Loan Alpha from Capacity Constraint
A loan fund’s size and investment opportunities are negatively correlated. This makes capacity constraint a key factor, allowing for high conviction focus on quality opportunities. Large loan strategies invest with low conviction, tend to hold lower quality credit in an effort to enhance returns, and have underperformed as a result.
Large loan strategies invest with low conviction. They do this for liquidity at the cost of alpha. As it’s difficult for a low conviction strategy to outperform, large managers have been overweighting CCC rated loans to enhance returns. However, low quality loans have consistently underperformed. We believe this low conviction, low quality headwind is generally avoidable with capacity constrained strategies.
Loan Strategy Average Characteristics by AUM
As of 10/31/2019. Source: Morningstar Direct Loan SMAs, Index: S&P/LSTA Leveraged Loan Index.
Capacity Constraint, limiting the size of the strategy, allows a manager to target the full loan market without compromising liquidity, conviction, or transaction costs. It also means foregoing additional AUM and fee revenue to improve return potential, a trade-off large firms oppose at the investors’ expense. Revenue from a $1bn loan strategy doesn’t move the needle of a trillion-dollar firm, while a $20bn strategy does.
For example, the median S&P/LSTA Loan index issuance size is $520mm, about the size of Cumulus Media’s 3/31/26 term loan. A $1bn loan manager holding $5mm of the issuance, for a 0.5% portfolio position, can liquidate the position intra-day*. A $5bn manager holding $25mm (0.5% position) would need 6 days to liquidate under normal conditions, at twice the transaction cost of the $1bn manager. A $20bn manager holding $100mm (0.5% position), would need 24 days at 6 times cost. Instead, $5bn+ managers opt to hold smaller, low conviction positions to improve liquidity and costs.
Bloomberg Liquidity Analysis: Cumulus Media $525mm 3/31/26 Term Loan
As of 12/13/2019. Source: Bloomberg.
Size and investment opportunities are negatively correlated. Large loan strategies have underperformed due to an inability to invest with conviction and preference for lower quality credit. Loan investors seeking to improve their risk-return potential should consider smaller, capacity constrained strategies.
For more information on capacity constrained loans, our research can be found here.
A PDF version can be found here.
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The S&P/LSTA Leveraged Loan Index is a market value-weighted index designed to measure the performance of the US leveraged loan market based upon market weightings, spreads and interest payments. Alpha gauges the performance of an investment against a market index or benchmark which is considered to represent the market’s movement as a whole.
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