The Astrea IV bonds recently made their maiden coupon payments to bondholders on 14 Dec 18. In conjunction with the interest payment, Azalea Investment Management Pte Ltd, Astrea IV’s Manager, released its first semi-annual distribution report. We highlight here five of the most important things that investors should know about Astrea IV’s portfolio performance and activity since inception.
1. Portfolio performance is solid
During the first distribution period1, Astrea IV’s underlying portfolio of private equity (“PE”) funds recorded USD83m of fair value gains. Starting with a net asset value (“NAV”) of USD1.098 billion, the portfolio generated USD134m of net distributions (distributions minus capital calls), and ended the period with a NAV of USD1.047 billion (see Figure 1). After paying USD35m of capital calls during the period, Astrea IV’s total undrawn capital commitments were reduced to USD134m as at 30 Nov 18.
We note that the healthy portfolio performance of Astrea IV was comparable to that of its predecessor, Astrea III. The Astrea III portfolio generated fair value gains of USD80m and net distributions of USD163m on a starting NAV of USD1.142 billion, during its own first distribution period in 2016.
The similar solid performance of both portfolios in their respective first distribution period shouldn’t come as a surprise, as we have previously highlighted that the quality of Astrea IV’s underlying collateral is good and on par with that of Astrea III (see “Astrea IV: What You Need to Know (Part 1)”). The two collateralized fund obligations (“CFO”) share many similarities in terms of their initial portfolios, including fund age—both reported a weighted average fund age of seven years at inception—portfolio diversification, geographical distribution, and fund strategy allocation.
Figure 1: Astrea IV ended the first distribution period with a portfolio NAV of USD1,047m
2. Healthy cash flow increased the likelihood of bonus payment
During the period, Astrea IV received USD169m of distributions from its portfolio of PE funds, and reinvested USD35m of those distributions through capital calls. The remaining USD134m was applied to the priority of payments, as depicted in Figure 2.
Figure 2: Priority of payments for first distribution date
As a recap, the cash-flow structure of a CFO is one of the most important credit considerations that investors need to understand. In Astrea IV’s case, after applying the available cash-flow to senior expenses and interest payments (Clause 1-6), the issuer will pay certain amounts4 to the reserves accounts on each distribution date until 14 June 2023 (the scheduled call date for the Class A notes). This feature allows Astrea IV to build up sufficient reserves (up to USD395m) for the redemption of all Class A notes.
On the first distribution date, Astrea IV returned USD91.1m to its sponsor, Astrea Capital IV Pte Ltd. Recall that the CFO has a sponsor sharing provision that requires it to divert 50% of the residual cash flow (after payment of all amounts ranking ahead of the sponsor in the cash-flow waterfall) to the reserves accounts, if and when the sponsor receives more than USD313m of distributions. This feature serves to ensure that sufficient value will remain in the structure for bondholders.
In addition, holders of the first retail PE bonds in the world—the ASTLC 4.350% 14Jun2028 Corp (SGD) - Class A-1 - Retail—are entitled to a bonus payment of up to 0.5% of their bond principal at redemption if Astrea IV achieves the abovementioned performance threshold on or before 14 Jun 23. Given the strong track record of the Astrea series of CFOs, and the healthy distributions of the Astrea IV portfolio in the first distribution period, its prospects for meeting that performance threshold look promising in our view.
3. Portfolio remains well diversified and positioned for strong distribution cash flows
As highlighted in our previous article, the quality of Astrea IV’s underlying portfolio is the primary determinant of bondholders’ return. We mentioned that the Azalea Group has done the legwork of identifying the PE funds in their collection that are suitable for a more mainstream investor base, and the result is a mature portfolio with a weighted average vintage year of 2011 and total NAV of USD1.098 billion.
As at 30 Nov 18, Astrea IV’s portfolio profile remains largely similar to the starting portfolio and well-diversified across different fund investments, fund managers, and vintages. The largest individual fund investment is still Blackstone Capital Partners VI, LP at 9.6% of NAV (31 Mar 18: 9.2%), and the top three fund investments constitute 26.3% of NAV (31 Mar 18: 22.6%).
PE funds typically consume capital in their early years as they deploy money for investments, and only start realizing their investments and generating positive cash flows after a four-to-seven year holding period. We like that the Astrea IV portfolio has a large exposure to mature funds, which helps to ensure it stays cash generative throughout the transaction life span. At the same time, the CFO’s diversified investments across younger funds will contribute to growth and cash flows in the longer run.
It is worth noting that the portfolio’s investments in funds of 2011 vintage or older dropped from 46.8% of NAV to 43.0% during the first distribution period (see Figure 3), which demonstrates the cash flow patterns of PE funds just discussed above—the older funds deliver the payouts as the younger funds mature and appreciate in value.
Figure 3: Portfolio NAV by vintage year
Given the limited discretion the Manager has over changes to Astrea IV’s portfolio lineup subsequent to its launch, its geographical distribution and fund strategy allocation have also mostly stayed the same (see Figure 4 and 5). In fact, the list of funds in the portfolio now is exactly the same as it was at inception. The largely pre-defined portfolio makeup allows investors to know exactly what they are investing into, and provides higher visibility to the performance of the CFO.
Figure 4: The Astrea IV portfolio comprises of PE funds in the US, Asia, and Europe
Figure 5: The majority of the portfolio comprises of buyout funds
4. LTV ratio fell to 44.3%
Astrea IV’s total debt stood at ~USD504m at the end of November, comprising of the S$242m (~USD184m) ASTLC 4.350% 14Jun2028 Corp (SGD) - Class A-1 - Retail, USD210m ASTLC 5.500% 14Jun2028 Corp (USD) - Class A-2, and USD110m ASTLC 6.750% 14Jun2028 Corp (USD) - Class B. With USD1.047 billion of total portfolio NAV and USD40m of reserves balance, the CFO’s loan-to-value (“LTV”) ratio was 44.3%, down from 45.6% at the start of the period and well below the maximum LTV ratio of 50%.
Figure 6: LTV computation
| Calculated as of 30 Nov 18 (amounts in US$m) | ||
|---|---|---|
| A | Total Portfolio NAV | 1,047 |
| B | Total Principal Amount of Bonds | 504 |
| Liquidity Facility Loans Outstanding | 0 | |
| Capital Call Facility Loans Outstanding | 0 | |
| C | Payments to Reserves Accounts | 40 |
| B - C | Total Net Debt | 464 |
| (B - C) / A | LTV Ratio | 44.3% |
| Source: Azalea Investment Management | ||
5. High valuation and leverage levels suggest bleaker outlook for private markets
The past ten years have been a prosperous period for private equity investors, with the healthy global economy driving strong returns in private (and public) markets. As history teaches us, positive market environments often give rise to easy capital availability and dangerous market conditions. And we think there are multiple indicators in the private markets that signal a need for more caution today.
The strong historic performance of PE has attracted more and more capital inflows into this asset class. This trend is expected to continue this year, with market participants including Schroders5 and Hamilton Lane6 predicting that 2018 will be another record year for PE fund raising.
All this capital chasing deals, coupled with the conducive economic environment, have led to increased competition between PE managers and significantly higher asset prices. As shown in Figure 7, PE valuations are now at elevated levels. While we can’t predict how much longer this up-cycle can continue, we should be wary about the higher valuation risk.
Figure 7: Private equity valuation multiples
At the same time as PE managers are paying higher multiples for their acquisitions, the low interest rate environment has also allowed them to fund transactions with increasing levels of leverage. With ten years behind us since the global financial crisis (“GFC”), perhaps investors have forgotten how the excessive usage of debt can wreak havoc on financial markets. Leverage levels have trended higher and are now close to pre-GFC levels (see Figure 8).
Figure 8: US and European leverage multiples for buyouts
There are both positive and negative implications for Astrea IV bondholders from the market environment just described. On one hand, as mentioned above, Astrea IV’s portfolio comprises of mature funds that are past their capital deployment phase, so they are not competing with others in this heated environment. The youngest funds in the CFO’s portfolio commenced operations in 2014, so we think most of their investments were likely to be made during periods when valuations were more reasonable.
On the other hand, the steep valuations in private markets mean that prospective returns are lower and risks higher. Should prices come down whether due to negative developments in the environment (a recession in the US, for example) or just simply because investor psychology weakens, Astrea IV could suffer marked-to-market losses to its portfolio NAV, which in turn would lead to higher credit risk for bondholders.
Nonetheless, we note that the interest coverage ratios for leveraged buyouts have been rising. The private equity advisory firm Hamilton Lane said in its latest annual market overview report that the strong coverage ratios reflected the low financing costs, healthy cash flows, and economically strong companies being acquired.
Finally, when the Azalea Group launched Astrea IV, it commissioned Bella Research Group to analyze the transaction structure and simulate the future behavior of the Astrea IV portfolio under different performance scenarios. The simulations suggest that the probability of the CFO redeeming the Class B notes—which are subordinated to the Class A notes—by their maturity date is at least 98.8% even assuming weaker capital markets environment. The study by Bella shows that the Astrea IV transaction has sufficient margin of safety to withstand most adverse scenarios.
1 The first distribution period refers to the period from 1 Apr 18 to 14 Dec 18 (both dates inclusive). The information including portfolio performance, distributions, and NAV are based on the reference date of 30 Nov 18.
2 USD15m was set aside from the gross proceeds of the Astrea IV bond issuances for payment of fees and expenses incurred in connection with the issue and offering of the bonds. The residual balance after transaction and related fees and expenses was USD5m.
3 On each distribution reference date, the Manager may choose to retain an amount of up to USD5m for the purpose of funding capital calls, instead of such amount being available for payments.
4 USD40m will be paid in the case of the first to the fifth distribution date and USD39m will be paid in the case of the sixth to the tenth distribution date (which is also the scheduled call date for the Class A notes).
5 (2018, September 27). Market Overview 2018/2019. Hamilton Lane. Retrieved from https://www.hamiltonlane.com/what-were-thinking/MarketOverview/
6 Rode, Nils. (2017, December 8). Outlook 2018: Private equity. Schroders plc. Retrieved from https://www.schroders.com/en/us/institutional/insights/equities/outlook-2018-private-equity/
Declaration:
For specific disclosure, at the time of publication of this report, IFPL (via its connected and associated entities) holds a principal position in ASTLC 4.350% 14Jun2028 Corp (SGD) - Class A-1 - Retail. The analyst who produced this report holds a NIL position in the abovementioned securities.
