Chenavari Toro Income Fund Limited (TORO.L) Earnings Call Transcript & Summary

Ladies and gentlemen, I have the pleasure to welcome you to the quarterly update of the Chenavari Toro Income Fund. And I'd like to invite you to open the supporting slides, which are available on the company's website chenavaritoroincomefund.com, in the report section. And the agenda for today's call is to provide an update on the strategy and prospective returns to shareholders. Now before we start, I will read the usual compliance statement. Certain statements made during this conference call may be forward-looking statements, projections and are therefore subject to a variety of risks and uncertainties that could cause the company's actual results to differ from its expectations, estimates, and projections. Consequently, you should not rely on these forward-looking statements as predictions of future events cannot be relied upon when making investment decisions. Statements made during this conference call are made as of the 30th of December, and the company undertakes no obligation to update or revise any forward-looking statements, whether as a result of new information, future events or otherwise. Now before we proceed, I'd like to remind everyone that you can ask questions within the control panel available and by typing your questions, which will be answered by Fred towards the end of the call. And I will now hand over to Fred who will give us an update on the performance of the Chenavari Toro Income Fund in the fourth quarter.

Thank you very much, [ Guy ], and thanks, everyone, for attending the call. I hope everybody is fine and I'm glad to be with you for this quarterly update of the Chenavari Toro Income Fund. As we mentioned, the purpose of the presentation is to update shareholders on the performance of the company in the fourth quarter as well as its strategy and outlook for the foreseeable future. I've started the presentation with 2 slides on -- with an update on Chenavari, so existing and prospective shareholders can know where we stand and remind everybody of our meaningful experience and excellent track record investing in ABS and CLO as well as managing CLO, in particular, Slide 3, I can show you, we manage around $2.5 billion in CLOs and weighted average return on CLO equity has been 14.6%. And then regarding ABS and CLO, we've traded close to $5 billion of ABS and CLO since inception and with an aggregated IRR around 19.6%. Coming back to the company, in particular, which we think the Chenavari Toro Income Fund is an excellent vehicle to capitalize on that experience and track record. So if you remember, as we can see on Slide 4, we've defined 3 key pillars for the fund, a clear investment strategy, attractive return targets, and maximizing shareholder value. And so I will try to update shareholders on each of these points during the call. So the investment strategy, first, it's to invest in European asset-backed securities across the capital structure. And you can see in Slide 5, an update on our allocation per different strategy. So we have 57.9% in direct origination, 38.6% in public ABS and CLO, and 3.5% in cash. Within the direct origination book, we have Taurus representing 48.1% of NAV and SpRED 9.1%, and Shamrock 0.7%. So from the allocation number, we can see that direct origination is still our main and largest investment strategy and mainly thanks to Taurus. However, as you can see also during the first -- fourth quarter of '23 and throughout the year, we've reduced the exposure to SpRED. And at the same time, we've been increasing our exposure to public ABS and CLOs. So the idea going forward is still to invest further in ABS and CLOs and in Taurus and progressively existing the exposure in SpRED.

And could you comment on the performance this quarter and the attribution across the various strategies?

Sure. Well, if you go to Slide 6, you can see that the fourth quarter performance of the company is 3.47% gross, and that can be split between the 2 main allocation; public ABS and CLO, and direct origination, 2.38% on the direct origination front, and 1.09% on the public ABS and CLO. If we move to the next quarter -- the next slide, sorry, you can see that the positive performance this quarter brings the last 12 months' net performance to 12.3%, and that's above our annualized NAV return target of 10%. And in the meantime, we've continued to deliver on the dividend policy of 2.5% of NAV per quarter, which is currently a last 12-month dividend yield on the share price of 14.3%. Slide 8 digs a bit further into that dividend and the shows on the chart on the left, the stability of the dividend for the last 3 years. And also, if you look at the slide on the right, the amount -- the magnitude of the cumulative distribution we've done since the IPO. Slide 9 regarding performance, shows you that the company either on the NAV or on the share price, have outperformed both crossover and Europe and high yield and both since inception and for the last 3 years, if we want to just look at the kind of a post-COVID environment. On Slide 10, we give you a summary of the prospective gross return by strategy in accordance to base case assumption. And so you can see that the invested part of the book has a prospective IRR of 10.8%. And then that if we adjust that to the share price, we get 15.1% given the current discount to NAV. So this shows that under our base case, we are on track to continue to deliver on the second pillar of attractive return targets. If we dig a bit further on Taurus, we get a prospective IRR of 10.9%. And then on public ABS and CLO, we have a prospective IRR of 11% under, and, again, our base case assumption.

Thank you very much, Fred, and precisely on Taurus, could you share more details on Taurus performance in the fourth quarter?

Yes, of course. So the Taurus risk retention strategies in the fourth quarter paid a combined total of $4.1 million, which on an annualized basis represent a return of 26% over the market value of the position. In Slide 11, you can see a good summary of the horizontal and vertical retention held in Taurus and their different metrics. The equity NAV, the portfolio NAV, and then the percentage of loans that are all CCC, the WARF, the Junior Test and the Most Junior Cushion, I mean, all the kind of data we look at when we manage the portfolio, and that's -- we think this internal information is quite interesting and good to share with the investor. And here, you can also see some of the CLO we've done horizontal retention and other we've done vertical. So we're also giving that information. If you go to the performance of the underlying loan, as you can see from that slide and the next, on Slide 12, you can see that the loan has recovered further this quarter. And so the portfolio NAV in Taurus has gone up to 96% in the third quarter and you can see it's pretty much in line with the investment universe. The fourth quarter was relatively benign in terms of idiosyncratic risk with limited downgrades and defaults. And so against that backdrop, we could see in primary European leverage loan tighter around 25 basis points, around 425 basis point margin with a smaller ID for newly issued loans versus 450 in the third quarter. On Slide 13, we provided you with our outlook for leveraged loan in 2024. And I think in summary, we can say that after a weak M&A in 2023, most of the activity has been focused on amend and extend. And so we expect the continuation of that amend and extend trend in 2024. We expect some recovery in M&A, given capital markets are a bit more active now and more people are confident that we will avoid the recession and more have kind of a soft lending scenario. So the M&A should bring some new issue on the loan side. And so the combination of this A&E and new issue should keep the spread of leveraged loan in check between E+375 and E+450 for the better quality of borrowers. As we mentioned in previous quarters, and we still believe that the next 12 to 24 months will present a bit of deterioration in the credit quality, right? And so some rating downgrade and also stabilization of the default rate around the 3.5% that we've witnessed at the end of 2023, which if you remember, the historical default rate is around 2%. So that 3.5% is above historical. It's not that high. We've seen 8%, 9%, 10% in the GFC and in 2002, so -- but it's still higher than historical. So with that in mind, our focus to continue to be to a strong focus on the risk management of the loan portfolio and especially trying to avoid those weaker credits in the C- and CCC area. And so you can see from Slide 14, the WARF. The WARF represents the average credit quality of the loan portfolio and so the lower the WARF, the better quality and the higher the WARF, the worst quality. And so in that chart, you can see the gray line is the universe and the orange line is Taurus, all portfolio of leveraged loans through the different CLOs. And you can see how we've outperformed for the last 2 years, and this is clearly something we keep on focusing on. And in this way, in a way, the main risk for the strategy is an increase in the default risk, and that's why we're taking this action to try to minimize that risk. On Slide 15, we provide you an update on the Most Junior Cushion. And you can see that while a bit lower than previous quarter, they're still healthy between 3% and 4.5% for most of the CLOs apart from TCLO 4, which is at 9.3% because it's in the deleveraging mode. So data is less relevant, but for the other one, between 3% and 4.5%, show that we should be able to continue to have a high distribution of cash flows in the coming quarters.

Thank you, Fred. Thank you very much. Now turning on to the public ABS/CLO strategy. Could you provide us an update on that front as well, please?

Of course. So the performance of the public ABS/CLO book was plus 1.09% in the fourth quarter. CLO spread have tightened during the quarter, as we can see from Slide 16, with AAA 15 basis points tighter at 160 basis points, a BBB 60 tighter at 450 basis points and BB 75 basis points tighter at 775. Despite the tightening, we think overall, on a long-term basis, CLO spread and especially the yield given the increase in interest rates are still a medium-term attractive. On the other hand, as we can see from Slide 17, the equity arbitrage has been improving. And so we think it should allow us to bring a new TCLO 9 in the coming quarter. Slide 18 gives you an updated expected return on the simple base and stress scenario for both Taurus and public ABS and CLO. So maybe I start with the assumption. So for our base case, given what we did, we mentioned before on our outlook for leverage loan in 2024. We've decided to have a peak default rate at 4%, so slightly above the current one of 3.5%. That's our base case, and our stress case has this default rate going up to 8%. And then the simple assumption is like market standard where people use a 2% default rate. So from this chart, you can see that under our base case, as we mentioned before, actually, Taurus has a 10.9% expected IRR and public ABS/CLO has 11% expected IRR. And so under the stress, the return drop, but are still above 0, right? So 2.6% for Taurus and 6.6% for the public ABS/CLO. And then on the simple, we can see how the return jumped to 17.7% for Taurus and 13% for the public ABS and CLO. So we can see that the base case, downside case, and upside case basically. On Slide 19, we have a chart. So this chart, if you remember, is trying to show you how resilient our investments are, so the previous one is about what return we can expect and then this one is about how can we protect capital how resilient are we to an increase in the default rate or to a decrease in the recoveries, i.e., an increase in the loss severity, right? So here, you have the loss severity and the CDR. And so you can see that the different lines represent the different credit rating, right, from AAA down to equity. And so both public ABS and Taurus are sitting between equity and B, which is another demonstration that often offers CLO equity-like return with better than generic CLO equity risk. The following slide gives you an update on our ESG investment process. You remember that the journey we started a number of years ago and trying to improve every quarter. And for now, we're still in the process of building this internal software application, and this is a way for the manager to be -- to manage more efficiently their portfolio using ESG criteria.

That was a clear and detailed review. And maybe could you add a brief update on the SpRED, which is a Spanish real estate development project?

Sure. So SpRED is now below 10% of NAV, it's 9.1%. As of the 31st of December 2023, we have now sold 81% of the units. The -- that's a good part. The less good part is the fact that the selling process is much slower than we would like. So for example, in the fourth quarter, we only sold 1 flat and 3 parking space, and we have 45 flats and 76 parking space left to sell. So the sales activities on the disappointing part, the sales activity remains sluggish. And we think it's mainly linked to the affordability of Spanish household, especially given the cost of mortgages. And one of the data we note, so all the projects here are in Catalunya, some in Barcelona, some in Gerona. And so we've seen that in 2023, there was 27.2% less mortgage granted in Catalunya versus 2022. So it's an indicator of the activities quite slow in that front. So given that slow process, we're trying to improve our cash flow either by selling one of the development in bulk? Or also, we could rent some of the property and getting some attractive bank financing given we have no leverage. I remember you, we have no leverage on those exposure. So that's what makes us comfortable that it should not impact overall to dramatically the return of the fund. If you have 9.1% on real estate, even if real estate in Spain drops by 20%, which we don't think is going to happen, but even if we would do, we would lose 1.8% at the fund level. So the exposure is going down with not leverage. The only thing it's a bit slow to sell. In order to accelerate the selling process, one of the good aspects we think during the quarter was one of the projects, Gerona - Belmirall was granted the touristic rental license. So this will give more liquidity to that project. So that's a good news. And also, there has not been a materiality of sales yet, but given that rates seems to have stabilized and actually starting to go down in Q4, there is more and more visits of the flat. So we expect that this year should see an acceleration of the same pace. So our aim is still to finalize the overall sale process of slot in the next 12 to 24 months, as we can see from Slide 22, with an expected IRR of 5% on the transaction, assuming an exit of the remaining units within the next 12 months at a level 10% below our current target sales price. So after successfully exiting private asset-backed finance in '22, we continue to want to exit SpRED, and that remains a key priority for us for the next 12 to 24 months.

Thank you, Fred. That was useful. And now maybe a word on the third key pillar of this company, maximizing shareholder value.

Sure. So to maximize shareholder value, we need to deliver on the NAV. We need to pay the enhanced dividend. And then the last part, we're investing in a share. There is a NAV that moves, but the share may not move the same way at the NAV. So in that respect, 2023 was a bit disappointing, given the discount to NAV started to increase at the first -- during the first 2 quarters and it stabilized in Q3. The good news is started to reduce in Q4. So that's a good news. I think we explained in the last quarterly call that some of the increase in the discount to NAV in 2023, we believe was kind of a generic across the investment trust market, and that's why we've provided some data here in Slide 23. And to be sincere, I think the recovery initially in the fourth quarter was also linked to that. So we saw discount going down in the overall trust market and Toro was also a discount going down. That being said, we're seeing some good demand for the product at the beginning of January. The discount is reaching 27% in January. And so hopefully, when we have the call next quarter, the discount would be lower than that. For us, the discount still seems to elevated, and so we are monitoring if there is any action we can do. But for the time being, we sold that continuously paying the 2.5% dividend, deliver on the NAV. And having Guy and his team reaching investors, showing the product, its quality of the return, the quality of the downside protection is for now the best thing we think we can do to see the discount reduce over time.

Very good. Thank you so much. Now I think, Fred, thank you very much for this presentation. So maybe we can move to our Q&A session unless you have anything to add on top of this.

Sure. It's fine. We can move to the Q&A.

Okay. Very good.

So I want to quickly remind investors, they can use the button on the control panel to type questions. And I will now read the first question. So S&P announced an 80% increase in default globally. How is this likely to impact your CLO portfolio -- portfolios?

Okay. Yes. So I mean, in Slide 13, we mentioned that the European leveraged loan default rate increased to 3.5%, right? So if we think that the previous year was just below 2% from 2% to 3.5% is actually an increase of 80%. So sometimes 80% speaks big number, but we have to see you for more, we're starting. So -- but anyway, we mentioned we expect that this higher than historical level of default should prevail again in 2024. And as we mentioned before, we're managing the portfolio conservatively as we can see from the evolution of our WARF. And so to try to basically have a better default rate than that 3.5% that it is a market, which we have achieved so far. And lastly, what we do is like we stress test our portfolio once we are long those loans. And what we've mentioned before, we can still produce a double-digit return with a 4% annualized default rate. So that's a different way we are kind of protecting the portfolio to an increase of the default rate.

Thank you. I'll proceed to read another question for you, Fred. Given the breakeven lines you're presenting for CLOs and given that the BBB seems almost bulletproof versus equity tranches, which will be more vulnerable to increase in defaults. Are you better off -- sorry, aren't you better off just buying BBBs in your portfolios and leveraging those BBBs 4x, 5x. Maybe we can pull the corresponding slide, which I think is Slide 19.

Sure. Do we have Slide 19. Yes. Okay. Thank you. Well, I mean you can see in Slide 19, you have the breakeven default rate for BBB and you can see that it's materially higher than our exposure, right? So -- and the reality, right? The higher you go in the investment and the better protection you have on default. So on the chart, the gray lines between the dark gray and the light grays, let's say, medium gray line is a BBB capacity to result default. To be honest, if you leverage the BBB 4, 5x, you're going to create a strong sensitivity of the return to the passive credit spreads. And that's why, for example, in 2022, people that were buying BBB and being levered were severely down, right, because the spread widened and so the price of the drum dropped, and people were down 15%, 20%, right. So and the credit spread on BBB, I think they reached 550 basis points, right, at the end of -- around Q3 '22 -- Q3 '23. And -- so in 2023, you saw the recovery of this credit spread tightening back to 450 basis points that I mentioned, right? So it was kind of the recovery of that product, right? So basically, people lost money in '22 and make it back in '23. So yes, probably at the beginning of '23, buying BBB levered was the right strategy to do. Now where we are today, BBB is actually trading at the end of '24 was -- of '23 was 450, but now is more 350, 400. It kept on tightening during the month of January. So at the current level, we think the upside downside of buying this portfolio and leveraging them, it's probably balanced and so we wouldn't want to do that because you get the potentiality of losing 20% of spread widen again. So yes, I think we look at credit losses. We try to find a portfolio that is less sensitive to the past of credit spread and that we try to protect from default through or loan selection of portfolio, and that produced double-digit return. That's the thing we try to do with Toro. And last thing I should mention, in the total product, we basically -- our view is to buy a portfolio of loans and leverage them through the CLO market, which is term leverage. It means like we are not affected by the mark-to-market and we're just sensitive to default, right? So if we can avoid the default, then we're not sensitive to mark-to-market and we should produce those double-digit return. But worth mentioning, the product has a 1.3 leverage limit outside of the structural leverage that you get from the CLO. So even if we love the BBB 4x leverage rate, we wouldn't be able to do it because it's outside of our limits. So the only thing we could do is take a small portion of the fund and put it in BBB and leverage it. But overall, we look at the overall investment universe, ABS, CLO, AAA down to equity, and we try to find the most attractive investment at any given point of time. And probably worth mentioning, we -- in Q4 this year, we thought equity was actually quite attractive, and we started buying some. It was very strongly protected to default given you are buying at a very limited low price, basically, so the price protects you against the rise in the default, and it would produce a front-loaded cash flow. So that's another way to protect you from default. And it was giving you 10% to 25% return between our stress or base and the simple scenario. So that's why we bought some.

Thank you, Fred, very clear. Another question for you from someone who clearly sees value in Toro at this price. Given the high dividend yield on Toro stock, one could expect buyers to jump in and reduce discount? And this question is why isn't it the case?

Yes. We agree with your view, and as such, actually, as a manager, and we've been vocal about it. We've been buying consistently over the last 3 years. And as I mentioned before, it seems to us that the increase in the discount to NAV in '22, '23 was more linked to the generic increase in the investment trust market than anything else. So as mentioned before, we noted that the discount has started to reduce in Q4 and continuing so in Q1. So this is positive. And hopefully, as more and more people agree with this view and our view, we see the discount reduce further.

Thank you, Fred. And finally, since CLOs have tightened on the secondary market, are you taking any profit in your secondary bucket? And if yes, what are you doing with the cash?

Well, I mean, as I mentioned before, we manage our overall book, and if we think that there is value in one, we can buy and sell another one. So there's constant reassessment and trying to have the best possible book at any given point of time. As I mentioned also, our public ABS/CLO exposure has been rising, going up consistently in 2023 because we believe it's quite attractive. And so yes, we've taken profits on some of the position we had, for example, in the investment-grade space, we bought some AA securities above 300, like 350 spread at the end of '22, beginning of '23, and we have sold it in Q4 because it was reaching 250 basis points. So we sold. There was not as much value. And we're invested in the equity tranche as I said before. So we constantly kind of turned the book to get the optimized position. So yes, we've taken profit on some position. But to be clear, the public ABS/CLO book has been going up, right? So overall, we've not taken profits because we still think there is value and good investment opportunity.

Another question for you, Fred. Could you comment on the asset quality in medium term for European loans? What are key variables and which are the vulnerable sectors, pockets of excessive risk taking in certain sectors? And how do you feel about this relative to your past experience?

Yes. So as we mentioned in our outlook in the presentation, so we currently have a default of 3.5%, which is above historical, and we expect this to stay the case for the next 12 to 24 months. So I think the -- if we think about excessive risk taken, it's more excessive risk taking in the past, right, until 2022 rather than since 2022 with a war in Ukraine and then the increase in interest rates, the -- as we mentioned, there was limited supply in 2022. And so the loans originated at that time and until now actually have pretty good quality, right, because the market was not as easy for people to borrow. So it's more issuance pre-2022 where you have to be worried about potential excessive liquidity. I think rather than very specific sector, always people are speaking what about cyclicals or chemicals or stuff like that. So for instance, chemicals, we like the market doesn't rely, but do you think you have a very good asset coverage and you're getting properly paid for the risk. But -- so rather than like a sector or whatever, I think there are specific names, right, are very levered and they were also levered and then they were barely making any money when you have low interest rate, then you start to have higher interest rates and then suddenly or do they make money? And how do they replace their debts. So it's more of a name-by-name approach, right? So we have a CLO management or we have a team of analysts that look at the market on a constant basis and try to monitor everything and determine when there's something that we don't like, and then we exit it. So it happens quite constantly. And we try to be as early as we can to exit, right? Because if you exit after the loan has dropped 20 points, of course, if it defaults then later, it's better, but you've already lost 20 points that if you sell, basically, you create a loss in the CLO structure, right? So the idea here is to constantly monitor try to avoid them as much as we can and avoiding them is either not being invested or selling them early, and that's one of the things we do. And so each time there is a name that looks a bit hairy, we try to reduce it in advance and switch for a less riskier name. And that's part of our investment process basically. In terms of [indiscernible] to my past experience, I think we are, let's say, a middle ground, right, between some good investment opportunity and at the same time, some excessive risk-taking in certain sectors, but also in certain names, right? And so the idea is to avoid those names basically. And also, if we look at the overall market as we stand today, I think the market is quite bullish on the fact that central banks will catch rates, which we agree, but maybe they get it later than people think. And so as long as they don't cut it, if people are very long, are they going to be a bit disappointed and start to sell credit remain to be seen, and we were not very pessimistic, to be honest on that front. But yes, I think people on the default front. But, yes, I think people on the default front, I think that's where we think the people are the most aggressive today. They are very -- if we say, for example, 3.5% was the end of December, and we expect 3.5% to 4%, probably more 4 in 2024. I think the market expectation for default is lower than that. And so that's why we are not on that comp, and we're building this portfolio with a lower WARF than the market.

Thank you, Fred. We have an investor asking or mentioning that one of the reasons of Taurus large discounts to NAV is the lack of public market liquidity? And what, if anything are you doing to increase the liquidity?

Well, I wish I could increase the liquidity, to be honest, right? Because I think that's the main reason for this kind of Toro is you have to price it than if you buy it, when you're going to sell it, it's not a product, I think you can buy one day and sell it the other day. So unfortunately, so we are 200 million a 308 million shares, more or less. As investors know, more than 50% of that NAV is among our hands between the partners and fund that we manage and those investors are not looking to sell. So we could say that the float, right, what we call in the equity market, the float is around a bit less than 50%, 45%. But we cannot force investors to buy or sell, right? So we have, as I mentioned before, our sales team, Guy, in particular, and all his colleagues are very focused on talking to investors, showing them the product, making sure they understand it, be it existing investor or prospective ones actually. And so we think that's a way for them to know what's going on. We do these calls. So everybody know what's going on, what are we doing, the dividend, stability of the dividend. All that saying, we're seeing make the product very attractive, but we have a corporate broker, JPMorgan, which is providing a market making. We have -- there's a few brokers and I think there's some new entrants there. So I think that will increase liquidity, right, as we have more broker looking at the stock -- but yes, the liquidity comes from investor buying and selling. And if they know that they can sell when they buy, they will buy and sell more. And so if the discount to have recovers and they see more liquidity in that front, I think the volume will increase. We have a slide actually in the presentation that gives you an idea of the volumes in 2023, which was slightly above 2024. Let me find it back. It is Slide 25. And so we can see that in 2023, we had 20 -- close to 28 million shares trading, right? So out of 308 million, of which around 50%, a little bit more are in our hands that are not trading. So if we're seeing 28 million out of 150 million, yes, it's not that small, but it's not that big, right? So ideally, we would want a bit more traded on a daily basis.

Well, thank you. Brilliant. I don't think we have any more question at this stage. So well, Fred, let me thank you. And I'd like to thank everyone for joining this call as well.

Okay. Thank you very much Guy. And also on my side, thanks everybody for attending the call. Bye-bye.