Q: Would you give an overview of the fund?
A: Artisan High Income Fund is a relatively new fund, launched in March 2014. It is a below investment grade credit fund, which invests across the entire capital structure. We look for superior business models and employ a bottom-up, research-oriented approach.
Q: What are the core principles of your investment philosophy?
A: We believe the non-investment grade market is well-built for active management. Our philosophy is that this market has inefficiencies that we can exploit through our process. These inefficiencies are often caused by cyclical, industry or company dislocations. We believe that, through our fundamental credit research and by identifying value across the capital structure, we can generate an attractive long-term risk-adjusted return.
A main differentiator of our approach is that we focus on higher-quality businesses than our peers. We are research intensive and rely on our core names, which are stable, predictable businesses. But when there are market inefficiencies, we are willing to make material investments in opportunistic buckets.
Q: How would you describe your investment strategy and process?
A: Our strategy is to focus on businesses with high multiples, which we find attractive from a business model perspective. Such businesses include software, insurance brokerage, or transaction processors with higher leverage points and enterprise values. They tend to have lower credit ratings but, over time, we expect material credit improvement.
For the core part of the portfolio, we aim to invest in companies with strong and predictable cash flow and relatively modest leverage, such as HCA Inc., for example.
We also run an opportunistic screen to take advantage of market technicals. We are definitely interested in event-driven ideas. For example, a year ago we invested in Williams Partners, which owns and operates premier energy infrastructure across the U.S. At the time, it was actually a high-grade company expected to be downgraded to high yield.
Our process starts with screening the Bank of America-Merrill Lynch U.S. High Yield Master II Index and the Credit Suisse Leveraged Loan Index. There are about 1,600 names in the indices and we narrow that universe down to only about 75 names for the portfolio.
Essentially, we certify yield by price and total return. We slice and dice the companies to examine the opportunity set and to identify the market movers. Then we perform our fundamental credit research.
We spend time modeling each company and understanding its capital and corporate structure. We need to know if a piece of debt could potentially hinder the companyís corporate objectives. Then we analyze relative value and combine it with our view on the security. The goal is to figure out the optimal risk-adjusted return, based on the trading of the bond. That gives us confidence to pursue the best business return.
Q: Could you give examples of specific holdings that illustrate your research process?
A: USI Insurance Services, an insurance brokerage firm, is one of our larger holdings. The company sells property and casualty insurance and health benefits mainly to small and mid-size businesses. Essentially, it is a commission-based consultant for customized plans. We discovered USI on our screen and when we made our initial investment, we aggressively added to the name.
One of the reasons was the very high retention rate of the insurance brokerage industry. That industry provides a mission-critical service that companies need in order to avoid potential liability. These businesses have low, but predictable growth rates and cash flow margins in the low 30% range. Since they arenít capital intensive, they can generate a lot of cash. Finally, the insurance brokerage space represents a very fragmented industry, with hundreds of players, and is being consolidated.
Onex Corporation bought USI four years ago and we bought the security after the deal. We believed they were able to accelerate the companyís growth rate through change in operations and to continue to de-lever the balance sheet. Thatís what the company has ended up doing.
When Onex bought the company, it decided to use financial leverage to enhance the equity returns, so it borrowed money. The only reason for the debt was to leverage the equity returns. We think thatís a great use of high yield paper as opposed to a company thatís struggling with its business.
We expected a strong risk-adjusted return from the business, since the equity was actually worth more than the total debt. At various points, we have received double-digit yields. Right now it provides a mid-single-digit yield, which is an equity-like return for a fixed income level of risk. Overall, we feel confident about the business and its predictability.
Q: Could you give an example of an event-driven investment?
A: Initially, we identified Williams Partners through our screens. At the time, there was a concern of fallen angels into the high-yield universe, so we ran a high-grade screen on all the substitutes in the Merrill-Lynch Investment Grade Index for companies yielding over 7%.
A year ago, there were big concerns about energy and about the takeover of the company by Energy Transfer. As part of the transaction, the company had to issue additional $5 or $6 billion debt on the capital structure of both Energy Transfer and Williams Partners, which would be downgraded to high yield.
In our view, Energy Transfer had a couple of options. One of them was to get out of the transaction and the other to cut the dividend to maintain the investment-grade balance sheet.
We thought the second alternative was unlikely, so we expected the company to get downgraded. Actually, we found a series of bonds that would benefit from such an outcome. Initially, we started to invest when the bond was at the high 70s to low 80s range. We viewed that as a win-win situation, because of the structure we were able to identify.
That company had world-class assets and, at the time we were building the position, it was trading as high-yield despite being rated higher. We liked the business quality. The company had an uneven distribution policy, which it eventually corrected, and the valuation was very attractive. Importantly, the structure protected us from any potential negative outcome from irrational decisions.
Q: How is your research team organized?