Hybrid Capital Investing

Mark Melchiorre: 

My pleasure. Thank you. 

Elana Margulies-Snyderman: 

Absolutely. So, to kick off the conversation, tell us a little about your firm, your background, and how you got to where you are today. 

Mark Melchiorre: 

Thank you. I'm the CIO of Forza Investment Group. We're a $1.5 billion alternative asset manager. I've spent about the last 28 years in my career in corporate credit across the capital structure and quality spectrum, mostly focused on leveraged finance, high-yield distressed with the DNA in that space. We generally focus on a liquid high-yield alternative strategy that we call the All Weather Alternative Credit Strategy. This is a strategy for everyone that basically focuses on the most liquid parts of the high-yield market, the BB and B space. It's a consistent steady strategy where we have long short credit, it's long bias, but it does have downside protection. The returns on that strategy are pretty special. It's very stable, generally has returned 16% annualized with about a 4.5 vol. So, to have those double-digit returns with that low vol, that's where we're pretty excited about it. It's not that levered, it's quite liquid and we think it's a great return profile that you can track back 40 years of those assets and how they perform which we find it to be a sweet spot, not only for high-yield but for all asset classes going forward. It's kind of like a nice little niche in the world from a risk-adjusted returns perspective. So, we're very excited about that strategy and we don't think that's a market timing strategy, we think that that's something that should be in everybody's portfolio, every type of investor, whether you're a hedge fund investor or an institutional investor. And we obviously think it's great for your traditional retail investor as well. So, that's our liquid approach to the market. Our Special Situations Fund is definitely less liquid, focused on public and private markets. It does corporate bonds, loans, hybrid instruments. Our DNA is pretty unique in that perspective because we have a capital solutions business where we can source our own deals, but we can also straddle public and private markets where we can also look at a deal flow that comes out of the public markets. It's also involved in the liquid public space, but we tend to focus on more event idiosyncratic stories that are most part are harder. And that's where we find, I think, our value add and what makes us different is that Forza is really well positioned, and all of our strategies are set up to take advantage of market volatility. That's typically when we do our best and our strategies are always set up to be in a good position to take advantage of market volatility. So that's when we can make good decisions and approach things from a relative value perspective when deals are best. When we do that, there's some key things, when you're investing in that second lien hybrid part of the market, which is typically more difficult, you have to understand how to work with first lien lenders, understand how to work with the sponsor, know how to structure things smartly, know what kind of covenants and details you have to have around it, and that's a key point for your downside protection. But then to structure a position that has convexity to the upside to where you can participate in significant upside, we find that to be an extraordinarily attractive part of the market. However, that fund is definitely more focused on events and outside returns. That's definitely a high double-digit strategy historically. It also has a protection to it, a tail protection to it, but we try to set up our tail protection and downside protection in a way that doesn't drag on performance. We're really conscious of that. We're really just trying to hedge unforeseen events and because of the way we set up the portfolio, it doesn't track. So, I think they're much very different strategies, but the approach is smart portfolio construction, just one strategy is more focused on liquidity, the other strategy is more focused on return. So, I think that that's kind of the ethos of the firm. But I think one thing, we sit in a unique position, which I actually think is very unique in that we sit in the ability to see public market flows just as much as people see private market flows in the private markets. So that's a unique characteristic to be able to straddle both markets in a fluid way where during COVID there were great opportunities in the public market then later in 2020 the private markets opened up, so you miss some of the best returns if you weren't in public markets early on. So, we think that's a really important part of Forza, I think that's what really differentiates us from many other firms. 

Elana Margulies-Snyderman:  

So, Mark, like you said, you specialize in second lien credit and hybrid capital. Why is this part of the market so important right now? 

Mark Melchiorre: 

I think there's $1.6 trillion in the private credit market with about $400 billion to invest. So, there's just been a tremendous amount of flow into what has been. We love private credit. It's been a phenomenal investment for the past eight years, when rates rose, so in a difficult world, there was very much outsized returns for people who can participate in that space and take advantage of the time. So, I think that was what was very compelling to people about being in the space and 100% accurate and definitely great risk-adjusted returns. Now, because of the success of the space, the spreads are now as tight as they've been to public loans, and that's not necessarily a bad thing. I think things are justifiably tight spread, but absolute yields are still quite high. So that is still an opportunity. However, it's very competitive and there is a need, especially in harder situations, for unsecured investors to step in second lien hybrid capital. And that's typically the more difficult capital to source to create, but more importantly, it's a place where there's not that many participants. It's growing rapidly because people are starting to see the value add. The difficult part in the space is you don't want to buy everything. You want to do quite a bit of work on credit selection, you want to structure things smartly, you need to price the risk accurately. But I think it's important to work with the first lien lenders and to work with the sponsors to make sure that you can position yourself to protect your downside but also give yourself more convexity to the upside than you would with bank debt and be aligned with the sponsor. We tend to be partnership capital, so I think the sponsors see us as value add as well as the companies, and that's what we do try to provide. We just don't make an investment and disappear; we usually take a very active role in the company going forward. So that's what I think makes us differentiated from potential other hybrid investors. And the key thing is getting that type of capital placed and finding investors in that space, you really need to know what you're doing. And I think we've shown over our years that we are getting things done when things are the hardest, and I think that's an ethos of our firm as well. I would say that equities have a pretty full valuation. Private equity has had a difficult time putting capital to work, but there's so much money there. And public credit is, again, justifiably tight spreads, but priced for perfection. You're really pretty much at the all-time tight on high credit spreads. So, it just happens to be that one place in the world. But again, you can't admit where we are in a cycle and how bullish things are so you got to be careful about the levels you're investing at. 

Elana Margulies-Snyderman: 

So, Mark, as a follow-up with private credit becoming so dominant and high-yield trading at tighter spreads, where do you see the future of this market evolving? 

Mark Melchiorre:  

I think the high-yield market is now about, I believe, close to 60%, 55%  BBs, and a lot of these BBs are almost investment grade like companies. One could actually argue that maybe they should even be drawing the line for investment grade at BB. So, one thing we love about our alternative AWAC strategy is it is a great place to invest, it's a great asset class. And so, I think that that's why you're seeing so much flow in investors in that market, corporates in that market. So, it's a great bucket to be involved in. However, spreads are quite tight, yields are maybe finding a level and you're not going to see outside return, but you're volatile. B credit is another sweet spot. I think you see a ton of capital in the BB and B space, and we have a strategy that reflects that. However, if you're trading poorly, if your yields are in a stressed place now, then there's probably something wrong and then navigating that space becomes increasingly more difficult. That is where private credit steps in. So, when you have middle markets and small cap markets that have a really difficult time accessing normal high-yield capital markets, the change in levels that you have to raise money at is significant, the covenants you have to give up are significant. But the thing that makes private credit great also is what makes it bad because if you have to charge people such high interest rates and such restrictive covenants, it only takes a small amount of stress for those loans not to be in a great position. When you're making somebody pay a high interest rate for a long time, maybe sometimes they can't afford it because they're probably in a difficult position to begin with. So that's why I think you got to be very careful and make sure when you're investing in private credit, you're investing with savvy fundamental credit investors who know how to structure their stuff correctly. A concern would be that so much money is floating into the space, that there's a lot of bull market investing going on and people are kind of what has happened, what can happen in those markets. The default rate has been low, so it's been a great investment. I personally think that there's just so much capital has flown into it and it's maybe a little too popular and patience is hard in a space like this. You certainly want to chase, everybody's making money, it's actually probably, I would say, easier to invest when the markets are firm like this because people have their heads about them and relative value works and catalysts come through because there's opportunities to have M&A, to have catalyst events occur that put a company into a better situation because things are healthy. But again, I think with the New World Order, there's plenty of potential for unforeseen market volatility. It's unclear as to whether, I personally think rates will settle within 4% or lower, but if inflation does continue and rates start going the other way and they start going back towards 5%, I think the market will have to recalibrate to that in a pretty big way. And you could see default rates in private credit rise because the floating rate asset class interest expense will go back up. So, I think that that's going to be an uncomfortable place for private credit and just credit in general. But again, the sponsors will really need to utilize that hybrid prof second lien space because that was what will extend their equity call option. They're willing to maybe give up that component of the enterprise value just to extend the life of the company. It also can be used as a tool to get first lien deals done. So sometimes a first lien investor just won't invest as much capital into the capital structure at certain leverage and attachment points. So that's when the preferred investor comes in and gets that deal done. And I think if you're in a difficult position in this market, you're going to need that if things get more difficult. And that's what will provide great opportunities for our hybrid prof second lien type investor. 

Elana Margulies-Snyderman: 

Mark, this has been a fascinating conversation. Where can people learn more about your firm? 

Mark Melchiorre: 

Forza Investment Group, and if you look around, you could probably find us. So, we have a website as well as just generally being on Bloomberg in the market section. 

Elana Margulies-Snyderman: 

Mark, I wanted to thank you so much for sharing your perspective with our listeners. 

Mark Melchiorre: 

Thank you for having me. 

Elana Margulies-Snyderman: 

And thank you for listening to the EisnerAmper podcast series. Visit eisneramper.com for more information on this and a host of other topics and join us for our next EisnerAmper podcast when we get down to business. 

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