Evergreen Investments, the investment management business of Wachovia Corporation, the fourth largest bank in the US, recently bought a majority stake in European Credit Management (ECM) a London-based fixed income boutique with €20bn assets under management and some 400 institutional clients in 40 countries.

The deal, which gives Wachovia a European platform for its fixed income business, is also a recognition of the success of ECM, which - as its name implies - has focused exclusively on European credit and its permutations.

Since it set up shop eight years ago ECM has proved two things: first, that there is a discrete European credit market with its own characteristics and preferences; and second, that it is possible to achieve sustained outperformance through good times and bad.

ECM, now a firm of 145 people, was set up in 1999 by a group of former Merrill Lynch investment bankers. The trigger was the launch of the European single currency.

“We recognised was that there was the potential for a very significant growth in terms of the number of issuers that were going to take advantage of the euro-denominated capital market,” says Steven Blakey, chief executive and
co-founder of ECM.

“We also saw that there was going to be significant diversification across all the different asset classes - not just corporate issuance but increased securitisation that would lead to more ABS issuance.”

The growing market for European bank capital was also a factor, he says. “We saw the significant amount of capital that was needed by the banking and insurance sector and the fact that they didn’t need necessarily to just go to the US capital markets which had previously been the case.

“We saw significant real money demand for diversified sources of stable, higher return alpha from a wide range of clients who needed yield as global fixed income returns were declining and who did not have the in-house expertise to manage the credit analysis. “We were also fortunate in that European clients had to be involved in this market. Clearly if you’re a German insurance company you have to put some meaningful allocation into credit, and our niche was the lower volatility part of the spectrum.”

The aim, however, was to make European credit attractive globally. ECM’s core offering was, and remains, investment grade European credit, Blakey says. “Our pitch was that BBB corporates and weak A subordinated financials was a sweet spot in terms of risk/reward and low volatility.”

Today ECM is also a substantial player in the non-investment grade market. “Of the assets that we manage, between $6bn (€4.5bn) and $8bn will be in non investment grade. There aren’t many other players with such large European-only credit holdings,” he says.

ECM also ventured into more adventurous fixed income asset classes such as asset-backed securities (ABS), mezzanine finance and leveraged loans at a time when these were relatively unknown in Europe.

“We were fortunate in the sense that we built the business around a major growth of the various asset classes. People were predicting significant growth in the asset backed market and we built a big ABS business in advance of that growth,” says Blakey. “The leveraged loan market is huge now but at that time it didn’t exist in an institutional form.”

ECM has approached some fixed income asset classes with caution, says Stephen Zinser, chief investment officer and co-founder of ECM. “When we opened for business the new hot area was the nascent European high yield market. Of course, it was about to go into a major correction. In 2001 and 2002 there was a huge number of defaults by principally TMT issuers. We were involved a little in the early days of the market and but we were prudent enough to exit it well in advance of the serious problems which emerged. Limited capacity was also a consideration. The nascent European high yield market was going to be too small for us to access the amount of portfolio growth we envisaged, and too volatile for our clients’ objectives,” he says.

With an investment banking background, the ECM team was able to bring something new to the asset management party - structured finance and the use of derivatives.

“Back in 1999, one aspect of the capital markets business the asset management industry hadn’t really utilised was the use of swaps and derivatives which were very much part of our whole mindset in terms of alpha generation,” says Blakey.

“The ability to use swaps to best deliver returns to our clients and to hedge out unwanted market risk was in 1999 very much a new concept in the asset management industry.

“We thought we could use a simple but really quite revolutionary investment banking approach in terms of using swaps, not to take risk but to take all of the interest risk away. That in turn has led us to develop and grow quite a significant LDI business.”

Unusually for an asset manager, ECM provides structured liability driven solutions as part of its asset management offering without charging clients for this service. This is reassuring for pension fund clients, says Blakey. “One of the barriers to implementing structured liability driven solutions for pension funds is the opacity of the fees charged by investment banks. We are in business to provide best execution both of bonds and swaps, so any structuring that’s provided by ECM is free.”

 

CM has been predominantly long-only, but it has developed long-short and relative value investing as demand for these products has increased, says Blakey.

“As the market has evolved and as our clients’ taste for different strategies has developed, we have rolled out different variations of the theme of what we have done historically. We now have a number of long-short credit hedge funds, targeting 9% to 12% returns which have been very successful.

“Last year we launched a relative value-oriented fund which is just shy of €1bn today. This fund, through a combination of CDS and cash bonds, is long and short individual credits on a relative value basis.

“We also launched a dedicated leveraged loan fund two and a half years ago which we think is unique. It was the first open-ended fund of its kind and has attracted over €1bn.”

Leverage is used sparingly and for limited purposes, Zinser says. “While we do use a modest degree of leverage in our programmes, it is primarily as a treasury management tool. ECM is a very low volatility business with a low level of leverage. That really is our niche.”

ECM has set itself apart to a certain extent from other money management firms by offering institutional investors pooled rather than segregated funds.

“Pooled funds provide diversification and liquidity for the investor, so it tends to be a win-win situation. Our flagship fund has over 600 credits in it,” Zinser points out. “We really haven’t had many pension funds saying it has to be a segregated account.

“Certainly the UK pension funds, through the consultants, understand that they get instant diversification from our pooled products. Pension funds can choose where they want to be on the risk and volatility scale. Having made that choice , they can then customise their return profile exactly to the benchmark they want, in the process getting access to the swap market without themselves being a swap counterparty.”

Research is central to the investment process, says Zinser. “It is a fundamentally based process looking at individual credits. The skill of the game, particularly in investment grade credit, is being able to avoid the blow ups.

“The aim is reach rapid consensus between portfolio management, which has a good feel for the day to day happenings of the market and the research department which does the heavy credit lifting. Getting that balance right and understanding what can go right and what can go wrong is as much an art as a science.”

In the end, it is performance that counts, and ECM has ridden out some rough seas in the credit markets in its early years. In contrast the past 24 months have been benign, and the challenge has been to outperform a listless market.

“Our largest fund, ECL, which has over €8.5bn of AUM delivered a net return to clients of swaps or LIBOR, being the benchmark, plus 151 basis points in a market where spreads were relatively unchanged in the investment grade world,” says Blakey. “DEC, our second largest fund, and still investment grade, produced a net return of 287 basis points.”

Wachovia’s acquisition of a majority stake will mean no change in ECM’s strategic direction, Blakey says. “The transaction that we have entered into with Wachovia has just enabled us to grow the scope of our original vision more quickly than we would have done otherwise. The investment process, with the new partnership, is totally unchanged.”

The transaction will give Wachovia a European platform and ECM an enhanced US platform for distributing products. “The Wachovia/Evergreen distribution in America is quite significant, in terms of people, offices and client coverage” says Zinser. “In addition, there will be an opportunity to work with Evergreen to customise their products for our international clients, whether it’s US credit, mortgage-backed or any other fixed income asset class that would complement our current capability.”

Blakey and Zinser counter any suggestion that ECM will be subsumed by a US super-bank, and lose its unique selling proposition - a mastery of European credit. “There will always be the criticism that the larger you grow in terms of assets under management, the more you will dumb down and return to the median,” says Blakey.