The First Eagle Credit Opportunities Fund (FECRX) takes an intensive, research-driven approach to income-oriented opportunities available across the alternative credit spectrum—including both private and public investments—in an effort to deliver current income while providing long-term risk-adjusted returns through a focus on senior-secured assets. Further, the Fund’s selective, flexible process enables it to take advantage of changes in credit markets over time by actively allocating to what the portfolio managers believe to be the most attractive risk-reward opportunities across the alternative credit space.
On August 11, I spoke with Andrew Park, the senior alternative strategies director at First Eagle, and Christian Champ, a co-portfolio manager of the fund and a managing director at First Eagle.
Last year, First Eagle launched its Credit Opportunities Fund. Tell me about the fund's objective and its approach. Why did you launch this fund now? What was the opportunity you saw?
Andrew Park: If we roll back the tape and think about why we created this fund, we launched this fund because we saw it as an opportunity for investors to extract an illiquidity premium from the private markets. But what's important about structuring a product around that access is creating a limited-liquidity structure in order to enable our portfolio managers to go into those illiquid investments and our end clients to draw down from them in an attempt to create attractive returns relative to traditional fixed income. If you look at the offering set for products, you have daily-redemption products, such as high yield bond ETFs or mutual funds, and senior-loan ETFs or mutual funds. They're all generally under-yielding. Advisors and clients have gotten blue in the face waiting for yields to normalize, and they're just not normalizing as of today.
Then the other side happened, where you saw large, institutional credit managers, like us, come out with products like private business development companies (BDCs)—which have super-limited liquidity structures, significant amounts of leverage, and generally more attractive target returns—to balance out the equation. Investors could historically get 4% in high yield daily redemption or 8% in illiquid private credit. A yield of 6% is three-times target inflation, which is what everybody's trying to solve for.
We decided to take a simpler approach. We wanted to take the core competencies of our platform, which is direct lending and opportunistic credit within the bank-loan space. We can blend those together in an interval-fund structure that, from our perspective, takes a more balanced approach to extracting an illiquidity premium while better managing the illiquidity risk that's associated with that.
We believe that the timing of this fund’s launch was fortuitous. In some ways, we intentionally waited. We started talking about this fund in January of last year, and we waited to seed this fund because of the disruption in March and then the reopening of our markets in September. Ramping this up in September was an attractive opportunity for us to create what we believe are good, strong foundational investments in the portfolio that should be beneficial to our investors for the long run.
This sounds like an attractive fund for advisors and their clients who are looking for yield. Where are you finding those opportunities?
Christian Champ: On both sides of the house, we're finding a lot of opportunities. On the private-credit side, with the COVID disruption, that market backed up. You had several months when you didn't see deals price, which led to a nice backlog of deals to put into the fund with 5- to 7-year maturities, which builds a really strong foundation. From a timing perspective, as Andrew talked about, we viewed it as a perfect time on the private-credit side. That private credit opportunity set has only expanded into this year. There's been over $2 trillion raised in private equity. We think that bucket that we play in is about $100 billion to $300 billion. There seems to be significant dry powder on the private-equity side.
All the deals we do are with private-equity sponsors. We're looking for 30% to 50% loan-to-value on those transactions. In our view, it's a perfect opportunity to find the right private-equity partner for the deal that works for us, given that there's so much capital that's going into this space.
On the opportunistic-credit side, there is a very similar dynamic to what we've seen in private credit, with the reopening and the COVID opportunity. The initial investments that we've put into the fund, all of which were post-COVID lockdown are helping us make investments at the top of the capital structure for what we believe are very attractive businesses.
How is the market for private-equity-sponsored loans structured and which segment of that market do you target?
Christian Champ: Really since 2009, the private credit markets have evolved quite dramatically. What started as a market with a few players scrambling to fill the funding void in the middle market while traditional banks stepped away has grown into a very large and foundational part of the corporate debt ecosystem. Today, we see a bit of a stratification of the direct lending markets. You have large cap lenders who may define their lending opportunity to be somewhere around $5 million to $150 million in EBITDA all the way down to microcap lenders where you may classify peer-to-peer lending platforms like Prosper. At First Eagle, we focus on the lower-middle market and define our lending opportunities to companies that generate somewhere between $5 million to $25 million in EBITDA. It is a more specialized market, but one where we believe we can potentially achieve attractive returns and leverage our long-standing presence in that segment to create strong deal flow.
Given the inflation and interest-rate environment, how is the fund positioned to identify risks and opportunities in your view? How do you think it will perform in high- and low-inflation regimes?
Christian Champ: We're a deep-value credit shop. That means we do deep-credit work. We start with a bottom-up analysis of each individual investment. We deduce whether the business generates free cash flow across the cycle. For any investment that we're putting into the portfolio, we're making sure that it's going to meet the goal of generating free cash flow.
We also have an industry overlay that we put on top of our credit analysis. If you look at where funds have underperformed or where we've seen issues with individual portfolios, it's usually industry selection. That’s where defaults show up on the Moody’s side when there's a particular industry, be it telecom, energy, retail, or restaurants, where you see a preponderance of the defaults.
We have an industry overlay, and we're currently focused on technology businesses—particularly businesses that follow a software-as-a-service (SAAS) model. We like health care services, typically rejecting companies that have Medicare/Medicaid risk and focusing instead on sectors like dental or dermatology practices. We are also currently positive on business services, including sectors such as plumbing, maintenance and repair. Whether it's the private-credit or the opportunistic-credit bucket, we're looking for businesses that we believe have good margins and pricing power in any environment. If we see inflation, they're able to pass the costs along. If we see deflation, they still have pricing power and there's less expected customer turnover. It comes back to underwriting businesses across the business cycle that are going to generate that free cash flow.
First Eagle is known as a global value investor, and indeed, one of the premier global value investors. How does this fund fit into that family?
Andrew Park: I think it's even more than value. It's focusing on the avoidance of the permanent impairment of capital, and that’s why First Eagle’s equity strategies have generally outperformed across multiple market cycles over a very long period of time. We looked to those two philosophical pillars to build this fund.
In terms of First Eagle’s product lineup, we fill a specific niche in that we’re a pure income-oriented strategy targeting higher-yielding opportunities. If you think about a client's investment cycle, you're looking at three phases: accumulation, transition and decumulation. Decumulation is the stage where clients strive to generate consistent current income that enables them to maintain their standard of living while avoiding drawing down on principal. This is the client need Credit Opportunities seeks to meet, and we do so by focusing on the downside, looking to hit singles and doubles rather than swinging for home runs. This is the biggest alignment of interest between our legacy philosophy and the philosophy of First Eagle.
You've chosen to structure this as a closed-end interval fund. How is that structure going to operate and why did you choose that structure?
Andrew Park: From a structural perspective, our fund is an interval fund that will provide daily purchase opportunities at NAV, monthly distributions with the option to reinvest those distributions back into the fund, and quarterly redemptions at a minimum of 5% of total shares outstanding, at a minimum of 20% over the course of a calendar year. The point of this structure is to allow us to go into the illiquid markets and to have a much clearer picture of how we're expected to manage liquidity in the fund for our investors, and frankly, not be beholden to forced selling, which you see so often in the daily-redemption space.
We want to help maintain investors’ staying power while providing them a strategy that is structured with the potential to perform across the cycle by investing in less liquid and illiquid markets, and also avoid the indiscriminate selling that you might run into on the daily-redemption side.
The idea of the 60/40 portfolio has turned into a conversation on how to get creative in the 40% that is fixed income, which has been very difficult. You either have significantly greater risk in the illiquid product offerings or pedestrian, vanilla, under-yielding daily-redemption strategies.
By allowing ourselves to invest in those private-credit, direct-lending assets, we’re attempting to create those attractive returns for clients, all while still maintaining senior-secured status in the capital structure to help mitigate some of the risks on the downside.
What distinguishes this fund from other similar, alternative-credit funds?
Andrew Park: I'm going to make generalizations here for the benefit of the conversation. If you look at the interval-fund space, which is where the vast majority of alternative-credit strategies are being provided to individual investors, you can pretty much bucket them in two categories. The first category is public-market strategies, buying everything that you can access in other types of vehicles with the added yield boost given the ability to include leverage in the interval-fund structure. Your other bucket looks similar to ours. It has a mix of private credit and opportunistic credit, but a big differentiator there is going to be structured-credit exposure.
Where we're seeing most of the structured-credit exposure in these funds is through collateralized loan obligation (CLO) equity and debt investments, which can be significantly more volatile. They are subordinated investments in bank-loan portfolios that can be levered as much as 10x. From our perspective, it is significantly greater risk than an individual investor needs to take, even at a 10% or 15% weighting of an overall portfolio, relative to the returns that we're finding on a pure, direct basis through our private- and opportunistic-credit buckets.
That's the biggest way we're differentiating. We're attempting to create very attractive returns without having to take any additional risk in structured credit investments.
How does it differ from a traditional, high yield or bank loan fund?
Christian Champ: From a high yield perspective, we're predominantly floating rate. If rates go up, we capture that because it's LIBOR-based. As rates decrease, we have LIBOR floors on the portfolio. We don't expect to see any degradation in our yields. Most high yield bond funds tend to be in the more liquid names. We've seen more money flow into that sector of the market. We see spreads substantially tighter than where our product trades, from where we're putting money to work. We're capturing that illiquidity premium that doesn't exist in the high yield market.
We're senior secured, whereas high yield is predominately unsecured. In general, we're at the top of the capital structure and high-yield bonds are subordinate to us. We're capturing excess spread. On the traditional bank-loan offering, which is on the more liquid side, you have that same dynamic where spreads are tighter, and we're just outside of that. Whether we're on the private-credit or opportunistic side, we're capturing that illiquidity premium that doesn't exist in the traditional, bank-loan side. We've seen more money come into the bank-loan space, and that market has just continued to tighten.
Where does alternative credit fit into an investor's portfolio? Is it a substitute for traditional fixed income? Where are advisors taking the allocation from when they add this to their portfolio?
Andrew Park: One of the intentions of our fund is to be a foundational alternative-income solution. That's the ultimate goal because of what we talked about earlier: pedestrian, subpar returns on the daily-redemption side relative to the less liquid side of the spectrum. It's not a pure substitute for traditional core fixed income exposures—Treasury, AGG, and investment grade—but rather an alternative to preferred securities, high yield municipal bonds, and below-investment-grade credit through the high yield bond market. In this context, it changes the conversation to one about credit risk versus interest rate risk or duration.
If you think about high yield, you're potentially earning sub-4% with a four-and-a-half-year duration. If you're going into high yield municipal bonds, you've got maybe 4.5% or 5%, depending on the type of project you're lending to, with five to five-and-a-half years of duration. Our portfolio, which resets every 30 to 90 days and has an effective duration of less than half a year, we can take that credit versus duration out of the equation and just focus on credit. If you're focusing on just credit risk, this is a great substitute that we're seeing advisors implement as preferreds are rolling off, as they're seeing the spreads tighten and prices increase in the high yield bond space.
We've watched the growth rally continue. Everyone talks about historically high valuations in the equity markets, and we're starting to see advisors take money off the table from that perspective and into our strategy.
The most interesting thing is that we're seeing a lot of advisors who have never allocated to alternatives, allocating to our strategy. They told us that they have found it to be easy to understand and, therefore, easy to explain to their clients. So many of the options they're investing in allocate to two or three different countries with 12 to 14 different asset classes. You can't explain it, other than maybe mentioning the brand name and hoping that that recognition helps the client get over the hurdle of not understanding what's going on.
This easy-to-explain solution has shown to be a very strong entry point for advisors to allocate, to get their clients to look forward and get more comfortable with the idea of alternatives.
This is a relatively flexible alternative credit strategy. That said, there are places and securities where you won't invest. What are those? And why?
Christian Champ: It's a middle of the fairway, alternative US credit product. We're not doing anything outside of the US. We're not taking any forex risks. We're not doing any structured credit, so there's no CLO equity or CLO debt, which also are substantially more volatile, especially in a downturn. We've attempted to take out that volatility.
The First Eagle Credit Opportunities Fund (FECRX) takes an intensive, research-driven approach to income-oriented opportunities available across the alternative credit spectrum—including both private and public investments—in an effort to deliver current income while providing long-term risk-adjusted returns through a focus on senior-secured assets. Further, the Fund’s selective, flexible process enables it to take advantage of changes in credit markets over time by actively allocating to what the portfolio managers believe to be the most attractive risk-reward opportunities across the alternative credit space.
