This content is from: Home

THE BUY SIDE - Did Anyone Say More Leverage?

Amid a credit shakeout, Lehman makes a bold bet on CLOs.

What do you do when markets wobble and the subprime mortgage contagion starts to spread to leveraged loans? If you're Lehman Brothers Asset Management, you jump into the market headfirst. In a bold, contrarian move last month, Lehman bought Lightpoint Capital Management, an aggressive young Chicago-based manager of collateralized loan obligations that has grown to $3.2 billion in assets since veterans of ABN Amro Bank, First Chicago Corp. and GE Capital founded it in 2002 and closed their first CLO in February 2004. Terms of the deal with Lehman were not disclosed.

Like most CLO managers, Lightpoint, which is now part of Lehman, makes money on the arbitrage between the junk-grade bank loans it buys and the investment-grade bonds it sells. The company has put together eight CLOs using offshore companies registered in the Cayman Islands and other tax havens. They are backed by about 350 senior secured bank loans to companies that are distressed or involved in buyouts. The spread between the LIBOR-based interest rates on the underlying loans and the interest Lightpoint pays holders of the rated bonds averages about 200 basis points. Lightpoint and Lehman declined to disclose profits or revenues.

Lehman regards Lightpoint as a good risk not only among leveraged loan managers but among corporate credit managers in general. Because most of the loans backing its CLOs are senior secured, Lightpoint is first in line should creditors declare bankruptcy. It has seen only two defaults in three and a half years and has recovered an average of 96 cents on the dollar, according to lead portfolio manager Timothy Van Kirk. The loans are scattered across a raft of unrelated industries, from energy to health care to gaming; none is linked to the subprime mortgage market.

About 95 percent of Lightpoint's bonds are investment grade, with some 75 percent rated triple-A. Executives take pride in the strength of their technology platform, which provides investors with in-depth data about the underlying loans -- a capability that Thomas Kramer, who was CEO of Lightpoint and now heads Lehman's leveraged-loan team, says distinguishes the business from other CLO managers.

"If you look at the grand scheme of investing activities out there, Lightpoint is on the low-risk end of the spectrum," says Bradley Tank, managing director and global head of fixed-income asset management at Lehman in New York, who drove the deal.

Lehman bought Lightpoint to diversify its fixed-income business, which enjoyed solid growth and strong performance last year. The firm's fixed-income assets under management, including preferred shares, grew 11.4 percent in 2006, to $60.1 billion, partly as a result of plan sponsors' hiking their allocations to more closely match assets and liabilities in response to changes in pension accounting rules. Lehman's total assets grew 27 percent last year, to $228.8 billion; they were up an additional 15 percent, to $263 billion, as of May 31.

"We weren't motivated specifically to enter the CLO market," says Tank. "We were looking for expertise in bank loan investing as a larger long-term opportunity. We have limited capability to manage bank loans, and it would take a long time to build it from scratch."

Lehman also wants to globalize its fixed-income business. Lightpoint opened an office in London last year that manages about $500 million in European assets, and the company now has 27 employees on both sides of the Atlantic. "We are starting to see tradable bank loans sweep through Europe and ultimately Asia, becoming a global market pretty quickly," says Tank.

In addition to new talent, Lehman is acquiring a stake in a resilient asset class at a time when clouds are gathering on the horizon. As inflation rises, the U.S. Federal Reserve faces pressure to raise rates. "The loan market is an excellent defensive asset class," says Steven Miller, managing director of Standard & Poor's Leveraged Commentary and Data service, which studies bank loans. "They have the worst relative returns when the market has its best years, but the best relative performance when the market is in its worst years."

Yet Lehman is acquiring Lightpoint's risk as well as its talent. During the first half of this year, demand for debt was so feverish that many borrowers were able to issue bonds without performance-related covenants, which offer protection for investors. Some 32 percent of loans issued during the first half were so-called covenant-lite. Tank says the vast majority of Lightpoint's underlying loans are secured by covenants.

"Investors have been relying too heavily on recent history. The relaxation of loan terms at this point in the cycle is a development the market will probably regret," says Anthony Thompson, head of collateralized debt obligation and asset-backed securities research at Deutsche Bank in New York.

Many market participants may already be having regrets after the credit market shakeout last month. In mid-July credit rating agencies said they were considering more-stringent requirements for covenant-lite loans and warned that they were prepared to downgrade hundreds of CDOs that were exposed to subprime mortgages. On July 10, one day before the Lightpoint acquisition, shares of Lehman fell 3.3 percent in intraday trading, to $72.41, on concerns that the ®≠rm's big fixed-income business left it vulnerable to the setback in credit markets.

Kramer says investors are already pricing in the risk of problems in the loans underlying CLOs, but he sees that as an opportunity. Yields on the loans that Lightpoint invests in dropped by about 50 basis points earlier this year, when the loan market was awash in liquidity. Now it stands to earn higher rates when it refinances loans in existing CLOs, but the fixed rates Lightpoint pays on its bonds are unchanged. Referring to the recent rise in rates, Kramer adds, "We are going to be capturing a lot of that back."


NAME: Bradley Tank

POSITION: Lehman Brothers Asset Management, global head of fixed income


WHAT WE KNOW: Tank drove Lehman's acquisition of CLO manager Lightpoint despite jitters in the loan market.