in synthetic credit. A very low interest environment can also dictate the amount of absolute yield that an investor is willing to receive for taking term credit risk, thus increasing the spread relative to the risk-free rate of return. These factors, however, diverge from fundamental analysis when determining the propensity of a given company to default within a specific time period. This disconnect has created significant opportunities for deploying risk capital in structured credit products where corporate defaults are the only factor in determining the ultimate return on investment.
“As a point of reference, to become Basel III compliant, European banks are faced with the dilemma of raising $450 billion of equity capital or selling 17% of risk weighted assets – a staggering $5 trillion of assets.”
What key challenges and/or opportunities does the current environment bring to your business and how do you intend to manage them?
Changes in the regulatory capital environment, especially the increased scrutiny regarding European banks, continue to dictate the ability of investors to remain in their legacy structured credit positions. These changes are forcing original holders to purge capital inefficient assets for non-economic purposes. Looking forward, we expect this forced selling to continue. As a point of reference, to become Basel III compliant, European banks are faced with the dilemma of raising $450 billion of equity capital or selling 17% of risk weighted assets – a staggering $5 trillion of assets. Unless sentiment shifts dramatically and banks can raise a massive amount of equity capital cost effectively, the liquidation of capital inefficient assets will be a secular trend over the coming years.
What is your reaction to the changing regulatory landscape? How will it impact your business?
The capital market climate for corporations, especially domestically, continues to be constructive. A key driver to this strength is the access to liquidity. Corporate debt issuance in the second half of 2011 was extremely challenging. In 2012, however, we have seen corporate debt issuance return to historic highs. The total amount of high yield debt issued in 2012 is roughly equal to the amount of high yield bond and loan debt that is maturing in all of 2012 and 2013. The looming “wall of debt” that has been a common conversation over the last three years continues to be pushed further in to the future. Equally important to the amount of debt that is being issued is how the proceeds are being used. So far this year, approximately 60% of all proceeds have been used to refinance existing high yield debt. This is a major sea change from 2008 when almost 50% of all debt proceeds was used to finance M&A and LBO activities. Corporate CFO’s have “found religion” following the results of their pre-Crisis actions. This change in philosophy has had a significant impact on lowering the rate of corporate defaults.
Looking ahead, what market development do you anticipate?
More generally, market sentiment has improved, especially relative to Q4 2011. The US economy continues to decouple from Europe and is growing, albeit more slowly and unevenly than many would prefer. At this point, data in a number of depressed sectors including housing and manufacturing is signaling an upturn. Industrial production is firming, oil prices have eased and the Federal Reserve continues to take a “wait and see” stance towards additional easing. We are bound to see bouts of volatility throughout the rest of the year as markets attempt to predict the potential impact of a Greek departure from the Euro. That being said, with the first quarter now behind us, the majority of domestic corporations have either met or exceeded performance expectations. The current landscape remains constructive for emerging funds like Varden Pacific who have the nimbleness and expertise to monetize tailored credit view in a careful and experienced manor.