AGM Statement

RNS Number : 8305V

T2 Income Fund Limited

17 July 2009

 



T2 Income Fund Limited ('T2I' or the 'Company')

AGM statement
17 July 2009

T2 Income Fund Limited (the 'Company') is holding its Annual General Meeting at 11.00am today. At the meeting, Geoff Miller, Chairman, will give the following statement:

This AGM statement is significantly longer than I would expect to make in future years. However, I wanted to take this first formal opportunity since becoming Chairman to elaborate on where the Company stands at present, what decisions have been taken since the changes in the Board and what steps have been taken to improve future disclosures and communication with the market, the investment management arrangements and other matters, and what further changes we expect to bring in coming months.

Current market conditions

The investment manager remains cautious on the short term outlook for the syndicated corporate loan market in which our Company invests and expects continued volatility. As this has an impact on the strategy to be taken within the investment portfolio, a fuller explanation is being released together with this AGM statement.

Investment portfolio

The Company's portfolio consists of corporate loans, almost all of which are held within the Company's collateralised loan obligation ('CLO') subsidiary, T2 Income Fund CLO 1 Ltd. ('T2 CLO').

Despite the extremely challenging market conditions in which the Company operates, the portfolio of loans held have continued to generate interest payments, with only one investment, among 69 companies in which T2 Income Fund has invested, defaulting on payments in the life of T2.  

It should be noted that the definition of a 'defaulted obligation' shown within the CLO covenant tests released monthly by the Company includes a range of factors in addition to actual payment defaults, explaining the apparent presence of delinquent loans within the portfolio when, in fact, none are currently held. Although the cash flow of the Collateralised Loan Obligation (CLO) structure within our Company's T2 Income Fund CLO I Ltd subsidiary, representing interest received by the CLO net of interest and other expenses, has remained healthy during the past year, our Company has not always received full distributions from the CLO over such period. The reason for this is that if certain collateral coverage tests are violated, some or all of the Company's income from the portfolio is retained within the CLO. This has only occurred in two quarters since the Company's inception. As at the end of 2Q 2009, the CLO met all of the covenant tests necessary for full interest payments to be made to the Company.

The majority of the loans held within the portfolio pay an element of their payments monthly, and so the Company would know very quickly were any of the loans held were becoming delinquent. The proportion of income received monthly and the proportion received quarterly will vary from time to time, but is currently roughly equal.

The Company has a relatively concentrated portfolio of 54 debt obligations held across a range of sectors. The vast bulk of the portfolio, 85% as at 30 June, is held in first lien senior secured debt. The loans offer a good spread over LIBOR because of their position in the middle market, have strong covenants that provide an early indication of financial distress which allows us time to restructure these loans to ensure that T2's interests can be protected, and are generally loans to companies that are modestly levered.

As at 30 June the weighted average leverage* of the companies within the portfolio through T2's debt was 3.6x, the median EBITDA* $82.9m, and the average spread 4.3% over LIBOR. Although the portfolio contains a variety of companies of differing shapes and sizes, these figures are fairly representative of what would be considered a core holding for the portfolio. The average spread* understates the true position, as this does not take into account LIBOR floors that some of the loans held have within their structures, which makes the effective spread at the current extremely low level of LIBOR higher.

In these difficult times the Company's investment manager continues to seek opportunities to acquire better quality assets at attractive prices, in order to drive the overall creditworthiness of the portfolio higher. Although there has been a deterioration in the overall weighted average rating factor over the past year, as certain companies have been downgraded, it should be noted that four out of the five most recent loan purchases by the Company have carried loan ratings of BB- or higher. Opportunities to buy these securities at a discount to their par value help not only improve the quality of the portfolio but will also improve the CLO's collateral test coverage, as this is measured against the par value of loans that are not in default, being restructured or are CCC rated or below.

New investments have been possible partly through sales but mainly as cash becomes continually available from amortisations and prepayments. Prepayments, which tend to be weighted to the first half of the calendar year as many are dependant on the audited Company accounts, totalled $21.0m in the first six months of 2009, whilst amortisations were $1.6m. This compares to $14.0m and $2.2m respectively in the first half of 2008.

Corporate Structure

Whilst the past year has been an extremely disappointing one for shareholders in the Company, it should be acknowledged that the Company has managed to survive events that have seen the end of many similar structures. If the CLO were not in place and the Company was geared with a bank loan, it is almost certain that the loan would have been called over the past year and shareholders would have lost all of their investment.

The CLO provides the Company with a very cheap source of funding, 75 basis points above LIBOR until 2019. A copy of the indenture, which sets out the way in which the CLO operates, is available for inspection at the Company's registered address. Within the loan structure there are $248.9m of notes outstanding that have been issued by the Company and this finances an investment portfolio as at 30 June comprising loans valued, for the purposes of the CLO covenant tests, at $272.5m and $29.5m cash.

Providing the various capital and income covenants are met within the CLO structure, it should provide a very attractive income stream and the potential for a return of capital to the Company at the end of its life. Over the past year it has not been possible for the CLO to meet all of its covenant tests all of the time, and thus a portion of the net cash flow of the CLO has remained trapped within the CLO and unavailable to our Company and its shareholders. However, it is important to note that the covenant tests that were breached only require that the CLO structure be brought back into compliance with the tests, rather than give the CLO noteholders any right to call the structure. It is this second possibility, an Event of Default, which would be an extremely negative outcome for ordinary shareholders.

For an Event of Default the value of the collateral within the CLO for the covenant test purposes would need to fall to the value of the AAA and AA notes outstanding. This would require a further $86.6m, or 29.6%, writedown of the value of the portfolio from June 2009 levels. To put this into context, it is worth noting that only 2 of 54 loans currently held within the portfolio are valued for the purposes of the covenant tests at 30% or more below their par values, and for any loan to be written down for the purposes of the covenant test generally requires the security to fall to a CCC rating, become a defaulted security and/or restructured security.

Although the pessimism regarding CLO structures has been one of the reasons behind the precipitous fall in the Company's equity value this year, the pessimism has created opportunities for the Company to buy some of the notes issued by the CLO and hold these outside of the CLO. Thus far the Company has purchased $1.1m of the AA notes and $3.0m of the BBB notes for an aggregate $0.9m. This has two significant effects; it reduces the Company's consolidated gearing level (held by third parties) and increases the income generated by the Company. At the prices at which these notes were purchased by the Company, the yield to maturity on the AA notes and the BBB notes is approximately 13% and 43%, respectively (assuming that the notes are redeemed in full in June 30, 2017). Negotiations continue with other noteholders, although at this stage it cannot be guaranteed that any further purchases will be possible.

Company

As at the end of the 2Q 2009 the CLO met all of the covenant tests necessary for a full interest payment to be made to the Company, and $2.4m has been received from the trustee. Having received a full payment for the first time (on July 15, 2009) since the third quarter of 2008, the Board will make an announcement of its intention with regard to its dividend policy before the end of August at the same time as the Board releases the net asset value as at the end of June.

The net asset value calculation is somewhat illusory as it combines theoretical prices at which the CLO notes could be repurchased with the theoretical price which the assets could currently fetch, but both are highly illiquid and the numbers should be treated with a great deal of caution. However, one thing that the substantial rise in recent quarters in the published net asset value calculation does show is the degree to which prices for CLO notes have fallen further than the loans within the portfolio. To the extent that this does present opportunities for the Company to buy back its own notes, this will be taken wherever possible, within the constraints of the cash available outside of the CLO.

It is also for cash conservation that the Board has currently taken the decision not to consider hedging its dollar exposure. Although this will be kept under review, the potentially negative short-term cashflow implications make the risk/reward balance unattractive at present.

Review of advisors and service providers

Since the change of Board members, the Company has begun a review of all of its advisors and service providers.

The most important of these is the investment manager. In very challenging market conditions the manager has kept the portfolio in far better shape than might have been expected. Despite the increased demands of managing the portfolio through difficult economic and market conditions, the manager is cognisant of the losses suffered by shareholders and has offered to discuss both a permanent reduction in the level of fee and a greater alignment of the fees to returns to shareholders. The details are currently being finalised and will be announced shortly. 

The Company has appointed new lawyers in London. Stephenson Harwood replace Freshfields and there may be other changes to other advisors announced in due course. 

One additional advisor to the Company is Financial Dynamics, who have been retained to advise the Board on how to better manage communication with the market and with shareholders. Although we are looking to keep costs under control, communication is a critical area in which the Company has not performed well in the past and it is essential that this is put right. Fees payable to Financial Dynamics will be results-oriented, to ensure that its 

interests are aligned with shareholders.

  Commitment to more timely and comprehensible disclosure and enhanced communication with investors

Many shareholders have expressed concern over the Company's disclosure. Although the amount of information available to the market has been significant, the content of the releases has varied and there has been little by way of explanation. The Company is now committed to more timely, more consistent and more comprehensible disclosure.

There will be four key releases in future:

- CLO disclosure. Disclosure of the CLO covenant tests for each month will be made in the third week of the following month. It will be accompanied by a brief summary of key portfolio statistics and a short narrative expanding on any significant movements in the statistics, or in the debt market. The format is being finalised, for the first release in August. In addition, all previous copies of the monthly covenant tests will be made available through the Company website. At the end of every quarter this release will include details of the interest payment received for the quarter.

- Quarterly net asset value. At the end of each quarter the net asset value calculation will in future be released by the end of the second month following the quarter end.

- Interim results. These we expect to release before the end of September, and will include an update on market conditions.

- Full year results. This year the results to 30 December were not released until June. In my view the process of preparation of the full year results must be streamlined and I have asked all service providers to work on accelerating their schedules next year. Our target is to have released the full year results for 2009 by the end of April 2010.

The Company will in future produce a presentation updating investors and analysts once a quarter, following the release of quarterly net value. These presentations will also be included on the Company's website.

Joining of the AIC

The Association of Investment Companies plays a valuable role within the UK investment company sector, and I believe that membership gives a strong signal of a company's desire to be within the mainstream of the UK investment company market, to broaden the reach of information flow about the Company and to ensure the business is being run to the sector's best practices. It is for these reasons that T2 has joined the AIC. There is no cost for membership in the first year, and so this has no short-term cashflow implications.

Conclusion

Whilst much of the attention over the past year has been on the negative aspects of the Company's structure and its equity performance, since joining the Board I have been struck by the strengths of the Company. It has a very cheap debt facility, the assets in which the Company is invested have shown their resilience over the past year and the manager has a good track record in managing those assets. My focus as Chairman is on getting the Company to a point where these strengths can be the major focus for shareholders' attention, rather than the weaknesses that have shown themselves over the past year.

My primary initial objectives are to improve transparency and communication, maintain disciplined cash flow management and position the Company so that it is able to take advantage of market opportunities in order to maximise long-term shareholder value.

In order achieve these goals, the next few months will be critical for our Company, but I believe that there are grounds for optimism that the challenges that will be faced can be overcome.

*'leverage' in this context is defined as principal value of debt through T2's investment level/EBITDA; debt/EBITDA and EBITDA for each company is based on each companies' own figures as of March 31, 2009. The average spread is calculated on the principal value of the notes held.

Current market conditions - investment manager's remarks

Over the past 18 months, the syndicated corporate loan market has seen both unprecedented price declines and unprecedented volatility. Although prices remain significantly depressed across most sectors and ratings categories, we have seen a recent upward move from the lowest price levels reached during the first quarter 2009. 

Despite substantial trading or indicative discounts from par values, and largely as a result of the recent increase in loan prices combined with broadly deteriorating macroeconomic fundamentals, our view is that certain larger-issuer broadly syndicated corporate loan prices do not at the moment adequately reflect the spreads necessary to compensate investors for the risks involved. 

We believe that concern over worsening fundamentals (lower GDP figures, increased unemployment rates and, inevitably, increased corporate loan default rates combined with lower recovery rates) into the latter part of 2009 will likely cause loan prices to retrace at least some portion of their upward move over the last 4 months. As such, our strategy includes the retention of a significant cash balance inside the CLO structure (that cash has grown with the large number of prepayments and cash sweeps we have seen over the past year). We expect to be in a position to add to the portfolio (which continues to be focused primarily on lower-leveraged first-lien middle market and special situations loans) during the second half of 2009 through the first half of 2010.

We note that the significant premium that has recently been placed on operational liquidity (the interest rates that commercial enterprises are willing or compelled to pay in order to secure debt financing) has been mirrored by much higher liquidity premiums in the secondary syndicated corporate loan market. More liquid loans issued by larger borrowers now trade at what we see as significantly larger premiums to less liquid middle-market loans. Additionally, we see the prospect for increased non-linearity in the pricing structure of loans across the ratings continuum. We see a number of factors, including the inability of certain types of investors to continue holding CCC-rated loans within structured finance vehicles (CLOs and related structures), combined with considerably more aggressive postures by the ratings agencies leading to opportunities somewhat above the CCC+ ratings level. Our intention is to seek to take advantage of that dynamic over the next 12-24 months as prices of those loans decline from current levels. 

From a macroeconomic perspective, we believe that the most traditionally reliable predictors of economic directionality have been made less relevant by the selective but extraordinary participation of the U.S. government across a range of industries. Various parts of the U.S. financial system can now be seen to be at least momentarily either directly or derivatively (counterparty-based) reliant on U.S. federal government support. The extent to which that support continues, and the forms it assumes going forward will likely have a greater influence on corporate loan pricing and issuer performance than it has historically.

Further, the interrelationships between U.S. macroeconomic strength or weakness, the more specific impacts on those various industry segments to which we are exposed, the relative strength or weakness of the U.S. dollar (an area of particular interest to us as a U.S. dollar-exposed but sterling-denominated and reporting Fund), LIBOR levels and volatility (to which we are exposed on the unlevered, equity-based portion of our portfolio), are becoming more complex and less predictable. As such, we continue to be committed to our general strategy of investing in lower-levered companies.

We have and continue to track a large number of loans and the performance of their various issuers with the expectation that we will likely be in a position to deploy our capital on better terms than we currently see available in the market. That said, we have recently made a number of selective purchases and continue to favor lower- leveraged companies where issuers stand to benefit from long-tailed revenue streams attached to lower-risk counterparties. We believe that, especially in the case of less liquid middle-market loans, supply and demand issues will likely continue to outweigh issuer operating fundamentals. In view of our current cash position, we regard that as a potentially beneficial dynamic.

For further information, please contact:

Geoffrey Miller

T2 Income Fund Limited

[phone]

Patrick Conroy
T2 Income Fund Limited
[phone]

Philip Secrett
Nominated Adviser, Grant Thornton UK LLP
[phone]

Michael Wentworth-Stanley

JP Morgan Cazenove

[phone]

Ed Gascoigne Pees

Financial Dynamics

[phone]

 

END

 

 

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