FREQUENTLY ASKED QUESTIONS
As Albert Einstein once said, “Make things as simple as possible, but no simpler.” In this spirit, we have produced a list of questions we feel are important to understand the Gateway process and market.
Gateway invests in the US corporate credit markets through the high yield bond and syndicated leveraged loan market. Together these two markets represent an investable universe of over $2.5 trillion. All securities are denominated in US dollars. We primarily acquire leveraged loans and high yield bonds in the secondary market. We do not originate loans or bonds and while we lean toward smaller issues (between $200 million - $600 million), we are not considered middle market. Our securities are publicly traded and almost always possess a rating.
Our mission is to protect investors capital, provide an attractive cash yield and still allow for capital gains generation. We create potential capital gains by typically acquiring our bonds and loans at significant discounts to par and have them called or refinanced at par or better prior to maturity. We consider ourselves “buy to event” investors with the primary events being a call, a refinancing or hitting our valuation target.
“Orphaned” credit is the primary inefficiency we look to exploit. Orphaned credits are created in both the loan market and the high yield bond market because the primary buyers of both asset classes are size focused. CLOs have size restrictions when purchasing loans and the large high yield ETFs and mutual funds have restrictions when purchasing bonds. In high yield, there are structural and legal limits established by these funds which typically can eliminate the ability to purchase any tranche size below $500 million. We prefer these orphaned credits to possess the three “U’s” — unloved, undervalued and under-owned.
Active portfolio management combined with a focus on company and industry fundamentals is the key to our “secret sauce.” Importantly, our investment strategy doesn’t rely on credit ratings as rating agency models are size biased. Stated another way, rating agencies give companies credit just for being big. Two companies with similar credit fundamentals can have dramatically different ratings based on size. This leads to opportunities as smaller companies with excellent fundamentals often trade at higher yields based on a lower rating. It is critical to understand that credit investing is a negative art; what you don’t buy is more important than what you do. Avoiding default-losses is key to outperformance in corporate credit investing.
To us, "alpha" is not a buzzword or moniker but a definable concept. We define and measure alpha by the yield per turn of leverage for each security. Our objective is to manage our default risk by purchasing securities exhibiting less leverage than those of the widely held indexes, while delivering a higher yield. We measure leverage by using market adjusted debt prices or “MAD” divided by EBITDA. We optimize our portfolio and weightings of individual securities using this measure. We believe this discipline helps us avoid stretching for higher yields at the wrong point in the cycle.
To us, the word "investment" needs a revised definition. Too many people focus their attention on potential returns or return ON capital. However, if there is no confidence or margin of safety in getting one’s capital back, it is speculation not investing. For something to be called an investment there must be some level of assurance that the capital will be returned—we call this return OF capital. Once that is thoroughly assessed, you can turn to identify the appropriate yield and/or capital appreciation potential.
Risk comes in many forms and definitions. For debt investors, it can be defined as duration, liquidity, correlation and default. Our focus is solely on one thing—the avoidance of losing money—which we view as default-loss. We work to address this with thorough fundamental and valuation analysis, paying close attention to leverage, liquidity, cash flow generation and capital structure sustainability.
Diversification is a misunderstood concept. Mathematically, diversification can be fully maximized by twelve securities in differing industries. While that would be too concentrated for most investors, many so called active managers hold hundreds of securities. To us this shows no conviction. We believe “di-worsity” (adding credits just for the sake of holding more names) is the enemy of performance and that there is a middle ground. Portfolio managers should have conviction in each of the securities they own.
Credit ratings continue to carry far too much weight in the business of lending, and we suggest investors use them with great caution. We view credit as AAA or D. It either pays us or it doesn’t. In over three decades of high yield investing, we still cannot tell you the difference between a BBB- or a BB+ security, yet one is considered investment grade and one is considered junk. Credit ratings have been at the heart of the last two “nuclear winters” in credit: Worldcom and Enron in 2002 and the mortgage crisis of 2008. We believe they will once again be at the heart of the next credit crisis as many have looked the other way with the pro forma further adjusted EBITDA calculations, which have allowed a massive amount of over-leveraging. Yet with all the fervor surrounding the great financial crisis of 2008, credit rating agency power is more dominant than ever. In fact, several recent relief programs launched by the Fed have credit ratings at the heart of them.
We are skeptical of management reported EBITDA numbers because of the proliferation of add-backs that both management and investors alike seem to accept these days. These reported EBITDA numbers are often misleading and mask the company’s actual performance. While EBITDA can be a useful comparative valuation tool, EBITDA is not cash flow. Cash flow from operating activities take into account true cash flows and working capital items. Subtracting capital expenditures from this number provides you a tangible free cash flow number. We also remain skeptical of management explanations of “growth” versus “maintenance” capital expenditures. Our experience is that all capital expenditures are often maintenance, as we find most of them don’t produce any growth.
As mentioned previously, we give little credit to management reported EBITDA and their associated add-backs. We include adjustments for non-cash charges, such as stock-based compensation or non-cash write-downs but restructuring charges and “one-time” expenses occurring on an annual basis generally are ignored. Pro-forma cost savings are another line item we will not add back. Management also tends to forget about the associated cash costs of implementing cost-savings programs. Given that our EBITDA estimates for each company are more cash focused, most of our estimates will be lower than go-forward sell-side estimates. We believe conservative EBITDA estimates aide in decreasing default risk.
Our team’s investment history has been squarely in the high yield bond market. This is important because high yield has historically been senior unsecured risk. This requires us to spend far more time understanding a business’ cyclicality and cash flow generation than most credit investors of the past decade who focus on credit ratings, recovery and spread. With our fundamentally driven process, we have more in common with equity analysts. Traditionally, in high yield your exit strategy is don’t get it wrong because you get called or killed.
The great news for credit investors is that mediocrity is our friend, and we have thousands of friends. What we mean is that businesses that have tremendous growth or above average profitability ultimately attract competition. Strategic planning departments are not in the habit of making huge investments in limited growth businesses or industries. These steady, low growth niche businesses often make for superb loans.
We prefer slow or no growth economic environments. In a slower growth world, management is more likely to pay down debt and de-leverage versus spending money on acquisitions, empire building or shareholder friendly activities. The focus is on the balance sheet versus the income statement, which is to our benefit as credit investors.
We are relatively agnostic as to whether the companies we invest in trade public equity or not. Information is easily accessible for public companies and public companies tend to have more scrutiny and therefore less abuse related to addbacks. The advantage to private issuers is that we believe we receive an “information premium” as getting financial information requires considerable effort. We take no additional comfort in sponsored companies or those owned by private equity shops. Whether the company is public or private, we do our own fundamental work and don’t rely on sell-side research.