Investor Letter Second Quarter 2020

Market Perspective

As we continue to navigate this global health crisis as a firm and team, we want to send wishes
of good health to all of our clients and their families. We are proud of the work our broader Vivaldi
team has done to adapt to these challenging times and the extra effort that many of them are now
putting in from home as they balance any number of competing responsibilities. While this letter
will focus on market commentary and outlook, we continue to prioritize the health, safety, and
stability of our firm and team so that we can continue to advocate for our clients and their
investment portfolios.

What a difference a quarter makes. With the staggering market correction and dislocation that
occurred at the tail-end of the first quarter, the equally as impressive rally in many asset classes
in the second quarter represents yet another environment over the last decade where very large
market moves have been nearly erased in what feels like the blink of an eye. This narrative does
not stand up to scrutiny if one really digs beneath the surface of broad-based domestic equity
indexes (which is certainly where we spend most of our time), but the simple fact that equities
saw a snap-back rally of this magnitude in the midst of a global pandemic is truly impressive.
Below is a snapshot of a collection of widely quoted equity indices.

Something we highlighted in our first quarter letter that we believe is worth revisiting is how
disparate was the dislocation across credit and equity markets. In many different sub-sectors we
saw credit securities trade worse than their related equity securities. The snap-back in markets in
the second quarter proved consistent with this dichotomy as equity markets recovered first and
most significantly, while many related credit markets have rallied but not by the same magnitude.
We understand the nature of market liquidity differences that drive these types of dislocations
over short time frames, but eventually these imbalances will normalize based on the fundamental
order of priority within a capital structure. Below is a snapshot of a collection of broad credit
benchmarks to put these comments into context.

One credit market that we were particularly focused on and active in during the market dislocation
was the municipal bond market. Municipal bonds are the poster child for understanding how
liquidity rather than credit risk can sometimes drive price movements in bond markets. The
municipal bond space is highly fragmented compared to similar credit markets, replete with
millions of different bond issuances, all with their own specific indentures and nuances. That
market is also highly opaque, dominated by retail-to-broker and broker-to-broker trading. Finally,
the ownership base of municipal bonds is itself highly fragmented and often relatively passive,
with many more investors looking to invest simply by adhering to specific credit ratings and
durations rather than by any fundamental bottom-up work on a specific credit. This ownership
dynamic is important because it means that when municipal markets dislocate, there are few
investors who are well positioned to be aggressive buyers of specific credits based on an informed
view of the credit risk of a specific name. All of these factors were further compounded by the fact
that the uncertainties of a global pandemic and the implications on cash flow and business
performance raised questions around even seemingly bulletproof cash flow streams. For
instance, there are not many economically-driven environments where toll road revenues would
be down 80% in a month; however, we saw just that in certain municipalities in March and April.
To put the municipal market behavior into context, below is a price chart of the largest municipal
bond ETF (MUB):

The combined fundamental and technical/structural aspects of the municipal bond market left it
particularly poorly positioned to weather a liquidity crunch in capital markets where bond traders
were working from home offices that quickly turned into unsupervised daycare centers.
Conversely, a view that our team held in mid-March was that interest rates had rallied incredibly
and that the highly interest rate duration-sensitive municipal bond market should probably rally as
well. While the headline risk of falling municipal revenues is an easy one to ascribe to, the actual
underlying credit picture of such a fragmented market is much more nuanced. By way of example,
California has been plagued with a bad headline reputation when it comes to municipal finance
dating back several decades. The reality is, however, that the state has been operating with a
balanced budget ever since the last financial crisis. Paired with a new constitutional requirement
that mandates contributions to a “rainy day fund”, California enjoys one of the most robust state
municipal balance sheets in the country. That, however, did not stop California revenue bonds
from trading down over 25 points within a two week window, depicted in the chart below.

As seen above, this particular bond had traded at a premium to par for its entire life, largely due
to the AA- credit rating, which historically means there is little to no fundamental credit risk in the
bond. The price decline from 110 to 85 in March was not reflective of any actual deterioration in
the fundamental credit risk of this bond. Rather, this was purely a liquidity driven dislocation in
which either municipal-focused mutual funds being forced to sell bonds to meet redemptions, or
retail investors looking to flock to cash at any cost, were willing to sell a bond at 85 that, given the
underlying credit strength of the issuer, should never pay back anything less than par. While the
market anomaly in this particular bond was arbitraged away in short order, we continue to see
dislocations like the above that have yet to fully recover from their March lows.

While we generally would not dedicate this much of our letter to a single sub-sector of the fixed
income space, we think it is worthwhile as we all attempt to find our footing on the back of a
dramatic spike in market volatility, even as that environment has abated despite the fact that we
remain in a highly uncertain time. We may never again see a move like we did in March within
the high grade municipal bond space, but it is yet another data point demonstrating the importance
of understanding mark-to-market risk versus fundamental risk, particularly when liquidity is

The last market metric we would note is the continued compression in interest rates across most
points in the yield curve. The importance of the level and shape of the U.S. Treasury curve cannot
be overstated, as it has implications for just about every sector and asset class in which we invest.
Whether it is fixed income, credit, equities, real estate, or venture capital, all of these sectors are
tied to and affected by the broader interest rate environment to differing degrees. Below is a chart
of U.S. Treasury rates as of July 21 compared to six months prior. Note that the United States
has remained the one large developed capital market where sovereign rates have not yet gone
negative, at least at the front-end of the interest rate curve. We think focusing on where the front end of the curve moves as the country makes its way through this recession is going to be critical.

*All Chart Sources: Bloomberg


Highlighted Research Process & Investment Opportunity

We spend much of the space in these letters discussing the trends and developments that we
think may be of interest in understanding investment performance and the opportunity landscape.
Most often, those observations happen at the asset class, sector, or potentially at the strategy
level. The reality, however, is that the Investment Research team spends the vast majority of our
time focused even one layer deeper at the investment manager level. Most of our efforts are not
expended trying to make a macro-level call or tactically allocate to an asset class or sector based
on a top down view, but instead are focused on identifying talented teams that we believe can
outperform, within their respective peer group, over a full market cycle. Our own research process
is geared toward attempting to find those teams, underwriting their investment process, portfolio
construction, and risk management frameworks, and holding those managers accountable to that
underwriting. Over the long-run, our team believes that we will add more consistent value at that
micro level, and that one of the most important steps in building an investment portfolio is aligning
yourself with the right team. Picking the right organization and team should help in environments
that are rife with opportunity as well as those that are more fraught. We actually tend to think more
about that alignment specifically in times of stress. In that vein, given the truly historic dislocation
we witnessed in the credit markets in the first half of the year, we thought we would provide some
insight into how one of the teams in one of the most impacted credit sectors fared.

As many of our clients have likely seen, there has been no shortage of headlines calling for major
trouble ahead in the leveraged loan market. After the last global financial crisis, the leveraged
loan market became one of the preferred ways for companies to finance themselves, pushing that
sector to consecutive years of all-time record issuance. As is the case with most credit sector
booms, as more dollars move into the space, the balance of negotiating power between creditor
and borrower tends to shift in the borrower’s favor. This paradigm was certainly true of the
leveraged loan space, with deals in recent years becoming much more “covenant-lite” (to borrow a term favored by financial journalists). One feature of the leveraged loan space that made it
particularly attractive for borrowers is that the loans originated are generally floating rate in nature,
disproportionately benefitting borrowers as global interest rates continued to march lower. The
large acceleration in issuance coupled with the stripping away of covenants prompted many
concerns about what would happen to the leveraged loan market once we hit our next recession
and the financial performance of borrowers is negatively impacted. We are about to find out.

Just over three years ago we began to invest with a credit specialist firm based out of Kansas
City named Palmer Square. The firm is focused on all forms of credit securities but has a
particularly deep experience and expertise in the leveraged loan market and the related collateral
loan obligation (“CLO”) market. Palmer Square is an asset manager that operates different
investment funds trading in primary and secondary credit markets, but is also a CLO issuer that
manages underlying loan pools as an asset manager. We have known and worked with Palmer
Square for some time and have come to regard their credit team as a conservative and rigorous
underwriter of credit risk. We also believe that their relatively boutique size has allowed them to
be more nimble and opportunistic in an effort to generate better risk-adjusted returns as opposed
to simply gathering assets alongside some of the much larger credit managers they compete with.
Vivaldi began working with Palmer Square by investing in one of their registered funds where they
look to trade the loan, high yield, and structured credit markets broadly. With that said, we also
developed a deeper relationship with the firm that allowed us to begin to co-invest alongside
Palmer Square in one of their CLO programs. We consider those co-investment opportunities to
be the purest exposure one could obtain to the raw credit work being done by Palmer Square’s
research team and the structuring work being done by their capital markets team, both of which
we feel are of the highest quality. While there was some stress in early 2016 in the loan market,
namely around energy-related credit, the first half of this year marks the first real extended credit
cycle since we underwrote the firm and the opportunity.

To put this discussion in some context, the second quarter saw 41 companies file for bankruptcy.
Those defaults accounted for $70 billion in aggregate loans and bonds outstanding. There have
now been $106 billion in defaulted loans and bonds thus far in 2020. That already puts 2020 on
pace to surpass 2009 as the worst year for defaults (measured by outstanding volume) as there
were $205 billion in defaults in all of 2009. That data just pertains to companies that have already
missed payments or formally entered Chapter 11. In a similar tone, the volume of investment
grade debt that has been downgraded to junk by the rating agencies has already surpassed the
2009 total at $190 billion. All this is to say that Palmer Square is now operating in a very difficult
environment for credit. Within our co-investment program where we own equity tranches
alongside Palmer Square’s General Partner, we have participated in six independent CLO
transactions. Those six CLOs have exposure to 1,985 individual loans. Of these, exactly two
issuers have defaulted as of the end of the second quarter, with only one of those loans defaulting
in the second quarter (of the 41 total companies noted above).Those two defaulting companies
represented less than 0.50% position sizes in their respective CLO pools. For additional context,
Palmer Square’s base case assumption to generate their targeted returns for these pools
assumes 3% in annual defaults. In addition, on the credit rating side of the equation, the CLO
pools we are exposed to all began with 0% allocations to CCC+ or lower rated credits. As it stands
as of the end of the second quarter, across our six deals, the CCC+ or lower rated bucket ranges
from 2-4%, less than half that of the average CLO pool. While we remain in the early innings of
this economic contraction, the realized credit performance metrics are indeed supportive of
Palmer Square’s conservative nature when it comes to underwriting credit risk.

We highlight this not as a victory lap as if we had seen the global pandemic coming, because
there are certainly areas that we could have allocated capital to that were less economically sensitive than leveraged loans. We just do not believe that we would have a very high hit rate in
making those top-down macro calls, specifically as it relates to environments like a global health
crisis which are nearly impossible to foresee or predict with any reasonable confidence on timing
and severity. Instead, we attempt to align ourselves with the best teams we can find across
sectors to give ourselves a better probability of weathering the storm whenever it comes and
however disruptive it is. We will almost certainly see more defaults in loans and bonds moving
forward and, undoubtedly, some of those companies will be in Palmer Square’s CLOs. To date,
however, we have been encouraged with our share of credit events relative to that fundamental
backdrop and we think that bodes well for where we end up after this credit cycle has run its


Organizational Update

Amidst these unprecedented times, our primary focus is to deliver our clients the same wealth
management experience they have come to expect. Since March, our entire organization has
worked remotely, and we are grateful for the energy they have committed to maintaining our
strong corporate culture. As we continue to operate with an uncertain road ahead both in route
and duration, we are focused on investing in our human capital and technology as we not only
adapt but ideally take advantage of a highly unusual environment to think critically about areas
in which we can improve our team processes and structure not just to survive this period but to
come out of it better on the other side. As a firm, we continue to have several new hires in the
pipeline across the functional units of our business and we are committed to continuing to invest
in those resources that will be beneficial to us in the intermediate and long-term despite the nearterm uncertainty. We look forward to sharing the backgrounds of the professionals that are joining
us as they come on board later this summer.

Below is a quick update:

‐ Our Advisory Team is well equipped for video conferencing and screen sharing so you can
continue to have productive and interactive one-on-one discussions about your personal
situations – just ask and we will set something up!

‐ The Client Service Team is fully operational to handle the day-to-day operations of servicing
your accounts as well as those “above-and-beyond” requests. We encourage you to reach out to or call 312.248.8300.

‐ We understand that this was a highly unusual tax filing season for a myriad of different reasons.
We would just remind you that we have a dedicated e-mail for clients for all tax-related inquiries


Kind Regards,

Michael Peck, CFA
President, Co-Chief Investment Officer


Brian R. Murphy
Portfolio Manager


To download a copy of this report, click here.