Ian Hazelton joined Duke Street last year to oversee the private equity house’s newest venture, a Collateralised Debt Obligation (CDO) fund. At euro750 million Duchess I CDO is currently Europe’s largest fund in this asset class. As chief executive of Duke Street Capital Debt Management Hazelton is responsible for investing the debut fund in a mixture of senior and mezzanine loans and, to a lesser extent, high yield bonds. The idea is for the debt investments to return enough to pay back the fund’s bondholders and produce a profit for the equity investors and a carried interest for the fund managers. With over two-thirds of the first fund already invested Hazelton is now considering Duke Street’s next CDO. He talks to evcj about Duchess I CDO and how it fits into Duke Street’s vision for the future.
What’s your background and how does it help you in your role managing Duke Street’s CDO fund?
I joined Duke Street last October, when CIBC, the fund’s sponsor, was already in place. Before that I spent eight good years at the Royal Bank of Scotland where I developed skills and grew with the acquisition finance team there, from start-up to the largest in Europe. I had worked on deals with Duke Street while I was with the bank so I knew the firm and it seemed a good place to work. For me coming here was a change and a challenge, working with the CDO is something that’s new and exciting. Although here the investments are made using institutional money rather than bank money, the skill set is virtually the same. You need a thorough understanding of leveraged buyouts and the financial structuring of deals. At Royal Bank of Scotland we were mainly arranging the debt for deals whereas now I’m on the other side buying it.
What other skills are required to run the CDO fund?
The mechanics of fund management are important and it’s a new skill for me. You need to pick the right asset for the fund to minimise capital losses. We have a wide range of assets, a mix of senior debt, mezzanine and some high yield bonds. To further spread the risk the assets are diversified by borrower, industry and country. Credit analysis is a large part of the job, basically choosing the safest asset and making sure we’re not taking an undue risk for the return on a deal.
What motivated Duke Street to launch a CDO?
Firstly, the long-term development of Duke Street into a more broadly based fund management company. Secondly, the CDO fund was conceived as a way of migrating mature debt assets with acceptable coverage ratios and yields from the equity side of the business into another vehicle. We haven’t done this as it proved to be much more complicated than we anticipated and also difficult to explain to investors. It would actually be easier to buy the assets of another private equity house. Firms in the States, such as Carlyle and Bain, have also tried it but we found the amount of knowledge you can leverage from private equity is quite limited due to confidentiality constraints. The real crossover has been the network of industry specific advisors. We would do the debt on a new Duke Street deal but only if it was arranged by a bank at arm’s length and we alone could not decide the actions of the bank syndicate. It would also have to be a deal where our holding wasn’t significant so we had very little influence.
How is Duchess I CDO structured?
The fund has a 12-year term but we will probably begin to sell down the asset portfolio after nine or ten years, possibly to another CDO. We have until the middle of next year to invest, or ramp-up, the fund but we expect to have completed this by Christmas. We then have seven years to reinvest any capital receipts. Five years is a more typical reinvestment period but we wanted the flexibility, even though it’s more expensive. I wanted to manage the fund as a proper business and not run out of time and be forced to buy assets that aren’t necessarily right. We also have a wrap on the class A notes, provided by Financial Security Assurance. This type of guaranty isn’t uncommon and it means the class A notes are rated triple A instead of single A. The ratings agency also looks at our assets to make sure they comply with the rating, as does the fund’s trustee.
What will the fund’s investment spread be?
The total size of the fund is euro750 million and it can invest in both sterling- and euro-denominated assets, although the notes are euro denominated. At least 65 per cent will be invested in senior secure loans in leveraged buyouts. The rest will be a mix of mezzanine debt and high yield bonds. The bonds will make up no more than 15 per cent of the fund; this is less than most CDOs. We’re deliberately behind on that target at the moment. We’ve looked at the bond new issues market but it’s too unpredictable and I’m not really comfortable with the blue-sky business concepts involved with many telecoms businesses.
In the UK the fund will take senior positions of up to euro30 million, for mezzanine and for investments in some other countries this limit will be euro18 million. The fund’s high yield allocations will be smaller still. Loans are more difficult investments than bonds, with the legal differences between the different countries, and they take longer to analyse because we have to be picky about the security and inter-creditor issues. But we have a big team, seven investment professionals, and prefer to stick to the asset class we know.
On average we turn down two out of every three deals we look at. And yes we have done a number of Royal Bank of Scotland deals!
How does the fund fit into the firm’s forward strategy?
CDO funds are a key part of Duke Street’s forward strategy to increase the firm’s perceived value. The aim is to build a recurring income that we can forecast. We’re looking at raising a second CDO in the first quarter of next year, but it depends on the capital markets. Other possibilities we’re considering include taking on a mandate from a single institutional investor to invest in the same asset class. I would think seriously about branching into another asset class.
What enabled you to raise Europe’s largest CDO as your first offering in the asset class?
It was certainly hard work raising the fund but we had good sponsors and big investors, influential and with deep pockets. We targeted the established CDO buyers, insurance companies and institutions mainly in the UK, Germany, Austria and Switzerland. The fund is not open to the public but it does include commitments from a selected group of private individuals who have worked with Duke Street before. It was important to us to raise a fund of this size, as we wanted to be able to invest large amounts in each deal if appropriate. Banks are more willing to talk to a CDO fund that can bring a good sized investment to a deal. I expect the next fund will be of a similar size.
What do you think the future holds for the high yield bond market in Europe?
I don’t think the success of high yield bonds over here will inevitably follow their success in the States. In the long term I think the market will become deeper and broader but it’s not definite that publicly traded high yield bonds will really take-off. Bonds can be very expensive to pay back early and new, attractive mezzanine initiatives could threaten the growth of this market. The introduction of the euro will help high yield bonds by increasing liquidity and it would be a huge boost if the UK joins.
How do you think CDO funds fit into the European debt market?
The banking market is shrinking at the moment and it will struggle to keep up with the demand for debt. This will be exacerbated by the introduction of the Basel Accord, although it’s been deferred and isn’t due to come into play for another couple of years. The accord means that banks will have to account for capital more conservatively. They’ll need to reassess the amount of capital reserves they hold to provide adequate cover for their risks. This will reduce their financing capacity and increase the demand for facilities such as CDO funds. I think CDO funds are going to grow strongly and nothing is going to stop this. While they appear like a single product they represent a wide range of assets, each a specialist market and I don’t think any single player is going to be able to take the lead overall. We would clearly like to grow as a leading player in the leveraged buyout business.