Year: 2024

Shiloh:

Hi, I’m Shiloh Bates, and welcome to the CLO Investor podcast. CLO stands for collateralized loan obligations, which are securities backed by pools of leveraged loans. In this podcast, we discuss current news and the CLO industry, and I interview key market players. Today I’m speaking with John Timperio, the co-head of Dechert’s global Finance practice. Dechert is one of the prominent law firms in the CLO industry and someone that I’ve worked with on many transactions with over two decades of experience. John is a trusted advisor to CLO managers and investors. I asked John to come on the podcast to discuss the exciting topic of CLO regulation. This podcast is going into the weeds, so buckle up. If you’re enjoying the podcast, please remember to share like and follow. And now my conversation with John Timperio. So John, welcome to the podcast.

John:

Thank you for inviting me.

Shiloh:

Are you guys having a busy August at Dechert? It seems there’s a lot going on in the market.

John:

We are as busy as I can remember across our finance practice. So I co-head the finance practice at Dechert and we do CLOs. We do ABS, CMBS, and large loan real estate, and all of those silos are going gangbusters. The CLO piece in particular has just been extraordinarily busy, in particular with private credit CLOs, which continue to enjoy or bask in the spotlight of investor demand.

Shiloh:

Gotcha. So how does somebody become a CLO lawyer?

John:

For me, it was a fairly circuitous path. I’ve been doing this for 33 years out of law school. I started doing real estate that market, this was 1991, was dead, transferred into the bankruptcy group, which was going on, firing on all cylinders at that point. When that slowed down after a few years, given my background and understanding of bankruptcy, remoteness and structures, it was a natural segue into structured credit when I started doing structured credit full time in 1998. It was also an interesting period in the market. It was right at the beginning of the CLO world. So I had at that point moved to Charlotte, North Carolina and was doing a lot of work with a bank, First Union, which was highly focused on middle market credit, middle market CLOs, and was able to get in on the ground floor of doing. And those are still
a huge piece of our CLO business 25 years later.

Shiloh:

There’s a lot of CLO lawyers out there. John, how does Dechert differentiate itself?

John:

Great question. There are a lot of CLO lawyers out there, although if you look across the market, there are probably five or six firms that do a bulk of the work. I think what differentiates Dechert is our platform and I think there are a lot of terrific lawyers that can agree to make collateral management agreement, read an indenture, make comments. I think what differentiates us is in addition to the CLO platform, we have the world’s best Advisors Act practice. And if you’re an asset manager, frequently with your CLOs, you have tons of Advisors Act questions or if you’ve got a BDC, you have all these conflicts and other issues that come up. So we’ve got this great platform which includes terrific advisors act practice. Our tax practice is top-notch in the middle market area, really groundbreaking in terms of their views. The tax issues in the private credit space are a lot more challenging for people to get their arms around because you have someone that’s actually originating a loan.

So you have to figure out a strategy if you have an offshore deal or offshore investors. So those can be more challenging. So we’ve got terrific tax practice. So really I think the reason clients hire us is not exclusively for the CLO piece, but it’s all the other pieces. We’re also the world’s leading rated funds practice, CLO equity fund practice, and when clients are putting all those things together, that’s how I think the calculus is tipped in our favor in some cases and it’s been very helpful. So when we’re chatting with clients, it’s focused around the platform and the resources there, and then the fact that we did close to a hundred transactions last year I think gives them a window into the workings of CLOs that can be very helpful as they try to think about what’s market and we can give them up to date, up to the minute color on, well, here’s how this stip or request from an investor is getting settled at this point in time.

Shiloh:

So if I go to a CLO conference today, they always allocate 45 minutes to have some industry lawyers on a panel to talk about what’s new in regulatory issues for CLOs, is there anything that’s top of mind or important for CLO investors or managers today?

John:

Great question. We at the moment are enjoying a relatively, I wouldn’t use the word benign, but stable regulatory front. So good news, is unlike in the years following the financial crisis, the pace of new regulation has slowed. Right now we primarily work with asset managers. A lot of our asset manager clients are focused on some of the conflict of interest rules, which will go into effect in the middle of next year. And their compliance policies with respect to those rules and those rules prohibit material conflicts of interest between managers and sponsors and investors, and were really designed to prohibit transactions that were designed to fail, which was never a real feature of the CLO market. But 12 years later or now finally going to go into effect and managers have to focus on some compliance there and putting up some information barriers. So we’ve been talking to managers about that.

Shiloh:

So John, as you know, CLO securities have performed very well across the stack from equity to AAA on a buy and hold basis from prior to the financial crisis and forward. So what was the push to have… Why was more regulation needed?

John:

Interesting question. I think the answer just based on the hard data is that the industry did not need additional regulation. As you noted, there really weren’t any CLO tranches, there were not many, at least that went into default or didn’t pay in full. So they’ve had a relatively pristine track record in the financial crisis though there was a conflation between CLOs and a product with a very similar acronyms CDOs, which did experience a lot of problems. What’s interesting now, though, is a decade and a half removed from the financial crisis, I do think regulators understand that CLOs are safe products. We have clients who have ETFs that buy CLO liabilities and we see a lot of interest in CLO equity. So I think regulators understand that this is not a dangerous product.

Shiloh:

So the biggest regulatory change for CLOs post the financial crisis was really, in my opinion, risk retention. So maybe you could give our listeners just a quick overview on risk retention, how it worked, and then the remnants of its implementation, how they continue to effect this even today.

John:

So the US risk retention rules are aimed at requiring a securitizer, which is a party that transfers assets into a ABS transaction and asset backed security, to retain skin in the game. And they calculate that a few different ways, but by and large in the CLO space, it’s either with a vertical strip of 5% of the CLO liabilities or an interest in the most residual tranche. The equity tranche equal to 5% of the fair value of all the notes issued in the CLO and initially in the adopting release, the SEC and the regulators took the position that the collateral manager of A CLO was —

Shiloh:

— the securitizer —

John:

— exactly — very controversial position, which resulted in a lawsuit where the LSTA sued the SEC.

Shiloh:

The LSTA is the loan sales and trading organization, that’s the organizational body for the leveraged loan industry.

John:

So they brought suit and the courts ultimately decided that the clear language of the statute was what governed and the language of the statute was based on a transfer of assets into a CLO. The interesting thing  is it had two implications. One is open market broadly syndicated CLOs no longer had to comply or did not have to comply with US risk retention. And those transactions, which are the 80% of the market, a manager faces the open
market and purchases either in the primary or secondary pieces of loans into
the CLO from third parties. And basically those deals are designed to allow
these asset management platforms, which are your clients as well. And some of the largest, most well-known asset management platforms in the world to gain AUM and management fees. And the track record is pristine, as you mentioned. The other piece of the market are the private credit middle market balance sheet side of the market that is traditionally or historically always been around 10%.

Last year it was 20%. It’s been hovering in that range as there’s been a lot of buzz and focus on private credit CLOs. That part of the market does have to deal with risk retention because in those transactions you do actually have an originator of assets, generally maybe it’s a BDC or an Alts platform. They actually make the loan, they underwrite it, and then they transfer it into a CLO. They use the CLOs as attractive forms of non-market to market leverage, which frees up other capital for them to make loans. And so in those transactions though, we’ve had to comply with risk retention generally in
those deals, interestingly has not been as big an issue because generally the
platforms that originate the loan want to retain all of the equity, or at least
most of it. I know you all also invest in that equity, but it has not been as
big a problem as it would’ve been on the BSL side where you have these BSL
managers who just could never write the amount of checks that would be required to manage 50 CLOs.

Shiloh:

So then the setup today is basically this. If it’s a broadly syndicated loan CLO, there’s no risk retention in the us. So the manager is not required to buy 5% of the AAA down to equity. They’re not required to own 50% of the equity, which I guess would be the other way to satisfy that previous requirement. And you can do that and you can sell the CLO securities in the US and you’re fine, but for that US broadly syndicated CLO security, if you want to sell it to European investors, then there is risk   retention still in place in that continent.

John:

Exactly. What’s been interesting is, as I mentioned, the
middle market CLOs or private credit CLOs, they do comply. There’s some
exceptions, but by and large they comply with US. Sometimes they also comply with European risk retention in order to sell the liabilities to European
credit investors. So sometimes they have dual compliant deals. In the middle
market context, dual compliance is a little more complicated given the type of
reporting that’s required for European compliance. So it’s a little more difficult for them to do that full suite of reporting. But we have a number of clients that have done it and continue to do it. In the broadly syndicated space, even though there’s no US, we frequently have some clients that will set up structures to comply with the European risk retention rules for the same reason it broadens the investor base the liabilities and thereby increases the yield on the equity of their buying equity.

So a lot of what we’ve been doing recently with the managers we set up is set up a structure where they can subsequently use that management company that they’re establishing to hold EU risk retention and thereby satisfy the EU risk retention rules. Interestingly, for BSL CLOs, the reporting is a little easier so that they’re not as troubled, although by that aspect to comply with the European rules, they have to hold 5%. Europe measures it a little differently. They look at 5% of the notional of the portfolio. So it’s a slightly different calculation than the US, but gets you roughly in the same ballpark. So if you think about the market or the landscape private credit, by and large, you do have transfer orders and they do comply broadly syndicated, no US risk retention. They sometimes comply with European in order to facilitate better execution. What’s interesting is there’s another part of the market that’s really picked up steam and that relates to rated feeders, rated note funds, and those are really primarily or exclusively in the private credit space, but they’re initially started out as feeders into private credit funds where people were structuring a feeder so that it had rated debt to facilitate investment by insurance companies.

But now sometimes those deals are very similar to CLOs and the tranching and how they look. But what’s interesting about that market is by and large, because there’s still a lot of fun like aspects to those transactions, people have not treated those as needing to comply with US risk retention. So you do have this other category, and that’s a very burgeoning part of the market on the private credit side.

Shiloh:

Why was it that risk retention was in the US only repealed for broadly syndicated CLOs and not for middle market CLOs?

John:

It was really because the way Congress had drafted the statute was to require a securitizer to hold risk retention, and they define securitizer as the party that organizes and initiates the transaction by transferring assets into the CLO. In a middle market context, you do actually have originators that transfer much like ABS deals. In the broadly syndicated CLO market, the asset managers just acquire from third parties in the open market, much like stock picker of a mutual fund would acquire stocks.

Shiloh:

So though in middle market CLOs, even though risk retention exists, what I see is that the manager of the CLO, they want to own securities in the CLO as well. So they’re required to do it by law, but they want to own a majority of the equity. They often take strips of the senior securities. So it’s not really a burden for them. At least that’s my perception of their business model.

John:

Absolutely. I think what’s been interesting to me, well a few things. One is over the last, I’d say again, 24 months or so, we’ve seen much greater interest in CLO equity and had a bunch of clients raise CLO equity funds. I think that that on the broadly syndicated side, not on middle market, so a number of BSL managers have gone out, dedicated CLO equity funds, and used that money to invest into their own CLOs generally in a way that was EU compliant as well. And that has been something that’s interesting because if you go back five years ago, those who are very episodic, where we might do one or two a year, now, we probably have 10 going on at the moment, people are able
to raise that money. We don’t see that in the middle market space for the
reason you mentioned, the managers really don’t always want to part with that equity and really when they are, they’re going to do it with a strategic
counterparty like a Flat Rock, who they trust and they know they’re going to be a good actor in our transaction.

Shiloh:

So then is there any expected changes to the risk retention framework that exists today? Are there any proposals out there to do it differently?

John:

No expected changes. Certainly there could always be new rule-makings, but nothing we’re aware of in the pipeline. What’s interesting is some of the vehicles that we helped set up in the very early days when people thought it was going to be applicable to both BSL and middle market are still around and in some cases highly successful. The one that comes to mind is Redding
Ridge, which is 25 billion or more in AUM at the moment.

Disclosure:

Note Redding Ridge Asset Management is an independently managed affiliate of Apollo specializing in structured credit.

John:

And that was set up initially as a collateralized manager vehicle, which was an option where you set up an independent company from the main platform and raise capital into that. And that vehicle has been incredibly successful and like I said, still exists and has an AUM that’s very enviable.

Shiloh:

So I guess the punchline is risk retention has gone away, but the manager in the past was able to raise risk retention funds and presumably the funds performed well. So even though the requirement isn’t there today, they keep these funds active.

So then changing topics, I know you guys work on negotiating both middle market and broadly syndicated CLOs. What are some of the key legal differences between the two?

John:

Very interesting, and we were involved with the full evolution of the private credit market and initially those deals emanated out of an ABS-type structure where it was repurchase and all this recourse back to the originator or the assets.

Shiloh:

So an asset backed security, so different from a CLO or what’s the terminology there?

John:

It would be asset backed security. So —

Shiloh:

— securitization of business equipment or aircraft —

John:

— that was the original DNA of middle market CLOs. And then over time they did converge and now the technology is largely the same, but they have a number of characteristics that are different between the two. And first off, the motivations are vastly different. As I mentioned, middle market CLO managers largely use the CLO as just a financing source for collateral, whereas in the broadly syndicated space, they’re really using these as a way of gaining AUM management fees, and as arbitrage vehicles. High level differences as you look at the two first, the collateral obviously middle market CLOs, the collateral is less liquid; generally has credit estimates versus public ratings, and there’ve been the B minus range, whereas the BSL broadly syndicated loan space, it’s a little higher, maybe B/BB minus. Generally middle market CLOs, the loans and middle market CLOs generally have covenants, which in our BSL world is not always the case and most of the collateral will not have covenants.

It’ll be covenant light as we say. Another difference is because the collateral is a little lower rated to begin with, there generally tends to be a higher triple C bucket and middle market CLOs than broadly syndicated CLOs. So generally 17.5% or slightly more in a middle market CLO, whereas in a broadly syndicated CLO, you might have 7.5% and then other differences, there’s a lot less trading that goes on in middle market CLOs, again, both the collateral and liabilities or much less liquid. And this generally with middle market CLOs and there’s lots of exceptions to each of these, but there’s generally not reinvestment, post reinvestment period. So again, the weighted average life will vary from a broadly syndicated CLO. The other thing I’d mentioned, and this would be attractive for investors, is there’s more credit enhancement at all the levels of the tranching. The equity is generally a larger piece of the overall transaction in a private credit middle market CLO than a BSL CLO. So the structures are sturdier than a BSL CLO, which are also  have performed in a terrific way. So not to cast dispersions there.

Shiloh:

So I think one of the things that is newer in CLO documentation today is the ability to protect yourself in a scenario where the underlying loan is being restructured. So the typical CLO would prevent the CLO manager from buying an equity security for example, or participating in inter-rights offering or maybe even buying a debt security that’s currently in default. Those are things that would generally, you think of them as being prohibited. In the past, distress funds would buy up loans of underperforming companies and
they would propose, through the bankruptcy process, a restructuring where a lot of the residual value of the company would come back in equity or warrants or other securities that the CLO couldn’t purchase. And one distressed manager described their business as arbitraging CLOs in this manner. So they buy the discounted loans, they propose an all-equity restructuring, that would result in CLO managers dumping even more of the loan to their advantage. And a distressed fund probably has no issue in buying equity and restructured companies. So the distressed funds were really taking advantage of the CLO’s strict rules, and over the last few years, there’s been a real effort to true that up so that CLOs can play on an equal footing in a restructuring process.

John:

Look, that was an interesting moment where as you pointed out, you had distressed and investors realizing that CLOs were limited in what they could purchase and really trying to take advantage of that. As you note though, over the last couple of years, by, I would say consensus of the market, really all the investors, those limitations or prohibitions or risks to CLO investors have been largely mitigated primarily through allowing the CLOs to purchase workout loans, which may include some securities as part of the package. Additionally, CLOs do now have, because of changes in the Volker rules, an ability to buy permitted loan assets, which had historically been a problem prior to the changes in Volker, there was a restriction where CLOs could not buy securities, equity securities, unless they were received in part of a restructuring, and that created a lot of risk for the CLOs.

Now they can actually own permitted non loan assets. So you’ve got a confluence of things along with an ability to contribute money for permitted uses, which includes buying workout loans and equity securities, that really have closed out loophole. But it was an interesting moment because you
saw these creative distressed fund managers all realizing that there was this
problem, and CLOs obviously own two thirds of the leveraged loan market, and it was very frustrating time for our clients. A number of those older CLOs were amended, and now the new deals do have a bunch of mechanics to address that.

Shiloh:

Well, one of the, I think easiest, mechanics is just that if the CLO manager wants to buy workout loans or other loans, that would generally be prohibited. The solution is you can buy them, but you just need to use cashflow that would’ve otherwise gone to the equity. So that’s a win-win
for everybody because the equity wants to make that investment because it’ll
improve the loan recoveries and that benefits the debt investors in the stack
and doesn’t come out of their pocket. So I think that’s one workable solution
there for everybody.

John:

Absolutely. And we see that uniformly with these
supplemental reserve accounts, which are prior to the distributions to equity.
People having an ability to put money in there and use it to fund workout loans and the like. So I agree with you, very helpful. The other thing you see is, now with permitted uses and contributions, equity can also make a contribution. So it’d be on a date other than a payment date to acquire the equity securities.

Shiloh:

So then when indentures are coming together today, what do you see as top few negotiated items, items where maybe the AAA and the equity have different views, or maybe the manager and some of the investors have
different views? What are you seeing being highly negotiated in docs?

John:

It obviously varies a bit from the perspective of who’s making the request. A lot of times the AAA investors are going to be focused around consent rights to lots of different things in the documentation. There’ll be a lot of negotiation around when you have to go get controlling class consent. They may also be focused a little bit around some of the concentrations and some of the buckets. So it varies a bit. I think what’s been interesting is recently with the changes in Basel III and improved regulatory capital treatment at the AAA level where they reduced it from 20% to 15, we’re now seeing greater interest amongst bank investors. And that’s been interesting and
driven a lot of changes with loan classes and the like, and certainly been a
positive change for the market to have the banks come back at the AAA level.
The other thing we’re seeing a lot of focus on, at least at the moment, is it
seems like people are very, I wouldn’t say concerned, but focus on PIKing
assets and the treatment of PIK assets and how they impact various tests like
the overcollateralization tests. And if you have a PIKing asset that is paying
a certain coupon, making sure that that is not haircut for OC tests. So it
seems like a lot of clients the moment are a little bit nervous around assets
that may defer some interest.

Shiloh:

So a PIK loan is one in which the loan is not paying interest or partially not paying interest. So the interest that would’ve been paid is capitalized into the par balance of the loan, which is growing over time. So I guess the question there is for the purposes of the par tests or the OC tests, higher PIKed balance of the loan, or is it the initial balance of the loan? That’s what we use in that ratio, is that correct?

John:

Absolutely.

Shiloh:

So I guess the reason that it’s maybe a negotiated point. On the one hand, why wouldn’t you use the current par balance of the loan? That would make a lot of sense. On the other hand, the loan is PIK presumably because the borrower doesn’t have the capacity to pay in cash. So it’s probably a principal balance of a loan that might be more at risk than a different loan that’s just making its contractual interest and principal payments each quarter.

John:

That’s right. Another thing I think we’ve seen more of this year, or at least recently has been truly private credit CLOs. So private credit CLOs where there’s no offering circular, just a handful of investors negotiating with a manager originator. And that’s been interesting. Again, it just shows the interest level and a lot of times you have insurers buying the rated liabilities there, so there’s been an uptick of those types of transactions as well.

Shiloh:

Is there anything else interesting happening in the CLO world today?

John:

I would say the one other thing that’s been really fascinating, I mentioned all the creativity in the rated fund rated feeder space, that space not exist five years ago. And since then there have hundreds of transactions in that space, and I think we have 30 going on in some fashion at the moment at Dechert. So red hot space. Also an area where a lot of creativity going on the box is not as narrow because you’re not solving for CLO ratings methodology. They use closed end fund methodology and lower tranche attachment points. So there’s a lot of flexibility there. But the other area that has been interesting to me has been the growth of joint ventures. This is again on the private credit side, joint ventures between middle market originators, managers,
and banks. And again, if I look at it historically, I’d say, well, we had
historically done maybe one a year, one every two years.

Now we’ve seen, and you’ve seen in the press, a number announced of these joint ventures where basically you have banks who will originate private credit loans and source them to middle market originators. Sometimes the bank JV Partners will also provide back leverage to the private credit manager on that portfolio. Sometimes they set up a private credit vehicle jointly and invest into it. So there are all these different permutations there, but that area has been proliferating. And it’s an interesting thing too because if you look at what is the proper role of banks, banks have trouble holding lots of leverage loans in their balance sheet, but they can be great syndicators of credit and earn very rich sourcing fees in that process. So you have the banks dealing with this long-term secular issue of they can’t hold leveraged loans, and for the first time being creative and saying, well, we may not be able to hold them, but we can source them and earn these fees. And then you have these private credit managers who are able to utilize the boots on the ground that these banks have. So it’s a win-win situation, and that’ll be interesting as those loans eventually make their way into CLOs, but that’s been a development that is quite novel.

Shiloh:

Interesting. John, thanks for coming on the podcast. Really enjoyed our conversation.

John:

Absolutely, and thank you for inviting me.

Disclosure:

The content here is for informational purposes only and should not be taken as legal, business, tax, or investment advice or be used to evaluate any investment or security. This podcast is not directed at any investment or potential investors in any Flat Rock Global Fund.

Definition Section

AUM refers to assets under management.

LMT or liability management transactions are an out of
court modification of a company’s debt.

Layering refers to placing additional debt with a priority
above the first lien term loan.

The secured overnight financing rate, SOFR, is a broad
measure of the cost of borrowing cash overnight, collateralized by Treasury
securities.

The global financial crisis, GFC, was a period of extreme
stress in global financial markets and banking systems between mid-2007 and
early 2009.

Credit ratings are opinions about credit risk for long-term issues or instruments. The ratings lie on a spectrum ranging from the highest credit quality on one end to default or junk on the other. A AAA is the highest credit quality. A C or D, depending on the agency issuing the rating, is the lowest, or junk, quality.

Leveraged loans are corporate loans to companies that are not rated investment grade.

Broadly syndicated loans are underwritten by banks, rated by nationally recognized statistical ratings organizations and often traded by
market participants.

Middle market loans are usually underwritten by several lenders with the intention of holding the investment through its maturity.

Spread is the percentage difference in current yields ofvarious classes of fixed income securities versus Treasury bonds or another
benchmark bond measure.

A reset is a refinancing and extension of a CLO investment
period.

EBITDA is earnings before interest, taxes, depreciation, and amortization. An add back would attempt to adjust EBITDA for non-recurring items.

ETFs are exchange traded funds.

CMBS are commercial mortgage backed securities.

A BDC is a business development company.

Basel III is a regulatory framework for banks.

The source for middle market CLO issuance percent is JP Morgan CLO research.

General Disclaimer Section

References to interest rate moves are based on Bloomberg data. Any mentions of specific companies are for reference purposes only and are not meant to describe the investment merit of or potential or actual portfolio changes related to securities of those companies unless otherwise noted.

All discussions are based on US markets and US monetary and fiscal policies. Market forecasts and projections are based on current market conditions and are subject to change without notice. Projections should not be considered a guarantee. The views and opinions expressed by the Flat Rock Global speaker are those of the speaker as of the date of the broadcast and do not necessarily represent the views of the firm as a whole.

Any such views are subject to change at any time based upon market or other conditions, and Flat Rock Global disclaims any responsibility to update such views. This material is not intended to be relied upon as a forecast, research, or investment advice. It is not a recommendation, offer, or solicitation to buy or sell any securities or to adopt any investment strategy. Neither Flat Rock
Global nor the Flat Rock Global speaker can be responsible for any direct or
incidental loss incurred by applying any of the information offered. None of
the information provided should be regarded as a suggestion to engage in or
refrain from any investment-related course of action as neither Flat Rock
Global nor its affiliates are undertaking to provide impartial investment
advice, act as an impartial advisor, or give advice in a fiduciary capacity.
Additional information about this podcast along with an edited transcript may
be obtained by visiting flatrockglobal.com.

Shiloh:

Hi,
I’m Shiloh Bates and welcome to the CLO Investor podcast. CLO stands for
collateralized loan obligations, which are securities backed by pools of
leveraged loans. In this podcast, we discuss current news in the CLO industry,
and I interview key market players. Today I’m speaking with Allan Schmitt, the Head CLO Banker at Wells Fargo. Allan has structured many of the CLOs I’ve invested in, and at my prior firm, Allan was part of the team that provided our business development company, an asset-based lending facility, or ABL, and ABL is just leveraged against a pool of leveraged loans. As you’ll hear during the podcast, Wells is active both in lending against diversified portfolios of loans and arranging their securitizations through the CLO market. I asked Allan to come on the podcast to discuss rated feeders, which are a new flavor of CLO that is growing in popularity. If you’re enjoying the podcast, please remember to Share, Like, and Follow. And now my conversation with Allan Schmidt. Allan, welcome to the podcast.

Allan:

Thanks, Shiloh. Excited to be here.

Shiloh:

Is it a pretty slow August on the CLO banking desk?

Allan:

I think most people might wish it was, but it’s definitely
been an interesting summer across the board. I think we’ve seen, obviously with
CLO spreads tightening, really across the balance of the year, has created
really an overwhelming number of reset and refinance transactions for the
market. So not only Wells, but across the board, you’re seeing 10, 15 deals a
week come across the transom. So I think everywhere from the investor side, as
I’m sure you’re aware, to the underwriter side, to the manager side, to the
lawyers, the rating agencies, I think everyone is really working through the
screws to get transactions through the pipelines here in August. So…

Shiloh:

It definitely seems that way. We’ve known each other for
quite some time. And maybe you could tell our listeners a little bit about your
background and how somebody becomes a CLO banker.

Allan:

Sure. So I’ve fortunately been in the industry around CLOs
my entire career, which dates back to 2006. So started right before the global
financial crisis. Certainly as an analyst at that time, it was an interesting
period to really begin to get involved in the market and certainly had a front
row seat to a lot of the activity that was happening at that time. My entire
career has been with Wells and predecessor firms, so I’ve been fortunate from
that perspective and as we moved out of the global financial crisis, was able
to be really on the front lines as well as we built the business at Wells
around private credit lending, around CLOs, and really was instrumental in
terms of growing my knowledge base, growing both internal and external
relationships during that period. So obviously where I sit today in my current
role, lead both our CLO effort across both broadly syndicated and middle market
CLOs as well as our private credit lending business there. And as we’ll talk
about more recently expanded our offering underrated feeders as just an adjunct
to what we’re able to do for our private credit clients. So obviously a
longstanding period of time here in CLOs, but excited about it.

Shiloh:

So what are some of the key character traits of somebody
who’s successful in CLO banking?

Allan:

So I think it’s a number of things. I think first and
foremost it’s being a relationship manager, so someone that’s communicative
both to internal counterparties, but even more importantly to clients and
investors like yourself, folks that have the ability to think dynamically on
their feet. CLOs are not an overly complex structure, but they do require the
ability to put pieces together both from a structure perspective but also the
different constituents, both equity manager investors. And so being able to
play that process effectively and walk out of transactions where everybody
feels it was successful I think is a key piece. So someone who can manage that
process and communicate effectively is critical and certainly is depending on
where we’re hiring people as folks move up the ladder, really being able to
develop and institutionalize a lot of the client relationships that we have in
the market.

Shiloh:

And then for the junior people you hire, are they spending
a lot of their time doing financial models? So accuracy is the key
differentiator there?

Allan:

Yeah, I think attention to detail, right, to your point,
and being able to both be intellectual around structure, documentation, et
cetera is obviously critical. Obviously it’s a learning curve that folks have
and folks get into, but someone that has that ability to grasp both the legal
and structural aspects of the business quickly, and obviously having that
strong attention to detail, is obviously important as well.

Shiloh:

And so as you become more senior in the CLO business, is
somebody like you still in the weeds with the modeling or are you reviewing at
a high level the work that’s done by others?

Allan:

I spend a lot of my time, I think on the client
development side of things, the more strategic side, whether that’s when we’re
bringing a CLO transaction, helping to formulate the distribution process, the
distribution strategy, certainly on the structuring side as well, helping to
provide ideas and thoughts around different structural nuances or things we can
focus on within specific transactions. So while not in the weeds punching
numbers necessarily, certainly maintaining a pulse on what’s happening in the
market and how we can create better structures for our clients to optimize from
an ultimate execution perspective.

Shiloh:

So I think there’s around 15 or so different CLO banks out
there. How is Wells differentiated from some of the others?

Allan:

There’s certainly a lot of players in the market around
syndicated CLOs and even becoming more around middle market CLOs. I think from
our seat, we try to differentiate ourselves a couple ways. One, I alluded to
the bAllance sheet that Wells provides into the private credit space, and I
think that has an extension into the broad syndicated market as well. And it’s
not just about providing bAllance sheet, but it’s providing that capital in a
way that is beneficial to client and can help drive business for the platform
holistically. But it’s also around providing bAllance sheet on a consistent
basis. I think what I mean by that is our approach to lending over the course
of the last 15 to 20 years has not changed materially. I think we’ve always
been an active participant or a leading participant in the private credit
space. So our clients have confidence, have an understanding in terms of how we
approach the market.

So that consistency, we obviously want to adapt and evolve
as the market evolves, but our ability to maintain consistency across different
markets, whether it’s volatility, as we saw earlier this week or what have you,
we’re able to consistently provide that capital to clients both in a strategic
and customizable way. I think the other is, it sounds simple, but from a
customer service perspective, the relationship management perspective, our
ability to help clients on the financing side for a lot of their funds from
start to finish is critically important. When we think about a lot of the funds
that have been raised, they need multiple forms of financing, whether that’s
traditional ABL financing, CLO financing.

Shiloh:

An ABL is an asset backed loan.

Allan:

That’s right. Wells is providing the senior financing on a
pool of loans, so substituting a CLO, AAA, AA for a bank, ABL financing.

Shiloh:

So there the point you’re making is that Wells actually
likes to lend against these loans, so you’re going to require some third party
equity obviously, but maybe before there’s ACL O, there’s a warehouse set up
where somebody again puts up some equity and wells starts advancing the debt
there and maybe there’s a CLO takeout at some point or maybe there’s not. And
either way, Wells likes to take the senior risk, if you will, against a pool of
senior secured loans. Is that how to think about it?

Allan:

That’s exactly right. When we think about our client base,
a lot of the financing to private credit is not necessarily in CLOs, it’s in
that ABL structure or that bank financing structure. And so we’re able, and we
like that product, we like that lending, its core to what we do as a business
and a platform. So we’re able to provide that to clients, but we’re also able
to facilitate and think about strategically the execution of CLOs for clients
as well. So all of that from a relationship management perspective, all of that
sits within our team. So we have the ability to really provide clients with
ideas and thoughts around the best form of financing for their funds.

Shiloh:

At a previous firm, as you know, I was the counterparty to
a Wells line of credit where Wells was lending against a diversified portfolio
of middle market loans, and I think generally an advance rate of 65 or 70%. Do
you have any sense for why it is that that business works for a bank like Wells
and other firms may not find that business to be as appealing?

Allan:

I think it’s interesting. I think we’ve seen other
institutions I’d say come around or become more active and engaged in that
senior lending there. So I think when your question on how does Wells
differentiate, we differentiate because we have consistency and a long-term
process around that business. But I think other banks and institutions are
active in it, are growing in it, and it’s becoming a more competitive space
there.

Shiloh:

So one of the things I’ve noticed in the CLO equity trade
is that before the CLO begins its life, often there’s this warehouse period
where some equity is contributed and loans are acquired using leverage from a
bank and at other banks, that warehouse is really something they’re providing,
really they want it to be as short as possible. They don’t really like the
risk, they want you to be in a warehouse for a couple months, then they’re
ready to do a CLO and then they earn a fee, the bank does. And then there’s no
real exposure to the CLO after that. In some of the warehouses I’ve done with
you guys in the past, the vibe is you put up equity, Wells like lending against
the loans as a senior lender, and we can do a CLO takeout soon or later or
maybe never. And it seems you guys are fine with that, which I think is
different from some of the other shops.

Allan:

I think it certainly obviously depends on the situation
and the structure of the motivation, if you will, of that vehicle at the
outset. But to your point, we are able to be patient. Again, we approach it
very much from a client relationship type perspective and want to find the best
takeout and the best long-term structure for the client. I think we certainly
want to do CLOs, we certainly want to earn fees on the backend, but in certain
structures we’re not here to force the takeout and want to develop partnerships
for the long-term. And I think we’ve done that over the years and you can see
that obviously in some of the repeat managers that we partner with, but
definitely take a longer term view of that warehouse to take out than some
others.

Shiloh:

So then in the CLO market, the three biggest categories
for CLOs would be European versus US, and then, in the US, and by the way, we
don’t do anything in Europe. And then domestically it’s broadly syndicated CLOs
and middle market are the big two. Could you maybe just compare and contrast a
little bit the structural differences between the two and then from there maybe
we could build into the rated feeders as well?

Allan:

Definitely, and I think when you think about those two
markets, probably syndicated and middle market CLOs, at this point, there’s not
a lot of structural differences between them. You certainly have similar rated
notes, you have similar reinvestment periods. BSL might be five years, middle
market might be four years, albeit there are middle market CLOs now getting
done with five years. I think the bigger difference really when you think about
the two markets is the underlying motivations for transactions. So middle
market CLOs are used typically by managers in most senses as financing vehicles
for larger fund complexes. We talked about the ABL business that Wells does and
others do, which is a big form of financing for these larger fund structures.
And CLOs are another form of financing. So where broadly syndicated CLOs are
going to be much more of a true arbitrage structure, where the manager is
partnering with equity and are going out and buying loans in the secondary
market, buying loans in the primary market from large institutional banks. The
middle market is much more of a longer term financing vehicle where they’re
originating assets on a direct basis over a long period of time and turning
those assets out. So the motivation that you see between the two is probably
the biggest difference there.

Shiloh:

So in your terminology, an arbitrage CLO is one where
there’s a third party equity investor who’s signing up, likes the risk return
profile of the investment, and that’s who the end investor is there. And then
for middle market, a lot of times it’s a financing trade. So by that there may
be a BDC or a GPLP fund with a diversified portfolio of loans and it’s
advantageous to them to seek leverage against that because it’s long-term
leverage done at attractive rates and that enables the BDC or GPLP fund to increase
their return on equity. But in a structure like that, the equity is owned a
hundred percent by the BDC or the fund. There’s no third party equity, there’s
no Flat Rocks involved in that case.

Allan:

That’s right, and I think that’s also when you think about
one of the bigger differences between the two BSL and middle market CLOs, BSL
is typically always going to issue down through double B rated notes or all the
way through equity and middle market Cs because of that financing structure for
BDC or a fund, they may only issue down through AA or single A because the
leverage profile of those vehicles or how much leverage those vehicles are able
to run is meaningfully less. So that’s why a lot of times you won’t see
mezzanine or non-investment grade tranches issued for middle market CLOs.

Shiloh:

So the broadly syndicated CLO might be levered, was it 10
times on average, where the middle market might be leveraged seven and a half
times. So less leverage there. And then the CCC basket is another big
differentiator. In broadly syndicated, you get a seven a half percent triple
CCC bucket. In middle market, you get 17 point a half on average. Of course
there are some differences in deals and that gives the manager more flexibility
because the middle market loans tend to not be as favorably rated by Moody’s or
S & P. And then you pointed out the middle market CLO might have a four
year reinvestment period, so a little shorter than the five years you get in
broadly syndicated. I think those are the key differences. Another minor one
would just be reinvesting after the reinvestment period ends. So in broadly
syndicated CLOs, whenever you get unscheduled principal proceeds, whenever
those come back to you, which is most loan repayments are unscheduled anyways,
then a lot of times you can reinvest that, subject to some constraints in the
deals. Whereas for middle market, actually the reinvestment period ends. It’s
very simple. There’s no more reinvesting. It sounds like a subtle difference,
but I think it does actually matter in terms of how long the deal will be
outstanding for and it matters for equity returns. I think. If you think about
the aaa, which is the biggest financing cost and broadly syndicated, the loan
to value through AAA is going to be about 65% would you say, or

Allan:

62 to 65%

Shiloh:

62 to 65. And then for middle market it’s going to be

Allan:

55 to 58.

Shiloh:

So it sounds like you get a lot more equity or juniorcapital in the middle market. And then in terms of your banking team, you havea middle market team and a broadly syndicated team, or these are similarproducts and everybody works on the different deals?

Allan:

As we’ve talked about, there’s similar enough products where we generically have everybody working on similar deals. We do have some senior members of the team more from a relationship perspective that are specialized in either BSL or middle market as they think about developing client relationships and whatnot. But from a structuring deal execution
perspective, we view there to be enough similarities between the products and certainly from an investor perspective as we think about distribution of the products, that there’s enough similarity where the same individuals are able to function there.

Shiloh:

And then one of the reasons I wanted to have you on the podcast this week was just to talk about rated feeders a little bit. So that’s a new flavor of CLO in the market. What are the basics of a rated feeder?

Allan:

So a rated feeder is a structured credit vehicle where, as opposed to being secured by underlying assets directly, as a CLO would, you’re secured by the LP interest of a private credit fund. And that private credit fund can really be of any type. It can be direct lending, it can be asset-based lending. It can be all sorts of different types of private credit assets, but for the most part, most of them have been done off of middle market direct lending assets. The structure has been utilized for many years. As you think about insurance companies who want to make investments in private credit funds, they’re able to do so through a rated feeder structure in a more capital-efficient way. So again, the underlying asset that is getting levered or is getting tranched out is an LP interest of a private credit fund. So when you think about that GPLP structure, LP fund where you have multiple different institutional investors making LP commitments, some of them might be insurance companies that want to gain access to that fund.

So for them to do that through a rated feeder structure, they’re able to do so in a more capital efficient way. And the reason for that is the leverage profile of a lot of these funds, as we talked about earlier, is only one or two times leverage. So they’re run at fairly low leverage points. And so while the rating agencies are able to get comfortable by tranching out that LP interest and adding incremental rating levels to that for any investor, but predominantly insurance companies to receive incremental capital efficiency there. So historically to this point or to recently, insurance companies have bought vertical strips as we call them, buying a AA, single A, triple B in equity of that rated feeder. And so they’re buying the entire portion for that capital efficiency. But most recently we’ve really thought about that structure on a more horizontal basis, which is more akin to middle market CLOs where we’re using that same radium methodology that insurance have used in trying that out, but selling that to different investors at different risk return profiles there. So instead of one investor buying it all, we might be selling AA, single A to different investors.

Shiloh:

So I think the structural setup here is, imagine your rated feeder, let’s call it 300 million, and let’s say the underlying fund is BDC just to make it simple. Then the rated feeder takes the 300 million that it raises from third parties, it injects that into the BDC, and the BDC over time will pay dividends up to the rated feeder in the dividends on the 300 million that arrived at the BDC. But in the rated feeder structure, as those dividends get passed up to their rated feeder, instead of having all the dividends just paid out rata to the 300 million of equity, instead the setup is the tranching that you mentioned, where first there’s a AAA or AA or whatever it is, they have the first priority on the dividends from the BDC down the line, and then there’s an equity investor and the rated feeder as well, and they’re the person who gets paid whatever remains.

So again, the total income into the rated feeder is the distribution from the BDC, and it just split up, senior to junior, with equity taking the remainder. One of the reasons these exist, I think to your point, is that if you’re an insurance company, you’re basically investing 300 million into the BDC. So the insurance company can either end up with a $300 million limited partnership agreement or LP investment in a BDC, or they can end up with 300 million of investments in a series of securities rated AAA or AA, whatever it is down the line to double B, and they’ll get just much more favorable regulatory treatment for that. So if you’re an insurance company, you don’t want to own a lot of equity, you want to own as many senior rated securities as you can.

Allan:

That’s exactly right. When you think about the rated feeder, especially to your point on the waterfall and how cash is distributed, it doesn’t look that dissimilar than any other structured vehicle where cash is being distributed down through the priority of payments or through the different ratings to the equity at the bottom. I think the difference obviously is there’s effectively one asset. So one LP interest to the fund is distributing that cash into the vehicle that’s getting distributed versus a CLO that might have a hundred unique assets where the cash is coming in. So the investors are really one step removed from the assets than they would be in a middle market CLO. But you have as an lp, as the rated feeder acts as an individual LP of the fund, it has the same rights that any other LP would have in terms of access to the assets.

Shiloh:

So then I understand the rationale for why an insurance company would want to use this structure, but are you also seeing interest from other investors that don’t have regulatory capital that would care about a Moody’s or an S & P rating?

Allan:

Certainly. So obviously the insurance company has been the predominant of the product there, but we have seen an expansion of that beyond insurance companies, not so much as to where they’re focused on capital charge
treatment, but investors are more focused on where they can find increased
spread or increased return really within the same asset class. So the ability
for banks or asset managers or hedge funds or different CLO investors, the
ability for them to buy a more structured complex vehicle is going to come with it a higher spread or a higher return. So we have seen a lot of investors,
we’ve seen spread compression across markets, look at rated feeder notes and look at these structures as another way to really gain access to the asset
class where there’s the ability to garner incremental spread through that level
of complexity through that level of illiquidity there. So we’ve obviously done
a few of these to date and have probably seen the investor base on each
subsequent one continue to grow and broaden and are seeing broad interests and growth there.

Shiloh:

So the most senior securities that are issued by the rated feeder, are they actually rated AAA or is it more of AA, single A, because you are, as you said, one step removed from the assets?

Allan:

So the most senior tranche in rated feeders is really AA. Most of them are either that single A or AA is the most senior rating. It’s certainly because of the one step removed from the assets. The other piece is the fund that sits above the rated feeder is also running leverage. So there’s leverage at that fund level, usually in the form of a bank ABL as we talked about. It could be in the form of CLO tranche, it could be in some other unsecured debt tranche, but there is some form of leverage typically at the fund level that sits above the rated feeder. So that’s another reason why obviously, from a rated entity perspective, they factor that fund level leverage into the rating as well.

Shiloh:

So then let’s just compare for a second, owning the AA of middle market CLO versus the AA of the rated feeder. So in the rated feeder, you do have this ABL sitting at the fund or the BDC level that has first priority or that’s in the first security position. If you’re sitting at the rated feeder, all the management fees and incentive fees that are paid to the manager of the BDC, those are taken out before any distributions are sent up to the rated feeder. So essentially those become senior to you even if you’re AA, whereas in the typical middle market aa, the only expenses you have ahead of you would be AAA interest and a senior management fee. Maybe there’s a little bit of other operating expenses, but it wouldn’t be material. So that rated feeder AA is removed from the assets, has an ABL in front of it, but also the management and incentive fees of the fund take priority as well.

Allan:

That’s exactly right. I think the biggest difference there though is the attachment or the leverage point of the ABL of that senior debt to the rated feeder. So to our earlier conversation on comparing middle market CLOs, when you look at the attachment of a AAA on the middle market, CLO, that’s all the way down to 55 to 58% advance rate. A lot of the rated feeders, certainly on the AA side that are being issued, the senior debt or the ABL is
only the 40 to 50% attachment. So you’re adding incremental subordination
through that senior ABL to the rated feeder to make up or offset some of those incremental expenses and fees that you alluded to.

Shiloh:

So I elicit the cons of the rated feed feeder AA, but the amount of junior capital that supports that is much higher than in the CLO. At the end of the day, they’re both rated AA, so presumably they would’ve the same credit quality.

Allan:

That’s the idea. And I think there’s obviously going to be pros and cons of each, but I think to your point, one of the biggest pros is the added subordination that exists for the rated feeder notes. In comparison to middle market CLOs.

Shiloh:

Let’s maybe just also compare owning middle market equity directly versus owning it in the rated feeder. What are some of the key structural differences there?

Allan:

So I think some of the key differences when you think about rated feeders to middle market CLOs is I like to think about rated feeders, really, they combine both the warehouse period for a middle market CLO and the term securitization. So when you think about a middle market CLO, as we
talked about, there’s a warehouse period that exists that equity has to come
into, the manager has to originate assets and you’re ramping assets over an
extended period of time, and then ultimately waiting for the securitization or
the long-term financing structure of that pool of loans or what’s the most
optimal time to do that. On the rated feeder side, it really combines both of
that warehouse structure as well as the term structure into one. And it does
that obviously through the fact that the notes are issued in delayed draw form. So the senior notes integrated feeder are typically done in delayed draw
fashion. So that allows the portfolio of the fund to be ramped up on a consistent basis, but also being able to draw that leverage as assets are contributed, whereas a middle market CLO is going to be fully funded or fully drawn day one. So that’s I think one of the bigger difference. The other is when you think about middle market assets, there’s a large delayed draw and revolver component that comes alongside those assets, whether those are being contributed to the fund or a middle market CLO, the manager has to find solutions for those. And in a middle market CLO, you’ll typically find

portfolios anywhere from five to 10% in delayed draws and revolvers, and that’s a drag to equity at the end of the day. In terms of having to cash
collateralize a portion of those assets in the vehicle. With the rated feeder,
you’re going to have a similar delayed draw and revolver component to the
portfolios. But the ABL line, the bank ABL line that we’ve talked about
functions as a revolver, so it’s more of an optimal solution to fund those
assets. So there’s going to be less negative drag or less negative carry on the
fund and ultimately the rate of feeder than there would be in a middle market
CLO.

Shiloh:

One other structural difference that we haven’t really talked about is just that in the middle market CLO, it’s almost exclusively firstly in senior secured loans. So the spreads are going to vary a little bit, but it’s three months sofa plus five to five and three quarters on the high end, whereas in the rated feeder, the underlying BDC or fund might be something more like 85% first lien, and then there’ll be a fair amount of second lien or pref or some other funky stuff there. The asset pools do look a little bit different.

Allan:

For sure, the rated feeder depending on the fund, but most of the funds that are utilizing the structure, there’s a lot more asset flexibility associated with it. So there’s the ability not only at the outset, at the original ramp, to be opportunistic in certain maybe non-first lien assets or recurring revenue, which are a big part of a lot of direct lenders. Today is obviously a key differential where middle market CLOs you’re required to be 95% first lien highly diversified. You have obviously collateral quality tests or other items that the managers have to manage too. So there is a lot more asset flexibility that’s allowable in rated feeders, and I think that’s at the outset, but also as the portfolio evolves and as there’s market dislocation, managers have slightly more ability to take advantage of that asset flexibility over time.

Shiloh:

So then moving back to we were comparing and contrasting
the middle market AA and the rated feeder AA, which should offer a higher
return, in your opinion?

Allan:

The rated feeder AA should offer more return to the investors for a couple of reasons. One, there is more structural complexity associated with it, and that’s in the form of obviously the delay draw that we’ve talked about. The investors have to bear the delay draw component of those structures, and with that, the notes have to be issued in physical form. So there’s some operational burden on investors there.

Disclosure:

Note physical form means the notes are not owned electronically. Rather a notarized paper is evidence of ownership.

Allan:

There’s obviously the asset flexibility point that we talked about as well, which is a little differentiated, but then there’s the liquidity point. I think middle market CLOs have established themselves as a fairly liquid asset class at this point. They made up about 25% of the overall CLO market last year. So the acceptance of that structure across the board for investors has been broad. We’ve seen the spread basis between middle market and broadly syndicated tighten over the past 12 to 24 months. So I’d say a lot of the juice or a lot of the incremental spread for investors has come out of that. So rated feeders are a way for investors to gain some incremental spread with some of those trade-offs around liquidity, complexity, et cetera. But we obviously touched on some of the pros, the parts of ordination that we talked about being obviously a key benefit. There’s also typically a longer on-call period associated with the rated feeders, and so there are some obviously structural positives away from just the spread component that investors obviously consider and take into account.

Shiloh:

So then if we are talking about CLO equity versus rated feeder equity, would a lot of your points from the AA be relevant there where it’s a newer structure, people need to do work on it and understand it and are asking for a premium or asking to get paid a little more for doing the work, but at the same time, you’re less levered through the rated feeder?

Allan:

Yes, you are less levered through the rated feeder.

Shiloh:

So from the perspective of equity, maybe the returns model out the same because the equity investor needs to do some work, understand a new structure, but on the other hand, there’s less leverage in the rated feeder
and then maybe another con or pro, depending on how you look at it, would just be that the asset quality of the underlying loans might be different from the 95% first lien that you mentioned.

Allan:

That’s right. I think one of the key differences we touched on is obviously there’s more asset flexibility, and I think over the life of these vehicles while CLO, you’re constrained in 95% first lien, the asset flexibility given into the rated feeders over the course of a four year reinvestment period. I think there’s a lot of optionality that exists for rated feeder equity there. So I think managers have the ability to take advantage of market dislocations, of market changes, opportunities like we talked about in second liens or recurring revenue, that might come up over the course of that period that managers would not necessarily have in a more structured middle market CLO. So certainly I think the less leverage is critical, but I think one of the bigger, more interesting dynamics that we haven’t necessarily seen totally play out yet is that asset flexibility and how managers are able to leverage that to the equity’s benefit over the life of the deal.

Shiloh:

Maybe I missed it or not fully understanding, but when you say asset flexibility, you’re talking about the ability to have more second liens or other funky stuff,

Allan:

The ability to have more non-first lien assets. I won’t use funky assets, but more differentiated assets because I think one big aspect of the market is you think about second liens, there are periods of time where second liens are not that attractive or not that in vogue for managers, but there’s other times where there’s a lot of opportunity in that part of the market to pick up incremental spread for pretty attractive assets. And the same goes for recurring revenue. There’s going to be periods of time where there’s a lot of opportunity to do that in periods of time that there’s not. So the asset flexibility or the ability for the manager to really pick their spots across different parts of the market is more available on the rated feeder side.

Shiloh:

And then one last question is just should the market
expect to see a lot of new rated feeders? Is this a structure that’s going to
gain in popularity over time?

Allan:

We certainly think so. We’ve put obviously a lot of resources into the market. You’ve seen there be a slow start to the issuance of rated feeders, but I think certainly as the market develops, as the investor base continues to grow, as the process for execution of rated feeders becomes more streamlined, I think there’s definitely the anticipation that there will be incremental issuance of the product. It’s not that dissimilar to middle market CLOs 20 years ago when there was only a handful issued annually, and that’s obviously grown. I think this is a market that has the ability to really grow, maybe not to that scale, but certainly to become a large part of the overall private credit financing market over the next few years.

Shiloh:

Great. Well, Allan, thanks for coming on the podcast.
Really appreciate it.

Allan:

Thanks, Shiloh. Thanks for having me.

Disclosure:

The content here is for informational purposes only and should not be taken as legal, business, tax, or investment advice or be used to evaluate any investment or security. This podcast is not directed at any investment or potential investors in any Flat Rock Global Fund.

Definition Section

AUM refers to assets under management

LMT or liability management transactions are an out of court modification of a company’s debt

Layering refers to placing additional debt with a priority above the first lien term loan.

The secured overnight financing rate, SOFR, is a broad measure of the cost of borrowing cash overnight, collateralized by treasury securities.

The global financial crisis, GFC, was a period of extreme stress in global financial markets and banking systems between mid 2007 and
early 2009.

Credit ratings are opinions about credit risk for long-term issues or instruments. The ratings lie on a spectrum ranging from the highest credit quality on one end to default or junk on the other. A AAA is the highest credit quality. A C or D, depending on the agency issuing the rating is the lowest or junk quality.

Leveraged loans are corporate loans to companies that are not rated investment grade

Broadly syndicated loans are underwritten by banks, rated by nationally recognized statistical ratings organizations and often traded by
market participants.

Middle market loans are usually underwritten by several lenders with the intention of holding the investment through its maturity

Spread is the percentage difference in current yields of various classes of fixed income securities versus treasury bonds or another benchmark bond measure.

A reset is a refinancing and extension of A CLO investment.

EBITDA is earnings before interest, taxes, depreciation,
and amortization. An add back would attempt to adjust EBITDA for non-recurring items.

General Disclaimer Section

References to interest rate moves are based on Bloomberg
data. Any mentions of specific companies are for reference purposes only and
are not meant to describe the investment merit of or potential or actual
portfolio changes related to securities of those companies unless otherwise
noted.

All discussions are based on US markets and US monetary and fiscal policies. Market forecasts and projections are based on current market conditions and are subject to change without notice. Projections should not be considered a guarantee. The views and opinions expressed by the Flat Rock global speaker are those of the speaker as of the date of the broadcast and do not necessarily represent the views of the firm as a whole.

Any such views are subject to change at any time based upon market or other conditions, and Flat Rock Global disclaims any responsibility to update such views. This material is not intended to be relied upon as a forecast, research, or investment advice. It is not a recommendation offer or solicitation to buy or sell any securities or to adopt any investment strategy. Neither Flat Rock
Global nor the Flat Rock Global speaker can be responsible for any direct or
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Shiloh:

Hi, I’m Shiloh Bates and welcome to the CLO Investor Podcast. CLO stands for Collateralized Loan Obligations, which are securities backed by pools of leveraged loans. In this podcast, we discuss current news in the CLO industry, and I interview key market players. Today I’m speaking with Drew Sweeney, the broadly syndicated CLO portfolio manager at TCW. In a previous life, Drew and I went to rival high schools in Arlington, Virginia, and we worked together as credit analysts at Four Corners Capital. Now Flat Rock invests in some of the CLOs that he manages. I asked Drew to come on the podcast to discuss his perspective on the quality of loan documentation in the broadly syndicated loan market, and to discuss examples of when loan investors were not as senior and secured as they might’ve liked to be. It’s a bit of a technical podcast, but that’s the only way to adequately treat the subject. If you are enjoying the podcast, please remember to share, like, and follow. And now my conversation with Drew Sweeney.

Drew, thanks so much for coming on the podcast.

Drew:

Thanks for having me. It’s good to be here.

Shiloh:

So I’d like to start off the podcast by just asking your background story and how you became a CLO manager.

Drew:

Well, as you know, many, many years ago we worked together in investment banking and I was syndicating bank loans at the time, and I liked the idea of being an investor as opposed to a banker. So I moved from First Union, which was a bank many years ago to the buy side and began working there. And we worked together again at a place called Four Corners, which I focused on managing bank loans in market value CLOs, and some closed-end funds, and a variety other products. And then just my path led me eventually to TCW, but I think it’s the natural progression of do you like to be an investor?

And then the most common vehicle with investing in loans are CLOs. And so it’s just a natural pairing.

Shiloh:

And what do you find interesting about bank loans in particular?

Drew:

I like bank loans because they’re not always efficient. So you can outwork competitors, you can meet with management teams on a regular basis. You can apply a level of discipline to and process. And over years, I’ve been doing this over 25 years. When you apply a level of discipline and a process, you can just see what works and doesn’t then you iterate on that. But I like investing in general and then you combine that with the inefficiencies of the bank loan market and I think it makes for great opportunity.

Shiloh:

So I think the attraction for me in coming over from the investment banking side was that in investment banking you work on a lot of deals that never really come to fruition, and that can be quite frustrating.

Whereas on the buy side, if you’re investing in bank loans, there’s in an active market, you’re a credit analyst, you cover an industry or two, and a lot of times there’s just a lot of activity. So you work on a loan opportunity, you might want to do it or not, but even if you don’t, it’s good to understand more of the companies in your space. So I just felt the amount of work that you do versus the product and how interesting it is really skewed very favorably to working on the buy side.

Drew:

Yeah, makes sense. It’s been a long time since I’ve been in banking, but you’re right, the number of deals that do not go through that you spend your weekend modeling is remarkable.

Shiloh:

Now you’re at TCW. Why don’t you tell us a little bit about the loan platform in particular?

Drew:

We have roughly six and a half billion dollars of loan AUM today. We manage 12 CLOs as part of that. And I think the idea of TCW Bank loans is really, we are a bank loan team that is sitting in a very large asset manager and we try to leverage all the things about being a large asset manager and get the benefits of being something more nimble. On the bank loan side, I think we offer a pretty differentiated product. There are three or four things that distinguish us from others. We have an integrated bank loan team, which means basically our analysts are looking at bank loans, high yield and investment grade. And simply put, we always say competition doesn’t stop at capital structure. So if you’re in technology or if you’re in telecom or if you’re in cable or a variety of industries and you’re only looking at non-investment grade borrowers, you don’t really know where CapEx dollars are coming from, or trends, and you really don’t know all your competitors.

And then outside of that, I think we’ve built, probably from investing in the product, one of the most robust databases that exist. We have information on roughly 850 loan borrowers in the loan universe. And if you think about the CS index, that was 1600 borrowers.

Shiloh:

So that’s the Credit Suisse loan index.

Drew:

Yes. And then if you say of those 1600, maybe 1200 are liquid, and we have three quarters of those mapped. So not only do we see how our borrowers perform each quarter, then we see how the borrowers’ competitors perform each quarter. And it allows us to use these as building blocks in exchange. If our chemical companies are doing not what we think and these chemical companies are, we can swap.

Shiloh:

If it’s a private market though, how are you tracking loans that you aren’t participating in in the primary?

Drew:

This is what it gets back to the disciplined and outworking competitors.

We have a whole team of research associates that work along with the senior analysts and they spend a lot of time getting access, keeping access, and adding that information on a quarterly basis basis.

Shiloh:

Interesting. So the theme for today’s podcast is weak loan documentation. So the idea of being a first lien lender is that in a bankruptcy, if the business doesn’t perform as expected, if you end up in a bankruptcy, I think it happens to about 3% of borrowers each year. But in the restructuring process as a first lien lender, you’re secured by all the collateral and you’re first in line for any proceeds. So that’s conceptually how a restructuring should work. But I guess what actually happens in reality doesn’t always conform to the description I just gave. Once you make a first lien loan, some things should be prohibited. So one is the payment of dividends to the company’s owners.

The first lien lenders are not signing up for that. Again, they want to be first in line. They’d rather see that cash go to repay the loan. In most cases, you’re secured by the collateral of the company. So you want to make sure that none of that collateral can leak away from you over time or through malfeasance by the owner. So then one exception though is if you do end up in a bankruptcy, oftentimes there’s a debtor in possession loan. So that comes in when the company is out of cash and somebody’s got to put up some additional dollars so that the company can pay its workforce, for example. And then in that case, the debtor end possession financing does come in senior to the first lien term loan. When you’re committing to a new loan in the primary market, it’s the sketch, if you will, of how the loan documentation is going to read.

That comes from the term sheet. We’ll see a term sheet first. And then what’s some of the important things that you would look for in the term sheet?

Drew:

You’re looking at all the basics of what you would expect or the price talk would be, what the maturity is, what your assets, so what the collateral is, and then whether or not what’s permitted in terms of repayment of debt for IPO proceeds, what’s permitted for dividends, whether or not any bonds or loans mature inside your borrower. So you’re going through a checklist of things to make sure that in essence, exactly what you described, a first lien senior secured loan is in actuality a first lien senior secured loan. Who the borrower is too, whether it’s at the Op-co or the Hold-Co, is something else you’ll see in the term sheet.

Shiloh:

So a company may have a number of different subsidiaries in your terminology.

The Op-co actually does have some business operations that it’s doing. And then the holding company in the organizational chart, that’s just basically the owner of the different op-cos. So then the idea of the first lien loan is that all the subsidiaries, all the different parts of a company, are borrowers under the credit agreement. There’s different assets of the different subsidiaries. The idea anyway is that all of that is pledged as collateral for the first lien loan.

Drew:

That’s the idea. And in reality, back from my days in investment banking, one of the first things I was taught is you want to be as close to the assets as you can, so as close to the collateral as you can. So in a perfect world, there’s one op-co and you’re lending against that. That’s not in reality what a company with 300 million to $2 billion of EBITDA has.

The org chart’s much more complicated than that. You want to have as many of those subsidiaries as your guarantors of the loan, and then you want to make sure that the subsidiaries stay your guarantor.

Shiloh:

So what are some reasons that a subsidiary would not be a party to the credit agreement?

Drew:

Some of those borrowers aren’t part of our guarantor package just because sponsors or the companies feel they don’t need to do that to get the loan done. So there’s some optionality in it. There’s some tax consequence to it when it comes to foreign subs. And then there’s some just natural evolution where there are times when the loan market is easily accessible and there are times when the loan market is not. So a company might do an acquisition in 2018 and follow that up with another acquisition in 2021, but they don’t want to pay down the debt of the 2018 facility.

So they might finance that separately, and it might be part of our box, but not our explicit guarantor. So there’s a variety of reasons it ends up there.

Shiloh:

But the general idea is that the material subsidiaries are guarantors of the term loan. So something foreign subsidiaries, like you mentioned, may not be guarantors. Maybe they’ve pledged their equity but are not specific guarantor. Maybe a subsidiary with an immaterial amount of revenue or EBITDA could also not be pledged. Maybe they just didn’t want to go through the hassle or the paperwork to do that. So some of these subsidiaries just end up outside of the borrower group and are not considered guarantors of the first lien loan.

Drew:

That’s right. And the last item you mentioned is something that happens quite a bit, I think in certain segments more than others, but some businesses will have an immaterial amount of EBITDA and it won’t be required that they’re pledged as a guarantor, that those assets are part of our collateral.

And in technology, those may be the fastest growing assets. So they may not be at the time you do the loan, but three years from now it could be driving the business. So there’s always that risk.

Shiloh:

Then what’s the difference between a subsidiary that’s a guarantor of the loan versus an unrestricted subsidiary?

Drew:

So we have a guarantor that is a guarantor in our collateral agreement, and we have a non guarantor that has to live by the credit agreement, but it lives by the credit agreement however, and it’s part of our restricted group. And then we have an unrestricted sub that’s actually outside of our borrower group entirely and not bound by the same obligations as the collateral agreement.

Shiloh:

Got it. So then it sounds like the primary market, you’re looking at a term sheet which is going to sketch out these terms, the terms that make it into the credit agreement, which is the legally binding doc once the loan closes.

So it sounds like the credit agreement is designed to give you the first lien that you want, but also some flexibility to the borrower. And so not every single asset makes it into the restricted group or the guarantors. There is some flexibility there and it probably should be warranted. You don’t really need to take every asset. So another concept I wanted to just chat through before we maybe get into some historical cases is just the concept of baskets. What’s a basket in a credit agreement?

Drew:

A basket is going to be a carve out of some amount. So most of our covenants today are in currents-based covenants. So you’re going to have a basket for permitted liens, a basket for dividends, and that’s saying you’re allowed to dividend out a certain amount per year. You’re allowed to invest in this non guarantor restricted subsidiary a certain amount per year.

And in the example that we talked about earlier where there’s a tech business that might be fast growing but not part of a collateral, the management and the owner and the sponsor will want to be able to invest in that technology. It may be part of the future of their business. So they create these carve outs and they create these baskets. And essentially those baskets, many of them have the right to build over time based on the growth of the overall company based on a leverage ratio or a variety of other things. So those baskets are also a natural part of credit agreements.

Shiloh:

So the basket is a function of EBITDA. So if you have a hundred million of EBITDA, a for example, then the credit agreement might give you some percent of that to invest in unrestricted sub, for example, or to pay a dividend.

That’s how to think about it.

Drew:

Yes.

Shiloh:

And then as EBITDA grows over time, is it warranted that the owners of the company should have more flexibility?

Drew:

I think to some degree it is. Flexibility is warranted when the company is growing, and the issue is it’s just whenever things are manipulated. So we’ve had borrowers go grow EBITDA nicely. It could be a cyclical business, it could be a business that has competition on the horizon that maybe the broader market doesn’t appreciate. Then they’ve maybe grown through debt financed acquisition, but they’ve realized synergies and they’ve maintained add-backs at the same time. So EBITDA appears to be growing rapidly, while it’s growing, but it’s growing mostly through acquisition. And then because they’ve built this basket, they take large dividend out because the market will be hot periodically, and you go back to the market, you dividend it out, people are in need of paper, and then within six to 12 months, all of a sudden EBITDA is not growing the way you thought it was because it’s either a cyclical business, like I said, or other competition has come online and you’re realizing those adjustments are not going to be realized.

And then at that point, you’ve just added a layer of debt.

Shiloh:

So I think there’s three cases in the loan market, and I’d like to talk through all three of ’em where lenders made a first lien loan and it turned out that there were some loopholes in the credit agreements where they weren’t as senior and secured as they would’ve liked to be. So one is J Crew. Why don’t we start there? What happened at J Crew?

Drew:

I think J Crew was particularly interesting for a lot of investors because it was litigated and the litigation allowed us to see what baskets a sponsor was using or company was using in order to drop collateral out. So this is really about leakage from your borrower group. So where you lose collateral, you think you have intellectual property, it doesn’t have EBITDA associated with it. So they valued it, and they valued it at $250 million.

And they happened to have some basket flexibility between their investment covenant and their general basket that allowed them to dividend out 250 million dollar worth of collateral. And in this case, they dividend out from the guarantor to a non guarantor. So once it was in that non guarantor box, they had something that allowed them to pass through from a non guarantor box out to an unrestricted sub. So essentially they dropped collateral in the value of $250 million, which you can easily argue was an underestimated number. They dropped it out of the borrower box, and they did this to facilitate an exchange of notes at the whole-co.

Shiloh:

Okay, so the intellectual property was collateral for the first lien lenders, and then they are able to move that collateral out through baskets, the baskets you mentioned, and then they start sitting in a subsidiary where they’re no longer guarantors of the first lien loan.

And then didn’t they also raise new debt against that intellectual property?

Drew:

They did.

Shiloh:

So even if they would’ve dividend the IP to the unrestricted sub, it could have stayed in the sub and that would’ve been a subsidiary owned by the borrower under the credit agreement. So that would really not have at the end of the day hurt your position, but it was the fact that at the unrestricted subsidiary, they actually raised more debt that effectively was jumping the line, if you will, in terms of the priority of payments that was really expected when the term loan was put in place.

Drew:

You’ve had collateral that you thought was yours that doesn’t have EBITDA associated with it, leak out of the borrower. So by default, you’ve essentially been primed. You’re not at the Opco where this collateral is now held. You’re at a Opco, but you’re at an Opco that doesn’t have IP.

Shiloh:

Is the market response to this that the market saw the weakness in loan documentation and for future loans, this is something that’s tied up and shouldn’t be a worry? Or is that too optimistic way to think about it?

Drew:

Yeah, it is addressed in many credit agreements. It’s usually tied to very specific collateral. However, in the market, it’s referred to as the J Crew trap door. So essentially on every one of our credit writeups, we have whether or not the J Crew Trap door exists or it doesn’t exist, but it does exist in credit agreements today. And in fact, in many, many deals when we receive the first term sheet, it exists there and then it’s very common for it to be pushed back on. But the reality is, is people are still trying to get it in. The reality is there are weaknesses in all these documents that you can say there’s no trap door in this deal, but it doesn’t mean you have all the collateral, and it doesn’t mean there aren’t baskets that they won’t be able to provision out.

Shiloh:

So that’s J Crew. Another big case in the market was Serta. Serta is a mattress company, And what happened there?

Drew:

Serta is a story about priming. So there’s a sacred right in terms of your priority of a lien, priority of payment, or that’s thought to be a sacred, right. And you had mentioned at the outset about dips. So when a company needs to file for bankruptcy and they raise a dip, that dip goes in front of the existing first lien. It provides liquidity and it’s agreed to essentially by all parties in the bankruptcy. But a bankruptcy, when you file for chapter 11, it’s a complete restructuring. You lower the quantum of debt and you also provide for the company’s liquidity via the dip, and you can restrike all your liens and get rid of things that you don’t want, close EBITDA negative stores. There’s a lot of things that can be done. With Serta,

essentially what happened is they voted, and with a simple majority, roughly about 55% majority in a 45% minority group, they were able to contribute $200 million of new capital to help Serta with their liquidity issuance just like a dip. And then as opposed to the benefit being pro rata to all lenders, getting the benefit of participating in the DIP, and then participating in what the other debts exchanged for, the majority component was able to exchange into a second out. And then there was also a third out provided for future exchanges.

Shiloh:

So a second out and a third out, it’s a secure term loan, but the second out only gets paid after the first out is paid.

Drew:

So the new money becomes the first out. The majority holders that are in the first lien, and some of the majority holders that are in the second lien, they move into the second out.

And then the minority holders within the first lien actually exchange into what would be a fourth out behind because they preserved a small amount of third out for future exchanges. But the reality is that they became third or fourth out, so they dropped from being a first lien senior secured lender with the right of payment from first to then essentially fourth.

Shiloh:

So Serta is a story about some lenders voting to give themselves the ability to prime or step ahead of other first lien lenders. Is, again the same question as related to J Crew, is that loophole that was found in the docks and now the loophole is largely closed, or is this a continuing risk in loan documentation?

Drew:

This exists in most deals today. A term sheet can say it’s cured or not cured, but in reality, when I talked about the evolution of credit agreement before and you had expanding allowances and then you had removing restrictions by increasing baskets and doing those things, the third evolution is essentially when you can make changes to the priority of payment by a simple majority.

So changing the voting rights within credit agreements and those voting rights are pretty pervasive within credit agreements today, meaning simple majority voting rights.

Shiloh:

So then I think the third case that was very prominent in the market was Chewy. So can you tell us what did it do and why has it become a case study in the loan market?

Drew:

Well, PetSmart acquired Chewy, which was an online pet retailer, and they acquired it for roughly $3 billion. And the thing that makes it notable is that Chewy was a wholly owned subsidiary at the time of the acquisition and as a wholly owned subsidiary, it was a guarantor of our credit agreement. It was in our restricted box and a guarantor. And in fact, they raised term loan money around this acquisition. So the catch is, it’s only a guarantor if it’s wholly owned. So if you sell 1% of a business in this credit agreement and it’s no longer wholly owned, then it’s not a guarantor.

So that’s what made it unique. So essentially what PetSmart and Chewy did, or what PetSmart did is they used investment capacity to transfer out 16.5% of the Chewy equity, and then they used a dividend to dividend out another 20% to a whole-co of the Chewy equity. So essentially 37% of this 3 billion asset got out of our borrower, and then it was no longer a guarantor of our credit agreement.

Shiloh:

So because Chewy was not a wholly owned subsidiary, they were able to send dividends up to the parent and get the capital to the business’ owners. How did Chewy end up not being a wholly owned subsidiary of PetSmart?

Drew:

It’s not uncommon for a company or a business to co-own something, have joint ventures and not own a hundred percent of a subsidiary. So the idea that a wholly owned sub, and you can only guarantee the collateral of what you own wholly, so that makes sense.

So it’s relatively a benign characteristic within the credit agreement to say it has to be a wholly owned sub to guarantee this debt. So the difference is the sponsor and the company use that relatively benign clause to be able to use baskets that were permissive where they could dividend out large portions of the borrower and essentially have value escape and also make it a non guarantor of our credit agreement, which the loan traded into the seventies at the time because it was thought to be pretty horrific. I think the thing that worked out well about it is they essentially ended up IPOing Cewy for a much greater dollar amount than the value of the entire term loan, despite the fact that lenders were in a bad position as a result of the weak credit docs, it turned out that Chewy was worth far in excess of the amount that they had paid for it, and they valued it at, and as a result, the term loan lenders got out whole.

Shiloh:

So in that case, the credit agreement had this loophole in it, but the business ended up performing well and the first lien got repaid. So that’s the punchline there. But it sounds like it gave the lenders a good scare. In all these case studies, is it that the weakness in the loan doc was put in intentionally, the private equity firm that owns the company was thinking that this is something that they might have wanted to do to lenders in the future? Or is it that the docs were just drafted this way and later only after the business had some operational difficulties did somebody at the company or the private equity sponsor figure out that there was some optionality for them and that the first lien lenders were not as secured as they might’ve thought they were?

Drew:

I think, this is my opinion, but what started as — we’ll talk to certain sponsors and they won’t even know the loopholes in these credit agreements.

So I think what started as attorneys feeling like they wanted to build as much flexibility into these documents, and they were essentially showing their ability to work around the credit agreement and create loopholes, and then some sponsors took advantage of some of those loopholes. But generally speaking, a lot of documents have weakness in them, a lot of documents, and we track every sponsor. One of the things we do within our database is we track every sponsor. We know what the average price of every sponsor’s deal is, if they have 64 deals in the market or if they have 12 deals in the market.

Shiloh:

And a sponsor, by the way, that’s the private equity firm that bought the company.

Drew:

That’s right. So while many of these documents, we have one favored private equity sponsor that we have the most exposure to any private equity sponsor, and they’ve never had a US borrower lose a dollar of debt, they don’t use these loopholes.

And guess what? These loopholes exist in their credit agreements too. So I think it’s two things. One is you have some sponsors who have been aggressive with it. All these sponsors have a capital markets person who’s focused on the docs.

Shiloh:

This is the broadly syndicated loan market.

Drew:

Yeah, the broadly syndicated loan market is this broad array of investors that could be in a variety of different investment vehicles and they’re investing in many, many deals. So for every new loan that gets syndicated, you may have 130 borrowers in it, but you only have one private equity sponsor. So that control pivot and having a single point person allows them to focus and push on docs in a different way than having a confederation of investors together. So I think yes, there’s an effort by private equity to make sure these loopholes exist. A lot of times they exist with private equity firms that don’t focus on them, and I think once they existed or once some of this stuff was developed, then essentially lawyers that developed these docs have looked to make them standardized and weaker across the board.

Shiloh:

So is it then to find yourself in a situation where you’re being harmed by loose loan documentation, business really needs to underperform? First off, the business is performing well and the loan doc is weak, you’re probably fine. You also need a private equity firm or sponsor that’s going to want to do something that’s not creditor friendly and risk the wrath of the loan market. From the perspective of a private equity firm, if they do this, if they screw over one group of lenders, I would assume people have somewhat long memories in the loan market.

Drew:

I think it does influence company’s ability to borrow, and we’ve seen that before. I don’t know how long the memory is, but I think you’re right. I think generally three things are present.

Shiloh:

You need a loose stock,

Drew:

financial stress,

Shiloh:

financial stress, and a private equity firm owner who decides that they’re going to put it to the lenders and bear the reputational risk for them that might come along with that.

And it may affect the borrowing costs of companies in the future who are owned by that private equity firm.

Drew:

I don’t know the memory that the collective investment world in loans has, but what we’ve been screaming from our little mountaintop is that we track, as I just said, every single financial sponsor. We know how many deals they have in the market, we know how many liability management exercises they performed, which we can get to, but we also know what the average price of their loans are. So when a sponsor is a bad actor on a repeated basis, we’re no longer lending to them. If they’re a bad investor and all their loans traded 80, we’re not lending to them. So that essentially means I think some of the sponsors you see in the market today are going to be cut out of the BSL market.

Shiloh:

Interesting. So it sounds like when you’re evaluating a loan opportunity, it’s not just the fundamentals of the business that you care about, but it’s actually the ownership team, the private equity firm, and how they’ve treated lenders in the past. That’s an important variable in your credit selection process.

Drew:

And we meet with sponsors on a regular basis. We go into offices, we have conversations and we have relationships. And I would say it’s really clear when you talk to some of the sponsors, some of the sponsors are very operations focused. They have teams of people that help drive synergies between businesses. Some of the sponsors are very legal based and they’re looking to have a way out in the event that things don’t work well. So we try to focus on that component.

Shiloh:

Okay. What’s an LME and why is that important today?

Drew:

An LME is a liability management exercise, much like what we discussed with Serta, and it is essentially an out of court bankruptcy.

It’s not as clean as a chapter 11. You don’t restate your leases, you don’t close doors. You usually don’t get rid of the quantum of debt you have outstanding, but it does restrike a lot of the borrower’s debt, and it does usually come with a component of liquidity where the lenders are inserting some liquidity into the borrower.

Shiloh:

So we’ve seen an uptick in LME activity over the last two years. What do you think is driving these out of court restructurings?

Drew:

For context, we’ve had roughly 60 LMEs since 2014 through the first quarter of 2024, and then we had 25 LMEs in 2023 and eight in the first quarter of this year. So clearly the ramp has been significant in the last two years relative to what we’ve seen historically. And I think at the end of the day we’ve seen the things that are driving that are high rates is the first and most prevalent thing.

A component of high rates is every credit agreement prior to 2008 used to require hedging. It no longer does in post 2008, credit agreements really didn’t include mandatory hedging.

Shiloh:

So the hedging would be you’re taking on this debt on a floating rate basis, so the business was required to hedge that floating rate risk or exposure in the derivatives market,

Drew:

and you hedge it out from floating to fixed for half the term loan and then fast forward to today, and that wasn’t required. So two things happen as rates spike so quickly that companies were not able to get hedges on, and then when they did get them on, they were considerably higher than if they’re putting them on at three or four percent SOFR/LIBOR, whatever measurement versus essentially a zero rate interest rate environment. Well, you’ve already missed the benefit of the real hedge. So high rates, lack of hedging, and then I think sponsors, because it’s been such a competitive market where they’ve raised so much money, there’s just been a lot of high purchase price multiples made over the last five years.

So all those things together mean you’ve got a higher quantum of debt and you have higher interest rates, and it’s very hard for some of these companies to bridge some of the last couple of years.

Shiloh:

The LME that’s tied to the specific case that we talked about was Serta. LMEs are tied to Serta where one lender group is trying to prime another, and this is the description of lender on lender violence. That’s where that comes in.

Drew:

We’ve seen LMEs performed on a prorata basis, meaning lenders aren’t harmed if they’re not in the existing group. And we’ve seen LMEs come in a non-pro rata manner, just like Serta, where the majority holders are favored and the minority holders do worse.

Shiloh:

So the LMEs have resulted in some pretty low loan recoveries. Is that a function of rapid business, fundamental deterioration, or the lender on lender violence?

Drew:

It’s a bit of all of that. So we’re in 2024, and it sounds crazy to say, but 2020, 21, 22, 23, and part of 24 for many industries, were dictated by still emerging from COVID. It sounds silly, but we lived through a period of zero revenue for some of these businesses. They had to take on more debt to bridge that gap. And then we had inventory management issues. We had logistical issues where you weren’t able to get supplies in and then you had inflation and then you had to pass along those costs. And then we’ve had destocking. So whether it’s packaging or whether it’s chemicals, some of these companies had quite a volatile performance over the last two, three years, or a travel business. They might’ve been dealing with the legacy of COVID and how much debt they took on during that period of time. Some of the businesses are just failing, and they’re zombies, and this has forced its hand.

So there’s a variety of reasons why a company might’ve gotten here.

Shiloh:

So how do you protect yourself from lower loan recoveries?

Drew:

This is part of this sponsor outreach and having those relationships. We have somebody who’s full-time in charge of reaching out to advisors and attorneys and came from an advisor background. So when you see a company with weakness, you need to get your hands around.,”Is there a group forming?” “Is there a cooperative?” The very first step is cooperative groups started to form to prevent this lender on lender violence that took place in the market. So I don’t know if it was a year or a year and a half ago, we started seeing cooperative agreements among lenders, formed on a lot of stressed borrowers, and the idea was in the event something happens, we are prepared to act as a united front, and that was the first step.

So we try to make sure that where there’s stress in a borrower, that we’re going to get involved in being part of that group and being part of driving the solution.

Shiloh:

How do you think a CLO equity investor should think about the lower loan recoveries and potential risks in the loan documentation in the broadly syndicated loan market?

Drew:

I think you have to look at the adjusted default rate. So if you look at default rates today, its loan defaults are below 2% the adjusted default rate, if you take in LMEs, it’s around four and a half percent, somewhere around that. So there’s about a two and a half percent difference between the actual default rate in LMEs. And some of the LMEs, it’s deceiving, because you’ll get 85% of your debt restated, you’ll get 90 cents on the dollar restated. The problem is in a bankruptcy, you are getting rid of a lot of debt, you are getting rid of leases, you’re getting rid of EBITDA negative stores, and in LME, it only is a cure if the business improves on the back end of it because you’re really not getting rid of the quantum of debt.

You’re only providing for liquidity. So obviously we’re in the weeds on all these names. So there are some borrowers where you see an LME exercise done, and it might be in healthcare services, and we have one borrower that’s in healthcare services. Well, if you think about the consequence of COVID for anybody who’s in healthcare services is they had a tremendous amount of inflation within labor. So first you had wages go up, then you had a lot of nurses leave the entire system. So then that spike wages higher. So if you only have a reimbursement rate that’s set by a government entity and your primary costs are wages and you’ve been having inflation in wages for three years, it takes a long time to get through that. It takes years to get through that curve. So we had one deal where an LME was completed and it was done on a pro-rata basis.

So everyone ended up at the same spot and the lenders injected additional liquidity, essentially primed ourselves, but then all got ratable treatment. And in my opinion, as that loan trades close to 90 today, is the best decision we could have made because fundamental performance is improving for the last several quarters. It’s improving because wage inflation’s decelerating, and they’re finally able to pass on the costs of all that labor. So every situation’s different.

So I’m curious because you have more than one manager in general, what you’re hearing and what your thoughts are on potentially lower recoveries.

Shiloh:

I definitely think that for the broadly syndicated loan market, lower loan recoveries has been the risk. So a lot of times an investor will throw a stat at me, okay, here’s some low loan recoveries in the index. But really the question for me is, well, are those loans in CLOs and then even more important, are they in my CLOs?

So my view is that if you’re working with the right managers in broadly syndicated that a lot of these lower loan recoveries and loose stocks can be avoided. I also think that this year, we didn’t really talk about it during this podcast, but refinancings and resets or CLO extensions have the ability to materially increase CLO equity returns. So on the one hand, we do have these low loan recoveries. On the other hand, the upside from refis and resets is significant, and then you’re a broadly syndicated CLO manager, but the majority of our equity positions are in middle market CLOs. I’ll give you an example. A few years ago we had a new VP who was trying to understand better middle market loan credit agreement, and we had a lawyer on the phone and we were going through the specifics of the doc, and this VP that we had was asking all these questions around J Crew around Serta trap doors, add backs, and the lawyers like, “no, no. In the middle market, there’s none of that. There’s no unrestricted subs, there’s no non guarantors or no baskets, there’s no dividends”

Disclosure AI:

Note, this is one example of a middle market credit agreement. Other credit agreements may vary.

Shiloh:

So I think for somebody investing in middle market loans or middle market CLOs, I think that recoveries there are going to track more to the historical norm of the last 30 years. So I don’t see it as big of a risk in the middle market CLOs.

Drew:

Yeah, I think there’s one other big factor out there. I think most of this financial stress is coming from higher rates, which 60% of our borrowers are sponsor driven. So if a sponsor bought a company, they’ve owned it for five or six years and they want to sell it, they can’t get the multiple they want today. If we fast forward, I’m not talking about rates going to zero, but if SOFR comes down to 3% and now all of a sudden you start seeing these assets trade again and LDOs increase again, I think it goes a long way to ease a lot of the stress and the interest stress that our borrowers are feeling today.

So I think we’re in the eye of the storm in the BSL market today. Rates will go lower at some point, and that will ease a lot. The other thing in the BSL market, we don’t have a lot of nearing maturities. There’s very little still to mature in 25, and there’s very little to mature in 26. So if you have several years to wait this out, it doesn’t really matter the vol that you had along the way, as long as you can get to the point of being able to refinance your debt.

Shiloh:

These loans have initially a loan a value of 45 or 50% or something like that. So there’s a lot of cushion in there. A lot of things can go wrong in the business, and as a first lien lender, as long as the wheels don’t fully come off the cart, we should be money good at the end of the day.

Drew:

Agreed.

Shiloh:

Well, Drew, thanks so much for coming on the podcast. Really enjoyed our conversation.

Drew:

Thank you. Thanks for having me.

Disclosure AI:

The content here is for informational purposes only and should not be taken as legal, business, tax, or investment advice or be used to evaluate any investment or security. This podcast is not directed at any investment or potential investors in any Flat Rock Global Fund. Definition Section

AUM refers to assets under management

LMT or liability management transactions are an out of court modification of a company’s debt.

Layering refers to placing additional debt with a priority above the first lien term loan.

The secured overnight financing rate, SOFR, is a broad measure of the cost of borrowing cash overnight, collateralized by treasury securities.

The global financial crisis, GFC, was a period of extreme stress in global financial markets and banking systems between mid 2007 and early 2009.

Credit ratings are opinions about credit risk for long-term issues or instruments,, The ratings lie on a spectrum ranging from the highest credit quality on one end to default or junk on the other.

A AAA is the highest credit quality A C or D, depending on the agency issuing the rating, is the lowest or junk quality. Leveraged loans are corporate loans to companies that are not rated investment grade

Broadly syndicated loans are underwritten by banks, rated by nationally recognized statistical ratings organizations and often traded by market participants.

Middle market loans are usually underwritten by several lenders with the intention of holding the investment through its maturity

Spread is the percentage difference in current yields of various classes of fixed income securities versus treasury bonds or another benchmark bond measure.

ETFs are exchange traded funds.

A reset is a refinancing and extension of A CLO investment period

EBITDA is earnings before interest, taxes, depreciation, and amortization.

An add back would attempt to adjust EBITDA for non-recurring items.

The Credit Suisse Leveraged Loan Index measures the performance of the broadly syndicated loan market.

General Disclaimer Section

References to interest rate moves are based on Bloomberg data.

Any mentions of specific companies are for reference purposes only and are not meant to describe the investment merits of, or potential or actual portfolio changes related to, securities of those companies unless otherwise noted. All discussions are based on US markets and US monetary and fiscal policies. Market forecasts and projections are based on current market conditions and are subject to change without notice, projections should not be considered a guarantee.

The views and opinions expressed by the Flat Rock Global speaker are those of the speaker as of the date of the broadcast and do not necessarily represent the views of the firm as a whole. Any such views are subject to change at any time based upon market or other conditions and Flat Rock Global disclaim, any responsibility to update such views. This material is not intended to be relied upon as a forecast, research, or investment advice.

It is not a recommendation offer or solicitation to buy or sell any securities or to adopt any investment strategy. Neither Flat Rock Global nor the Flat Rock Global speaker can be responsible for any direct or incidental loss incurred by applying any of the information offer. None of the information provided should be regarded as a suggestion to engage in or refrain from any investment related course of action as neither Flat Rock Global nor its affiliates are undertaking. To provide impartial investment advice, act as an impartial advisor, or give advice in a fiduciary capacity.

This broadcast is copyright 2024 of Flat Rock Globla LLC. All rights reserved.

This recording may not be reproduced in whole or in part or in any form without the permission of Flat Rock Global. Additional information about this podcast along with an edited transcript may be obtained by visiting flatrockglobal.com.

Disclaimers related to TCW

This material is for general information purposes only and does not constitute an offer to sell or a solicitation of an offer to buy any security.

TCW, its officers, directors, employees or clients may have positions in securities or investments mentioned in this publication, which positions may change at any time without notice. While the information and statistical data contained herein are based on sources believed to be reliable, we do not represent that it is accurate and should not be relied on as such or be the basis for an investment decision. The information contained may include preliminary information and/or forward-looking statements, Due to numerous factors, actual events may differ substantially from those presented. TCW assumes no duty to update any forward-looking statements or opinions in this document. Any opinions expressed herein are current only as of the time made and are subject to change without notice. Past performance is no guarantee of future results. Copyright TCW 2024.

The CLO Investor Podcast, Episode 8

Shiloh:

Hi, I’m Shiloh Bates and welcome to the CLO Investor Podcast. CLO
stands for Collateralized Loan obligations, which are securities backed by
pools of leveraged loans. In this podcast, we discuss current news in the CLO
industry, and I interview key market players. Today I’m speaking with John
Kerschner, one of the portfolio managers of the Janus Henderson JAAA CLO
Exchange traded fund. As of June 30th, JAAA had a market cap of 10.6 billion,
up from 3.2 billion a year prior. I asked John to come on the podcast to
discuss his perspective on the relative attractiveness of CLO AAAs versus other
asset classes. We also discuss how his team picks CLO AAAs and if the market
should expect continued CLO tightening, some of which being driven by CLO ETFs.
And for the avoidance of doubt, there’s no business relationship between Flat
Rock Global and Janus Henderson. And now my conversation with John Kerschner.
John, thanks so much for coming on the podcast.

John:

Yeah, thanks for having me. It’s my pleasure.

Shiloh:

Why don’t you start off by telling our listeners a little bit
about your background?

John:

Yeah, sure. So I came out of business school where I went, Duke
University, in the mid nineties and joined a small money management firm called
Smith Breeden Associates based in North Carolina, but they had an office out in
Colorado, which I eventually moved out to. And so it was very mortgage-
centric. Doug Breeden, who’s an academic professor at Duke, who started the
firm, started as a lab for his research work to see if it actually worked in
real life. And so we were investing in mortgages. It was kind of early days of
the mortgage market back then. And then after a few years doing that, I wanted
something else and they decided to give me the asset backed slash non-agency
mortgage group. No one was doing that. So they said, all right, John, why don’t
you go try your hand on that? And that was the year 2000. And very quickly it
became the non-agency mortgage group because that market basically went from
zero to 2.7 trillion over the next six years. So all that growth in subprime
mortgages, I was right in the middle in so background in securitized. I joined
Janus Henderson back in 2010 and really to build out the securitized group, and
now we manage 40 billion in securitized, including our ETFs. So it’s been a
really great ride.

Shiloh:

Great. So post GFC, were you working with CLOs more or RMBS or
what were you doing then?

John:

Yeah, so during the GFC I actually
left that Smith Breeden Associates and joined a hedge fund based in Boulder
that focused on commercial real estate. So I kind of went from agency mortgages
to non-agency mortgages to commercial real estate, obviously commercial real
estate. I had a very difficult time during the GFC. Our investments were very
good. They were mostly global, but when liquidity drained out of the system, no
one really cared that much about that. They just wanted their money back. So I
did some distressed debt investing for a couple of years at this firm, and then
that platform was shrinking. So I was really looking for my next opportunity.
And Janus at the time, now, Janus Henderson obviously, back in 2010, was really
trying to build out their securitized group. They had no assets and no people,
and yet close to 20 billion in fixed income under management. Most of that was
benchmarked to the aggregate index. So they needed some securitized expertise
and that’s why they brought me in to build out that group.

Shiloh:

Okay. And so one of the reasons I wanted to have you on the
podcast was that I saw recently that JAAA, your AAA fund, had passed 10 billion
of AUM. What do you think is the biggest driver of the growth there?

John:

It’s an incredible benchmark to have passed. And look, I think
it’s very simple that before we launched JAAA, there was really no solution for
people looking for high quality, floating rate fixed income with a decent
yield. Normally most of fixed income is actually fixed rate, which does very
poorly when interest rates go up. And particularly when the Fed’s in an
interest rate hiking cycle, people were looking for a way to use those rate
hikes as a tailwind, not a headwind, but at the same time, people were
concerned about the overall economy and the fact that most people were
predicting recession. So they wanted high quality, floating rate fixed income.
And it just so happens that the CLO market is a perfect place for that. It’s
floating rate. If you buy the AAA tranche, it’s very high quality. A AAA
tranche has never defaulted in over 30 years. And yet because the Fed did end
up raising rates quite a bit, the yields are quite attractive and currently
still around 6.5%. So those three things, people just looking for a solution
that didn’t really exist out there, at least not in scale. And it’s just a
matter of fact that most people have some allocation to a cash or cash
alternative. And so this was just a product right time, right place, and it’s
just gotten a lot of take up by a lot of different investors.

Shiloh:

Do you think it mostly is taking share from the Bloomberg-Barclays
Agg or are there other asset classes where people are choosing JAAA in lieu of?

John:

I do think there’s some of that taking share from the Agg, but I
actually think it’s taking more share from what traditionally have been cash
type of investments, whether that’s money market funds or bank certificates of
deposits or T-bills, things of that nature. Because traditionally, and
obviously past performance is no indication of the future, but traditionally
AAA CLOs have outperformed cash by somewhere between 170 to 200 basis points.
Now that comes with more risk, at least a little bit more

risk. So that’s key. But there’s
still, look Shiloh, there’s still 6 trillion plus of assets out there in money
market funds. And so there’s just this massive market of people out there who
are saying, look, I still think rates may be going up, or I’m concerned about
the overall economy. I want that safety of cash and it’s given me a decent
yield, particularly compared to where cash was over the last 10, 12 years. So
why don’t I just do that? But then when they look at last year, cash basically
gave them just over 5%. That makes sense. That’s where the Fed funds rate is. But
a JAAA with a little bit more risk gave them 9%.

Shiloh:

So how are the shares of the ETF? How are they created and
redeemed?

John:

Yeah, so a lot of people when they look at a JAAA, they’re not
used to ETFs, exchange traded funds, or how they actually work. Most people are
very familiar with 40 Act mutual funds where if you want to buy a mutual fund,
you make a trade and then you get the price where that fund priced at the end
of the day, and that’s the price or level where your cash is invested in that
fund. Exchange traded funds are very different in that they trade on an actual
exchange. Our funds tend to trade on the New York Stock Exchange. So it’s just
like a stock. There’s constantly buys and sells, constant buys and sells
throughout the day. And probably most important or most different, there’s a
market maker that’s facilitating those trades. And what does that mean? So
let’s just say you have a day where you have a million buys and a million
sells.

So the market maker probably is not doing anything. He’s just
matching those buys and sells and there are no create or redeems. Now, let’s
say there’s a day where you have 10 million buys and a million sells, maybe on
that day the market maker is like, okay, I’ve taken in 10 million of cash that
people want to buy and only given out 1 million in cash that people wanted to
sell. So I’m going to ping Janus Henderson and say, we’re going to actually
have creates for $9 million. And so we have a capital markets team in
Connecticut that handles this as part of Janus Henderson, and they will tell us
we have 9 million in creates, and that’s when the risk is transferred from the
market maker to us. So we get these creates throughout the day. There is a
cutoff usually around one o’clock our time in Colorado, three o’clock on the
east coast. So if we do get creates, we can invest that cash. And so it’s
different in that you can constantly see where the fund is being priced, unlike
a 40 ACT mutual fund where it’s once a day. So that gives investors more
transparency as to where the markets are. And quite frankly, I think most
investors appreciate that transparency.

Shiloh:

Okay. So what’s the typical bite size for you guys for a new AAA?

John:

You mean as far as creates goes or when we’re buying new issue or

Shiloh:

Well, let’s say you’re buying new issue. Is it like a 20 million
investment that you’re targeting or how do you think about the appropriate size
for your fund?

John:

It depends somewhat on what class we’re targeting. So your
listeners probably, maybe some of them know this, but most CLOs new issue are
around $400 million. Some are bigger, some are smaller, but that’s kind of an
average size. And so the AAA tranche is usually somewhere 250 million,
something like that. So if you’re a CLO manager and you hire an investment bank
to launch a new CLO, usually what you have, the equity or residual tranche is
usually already spoken for by the CLO manager. They will usually buy that, but
the AAA tranche, they have to go out and buy a buyer for it. And it’s a lot of
bonds, right? 250 million bonds. So they want to find in what they call an
anchor order. Usually this is a large bank or money manager that has at least a
hundred million to put to work. And so we’ve started, as JAAA has gotten
bigger, we’ve started buying more and more in the primary market and doing
these anchor orders.

And why is that important? You get a large block of bonds locked
up, which is important when you’re getting creates almost every day. So you
have that visibility and that certainty of execution. You get it at a spread
that you’re very comfortable with. There’s some negotiation there. But if
you’re buying that many bonds, you have some say in the spread. And then you
can also dictate some of the DOC language as well. CLO documents are not
standardized, unlike every other asset class in the universe. And so you have
some say so when we started out, we were buying more and more in the secondary
5 million, 1 million, 10 million blocks, but now we’re buying as the ETFs got
bigger, we’re buying more and more in the primary market.

Shiloh:

I think there’s about a hundred different active CLO managers out
there. How do you guys decide which aaas are the most interesting to you?

John:

Yeah, there’s actually about 160 CLO managers. About 30 or 40 of
those haven’t issued in the last couple of years. So let’s just call it about
120 actively issuing CLO managers. So you’re right, there’s a lot of CLO
managers. And so we spend an inordinate amount of time doing both qualitative
and quantitative analysis on the CLO managers. We haven’t met with all of them,
but probably about 80 or 90 at this point. And we’ve definitely met with the
managers whose CLOs we’re buying. And so it’s sitting down with these managers
at conferences face-to-face or having calls with them. And principally what
we’re trying to find out there is how experienced is their team, how large is
their team, who owns them, how safe the ownership structure is. Obviously we
don’t want to be buying CLOs from managers that aren’t going to be around in
the next couple of years, how much they buy their own equity, how much skin in
the game they have, and then really how they look at risk If we have a
dislocation, are they first to sell to reduce risk or are they looking as that
as an opportunity to add risk?

And so there’s all sorts of
profiles of CLO managers. Some are more equity-friendly. That usually means
they’re managing more for the equity. They own a lot of the private equity type
CLO managers would fall into that classification. And then you have other CLO
managers that are more debt friendly, maybe don’t take as much risk. Some of
these CLO managers come from money managers or insurance companies. And so
doesn’t mean we won’t buy equity-friendly managers, but we have to be very
comfortable with the way they manage risk. And then obviously we could talk a
whole podcast on our quant screens, but we’re basically taking a look at, we
probably have 30 different, maybe even more type metrics that we’re looking at
over the portfolio, how many CCCs, how many second liens, what the rating of
the overall portfolio is, and we’re constantly monitoring that. So really just
to make sure that what the CLO manager is telling us is actually what we see in
the data month to month.

Shiloh:

Would you say a debt-friendly CLO manager is one where the spread
on the loan portfolio is low and maybe there’s a 5% bucket to buy second liens
if they want, and maybe a debt-friendly manager doesn’t take advantage of that
and then post the period ending, some managers are going to be a lot more
aggressive in terms of reinvesting unscheduled principal proceeds while others
are not. Are those the distinctions you would use to comp equity versus debt
focused managers?

John:

Those are all part of the equation for sure. There are others as
well. But basically to sum it up, it’s an equity friendly investor tends to
just take more overall risk in the portfolio, whether it’s second liens,
whether it’s CCCs, whether it’s just the overall, what we call WARF or weighted
average rating factor of the portfolio, how aggressive they are in
dislocations. Now, again, I don’t want your listeners to get the idea that if
you’re an equity focused investor, you’re way over your skis and not doing a
good job for your investors or vice versa. There are very good equity focused
investors, there are less good debt focused investors. So it’s a little bit of
a classification that you got to be careful with. But that being said,
obviously if two CLO managers are very similar in many respects besides that as
far as team and experience and track record and size and liquidity and
obviously spread or pricing, we’ll probably be more inclined to buy the debt
friendly. And people might ask, well, why is that? Why are these two type of
managers exist? And quite frankly, if you are private equity-sponsored, their
equity or their return target or hurdles are probably higher. It’s probably
mid-teens, right? If you’re more of an insurance company, maybe out of your
equity you only need eight or 9%. So different sponsors have kind of different
return hurdles and that’s just how the market is fragmented right now.

Shiloh:

So in the primary market, I think top tier AAA and actually maybe
better than me, but I think it’s like three months. SOFR plus, is it like high
130? Is that what you’d say?

John:

Yeah, that’s about right. 135 to 140 is kind of the range right
now.

Shiloh:

Does it ever make sense for you
guys to not be in the top tier if you’re not in the top tier for AAA? I mean
you might pick up another 10 or 15 basis points and in that case you’re in a
manager whose shelf maybe isn’t as liquid or it’s a platform where they’ve
issued the less CLOs or maybe they have a new management team. Does it in
general make sense to kind of stretch for that extra yield in the AAA or do you
guys kind of hew to the most conservative established managers?

John:

So your listeners might get frustrated on some of these answers.
Most of ’em, it depends, right? So there is a tradeoff there. I think that’s
very important. But I also think it’s important to define what we mean by top
tier. And most people divide the CLO management group into three different
tiers, one, two, and three. And a lot of people have misconception that if
you’re in tier three you’re not a very good CLO manager. And that’s just not
true. It really stemmed from the fact that the Japanese CLO investors, these
large banks, including Norinchukin, has been in the news recently have an
approved list of about 40 or 50. No one knows for sure CLO managers. And if you
made that approved list, you’re kind of automatically top tier. These are
usually the bigger managers. The ones that have the most deals outstanding,
have the longest track record.

That’s what gets the Japanese investors comfortable and that’s
what makes top tier, Tier two can be a little less track record, a little
smaller things of that nature. And then tier three are usually newer managers
have been around only for a couple of years. There are very good top tier three
managers. There are less good tier one managers. So it really just depends. But
to answer the question, JAAA is about 65 to 70% tier one managers, whereas the
overall index is about 50 to 55%. So we are definitely overweight top tier
managers, and you’re right that you get maybe less spread, but you get a lot
more liquidity. So we are overweight top tier, but we do look for those
opportunities in tier two or tier three where we really love the manager and
then we’re getting a wider spread. So we take that trade off very seriously and
it’s a way to add value to the portfolio.

Shiloh:

So you mentioned preferences in the docs or the CLOs governing
document, the indenture from the perspective of somebody who invests in CLO
equity, things I would care about would be flexibility to reinvest after the
reinvestment period ends. We’d also like favorable language around the par
flush

Disclosure AI:

Note. A par flush can occur when the CLO begins its life with more
loans than required by the indenture. The excess loans can be distributed to
the CLO equity early in the CLO life.

Shiloh:

And I assume that you would be on the exact opposite side of both
of those debates, but what are some preferences that you guys have?

John:

Yeah, I mean those are both very important and this really gets in
the weeds, but I think one of the big topics that have been out there is these
liability management exercises. Instead of firms just going bankrupt, a lot of
times they try to work with their, and these are firms that are using the
leveraged loan market. So if they get into difficulty, oftentimes they to
manage out of that instead of just declaring bankruptcy. And there are
different things they can do as far as priming the current investor group. That
just means issuing new loans that are senior to the current loans. And
oftentimes CLO managers have a hard time just based on the CLO docs
participating in some of those exercises. So if they’re not able to, they
really have two choices. They can be in a situation where their debt actually
now is layered to new debt, which you don’t want, or they just have to sell the
loans at a very distressed price, which they don’t want to. So some of the docs
now allow for CLO managers to participate in some of these investor groups up
to a certain extent. And we think that’s actually a positive, right? Because it
allows them to kind of do what’s best for their end investors, which ultimately
are us. So that’s one very topical point right now you’re going to hear if you
haven’t already a lot more about that in the coming months and years.

Shiloh:

So you can buy bonds in the primary or the secondary. So is the
way you think about that, that an attraction of the secondary is that you can
buy bonds and they close T plus one

Disclosure AI:

Note T plus one refers to a trade settling one day after the trade
date, that’s when cash is exchanged for the security,

Shiloh:

But might be harder to source. Whereas in the primary market, a
lot of times you’re going to make a commitment and the bond’s not going to fund
for five weeks, it might be T plus 20 or something like that. Is that kind of
how you see the trade off there?

John:

Yeah, that’s exactly right. But the other part of the trade-off is
secondary bonds tend to trade tighter. Some of that is the fact that some
secondary bonds have shorter weighted average lives. And in general, if you’re
buying a bond with a shorter weighted average life, you’re lending money for a
shorter term. So it should be a tighter spread. But generally secondary bonds
because of this in the CLO market, this dynamic you just mentioned, T plus one
versus T plus 20 or 25, secondary bonds tend to trade tighter. So we’re
constantly evaluating that trade off. Is the secondary market so tight that it
makes a lot more sense to buying in the primary market or vice versa? At this
point, JAAA in particular is big enough. We’ll probably always be buying some
bonds in the primary market just to have that certainty of the pipeline of
being able to put the cash to work. But we’re also constantly looking at the
secondary market. People who don’t invest in the market on a day-to-day
wouldn’t know this, but there are bid lists, other investors, other banks,
other money managers constantly selling. We’re constantly involved in those bid lists to see if we can pick up
secondary CLO bonds at very attractive spreads. So that’s really the trade-off.

Shiloh:

So one of the things we’ve seen develop over the last year or so
is that there’s very short AAAs, like a refinance where there’s maybe a year or
so to go on the reinvestment period and those price well inside of new issue.
Is that something that’s interesting to a fund like yours or do you prefer the
wider spread and the longer reinvestment period deals?

John:

It also depends on the dollar price of the CLO. So most people
that are listening probably understand that the typical structure for a CLO is
a two year no-call five-year reinvestment period. What that means is when the
CLO is issued, it can’t be called for two years. And then if a loan matures or
is paid off, the CLO manager can reinvest that cash into a new loan after five
years. There’s a limited ability to do that. But in general, at that point, the
AAA start amortizing down and usually a deal is either called or refi or reset
pretty soon thereafter. So what you have to be very cognizant and this decision
changes a lot depending whether the market is mostly at a premium or mostly at
a discount, right when it’s at a discount. You love those kind of short
weighted average life going into or coming out of reinvestment period, starting
to amortize because you think the deal’s going to get called. And if you’re
buying it at let’s say 97, 98 cents on the dollar, you’ll get your money back
when the market’s more at a premium, you have to be very careful of that. So
it’s really an individual bond case by case basis. Right now the market’s
actually kind of right in the middle. It’s mostly right at par. So it really
just depends on the overall spread and the comparison. I would say right now
we’re more interested in the longer weighted average life, wider spread primary
market,

Shiloh:

And then in middle market CLOs, the AAAs, their price at around 30
basis points above the spread on broadly syndicated. Is that interesting to you
guys at all or do you prefer the larger broadly syndicated CLO market?

John:

We definitely prefer the BSL market. The middle market CLO market
kind of had a moment last year when issuance, which normally was five to 10% of
the BSL market, all of a sudden became 20 or 25%. This is just because there
were a lot of leveraged loans out there that were having trouble refinancing in
the BSL market and the private credit market came around to kind of help with
that. But the problem is the private credit market really hasn’t gone through a
massive dislocation covid, a lot less transparency, a lot less liquidity.
Usually it’s one lender, one borrower coming up with the docs and figuring out
the blending requirements. So you just don’t really know what’s going on under
the hood. And yes, they come with more spread and more credit enhancement and
more protections, but if we do get a large dislocation, a, you’re going to have
very little to no liquidity and you’re going to have higher defaults almost for
sure.

Leverage is higher in that market.
Debt service coverage ratios are lower, so almost for sure defaults are going
to be higher and no one really knows if the extra credit enhancement you’re
getting is going to be enough. So we have stayed away from the middle market or
private credit CLO market because for us, we think for our investors, liquidity
is paramount. Right now it’s a liquid wrapper, an ETF wrapper. We want to make
sure that our investors can get their money back if they want their money back.
We’ve had very large creates and redeems in this space. And in fact a couple of
weeks ago we had $400 million sell and we didn’t even get a redeem. So that
means somebody sold $4 million of J AAA and we didn’t see any outflow. And you
might say, well, how’s that possible? It’s because we’re constantly getting
creates at the same time.

And so the market makers were just able to offset that sell with
enough buys that we didn’t have to get a redeem. So bottom line is that’s a
great use case for our investors of how liquid this product and this market
actually is. But we know there will be a time we will have another C type
environment or GFC environment and maybe five years or maybe 10 years, but at
some point it’s going to come and we want to make sure that we have the
liquidity in the portfolio to meet any redemptions that we have and staying in
the more liquid BSL market as part of that strategy.

Shiloh:

And by the way, I would certainly agree the broadly syndicated
CLOs up and down the stack are going to be a lot more liquid than middle
market. But you did mention liability management exercises earlier. We invest a
lot in the middle market CLOs, and one of the attractions is just that there
really is not lender on lender violence there. There’s no, and so when loans
default, we’re expecting more of the kind of restructurings that we’ve seen for
the last 30 years. We’re not really expecting much to change, whereas broadly
syndicated, the loan recoveries really have been pretty poor for the last two
years or so.

John:

Yes, no, I totally agree. I don’t want your listeners to think
that I am really reigning on the parade of the private credit or middle market.
What you said is absolutely true, and there are some very good lenders there
that have done it a long time and know what they’re doing. And there’s probably
some very good credits there. I would just say again, there’s a lack of
liquidity and transparency and maybe hasn’t been proven through a more
dislocated market. But you’re right, some of these deals may be better, quite
frankly, in a dislocated market for the you just mentioned. But for the reasons
I mentioned, that’s why we’re sticking to the BSL market.

Shiloh:

So then AAA financing costs have come in really dramatically since
the spring of 2022. What do you think is driving that and should we expect the
trend to continue?

John:

There’s several things driving that. Interestingly enough, what
happened with Silicon Valley Bank just over a year ago now, and now the news
coming out of Japan with Nor Chuan is making both regulators and banks really
focus on their investment portfolio. I don’t think people necessarily know how
big some of these portfolios are, but look, banks bring in deposits and they
make loans and sometimes they can’t

make enough loans for all the
deposits they’re bringing in, so they have to buy securities to make up that
difference. And traditionally, banks have bought very high quality fixed
income, government debt, mortgage debt CLOs, but until this recent increase in
interest rates buying kind of long duration or treasuries kind of worked for
banks and then all of a sudden the thing goes, it worked until it didn’t and a
lot of banks got underwater. And so even though CLOs may seem a little more
complicated or more risky for a bank, they’re kind of the ideal asset class.

They’re floating rates, so they really don’t have to worry about
interest rate risks and they’re very high credit quality. And that’s why so
many banks are now trading out of their long dated treasuries and mortgages and
buying more CLOs. So that’s been a huge buyer. Money managers are buying more
and more. If we were talking six or seven years ago and we were talking about
who owned what money managers would be much smaller. They’re about a third of
the CLO market right now. They were much smaller back then, but the liquidity
has improved. And so money managers are using this as a tool for portfolio
management. And then quite frankly, it’s the CLO ETFs. If you look at the stats
so far, year to date, the net issuance of AAA CLOs is almost zero. That means there’s
been a lot of gross issuance, but there’s also been a lot of liquidations and
amortizations. So basically deals getting called or deals getting paid down to
offset that. And then you add on the 6 billion of AAA CLO ETF buying that’s
actually put to market in a net supply deficit. That means money managers or
other investors have to sell to make that up. And so you can never have more
supply than demand, but the demand continues to pays with money managers,
banks, and now the CLO ETFs and that is what’s driving in spreads.

Shiloh:

Let me ask you just specifically about CLO ETFs. Do you think that
there’s enough assets there that that’s a material factor in driving AAA costs
lower?

John:

I absolutely do, and I think it will continue. Now you might say,
well, where will that come from? I mean, I think supply will continue to
increase. So basically CLOs are just an arbitrage between where you can buy the
leverage loans, how much deal costs are, and then where you can buy the CLO
capital stack. And as AAA CLOs get tighter, that arbitrage gets better and more
created because the arbitrage gets better. So I do think that as spreads get
tighter, there will a be some motivated sellers at a tighter spread. But I do
think that we have only begun to tap the investor base when it comes to CLO
ETFs. I mean, we’re at 10 billion, we’re actually at 10.4 billion, but the
market’s just over 11 billion. I think this could be a 20, maybe even a 30
billion market. Like I said, there’s still 6 trillion in money market funds out
there. And so I do think it’ll be a very big market and I think the CLO
creation machine or the new issue machine will continue to ramp up and do
enough deals to feed that demand.

Shiloh:

Well from that perspective of a CLO equity investor, I’m certainly
sharing you on in terms of the raising assets and hopefully the result is lower
financing costs for the CLOs. So one other question is just around interest
rates. So does your fund pay a floating rate dividend and the expectation is
that when and if the fed cuts, the distribution yield will come down or how do
your investors think about it?

John:

I mean, in general, that’s definitely true. One thing people have
to realize is there will be a lag because CLOs are benchmarked to the three
months. SOFR rate, secured overnight financing rate, so they only reset every
three months. If the Fed cuts rates, things like repo rates will reset
immediately lower. It takes at least three to four months because the rate will
take three months to reset, and then there’s another month delay until they
actually see a lower distribution or dividend. So there is a delay. What I
would tell investors is, look, all indications the Fed has given us is they
probably will cut either later this year or early next year. It will probably
be only 25 basis points, and it will be very much a slow cut cycle. So we’re
not thinking it’s going to be 50 or a hundred basis points like we saw during
covid. So gradually your overall distribution yields will go down, but
currently you’re still about 50 basis points, higher yield than longer term
treasuries. So there’s a lot of reduction in that yield before you’re even
equivalent to what you’re getting with most corporate debt or treasury debt. So
I think the investors are still in a very good place.

Shiloh:

Okay. So are there any questions that I haven’t asked you that are
maybe topical for your fund or for the CLO industry in general?

John:

Well, I think when we’ve been out there talking to investors, we
always get the question about the GFC and CDOs, I guess because they’re both
securitized products, one letter different, both acronyms and the idea behind A
CDO isn’t that much different from a CLO, but what makes them extremely
different is the collateral that you use to build one. So a CDO is basically
subprime mortgages, most of which should have never been issued or created and
mostly given to people that probably should not have been getting those loans.
And so when the GFC hit and a lot of these people couldn’t refinance their
mortgage, and these subprime loans were a floating rate and the rates were
adjusting up and they couldn’t pay those. A lot of people we know in some prime
space, like 70% of people defaulted. So if you were creating an instrument that
was based on that subprime market, of course it didn’t perform well.

CLOs very different leverage loans have been around a very long
time, have been through all sorts of dislocations, have been through the GFC
and CLOs perform very, very well since then. A triple-A CLO has never defaulted
in the history of the market over 30 years. And a triple-B CLO even hasn’t
defaulted since the GFC. So these instruments are time tested, very safe. They
don’t have anything to do with what happened with CDOs in the subprime market
during the GFC. And if you have other questions as far as we can walk you
through the math, like you said, the recoveries have gone down over the years,
but you still need something like four to five or even six times A GFC
environment for a AAA CLO to consider defaulting. If we were in that type of
environment, any other financial asset you owned would be in a much, much worse
position.

Shiloh:

So you mentioned that low default rate at triple B. I mean, does
that imply though that people would be better off taking a little bit more risk
and moving down the cap stack rather than investing in the triple A,

which, and I know they’ve never
defaulted, so everybody feels good about that, but would it make sense for a
lot of people to take a little bit more risk and maybe get paid for it?

John:

It’s a great question. It really depends on the investor. What I
want to emphasize when looking at JAAA versus JBBB, so JBBB invest mostly in
triple B CLOs is yes, you’re getting more yield. You’re basically going from
let’s say a six and a half percent to kind of an eight and a half percent
yield, but you’re taking on a lot more risk. Whereas a triple A CLO is only
slightly riskier than cash, maybe one or 2% volatility. Triple B CLO probably
has four to five times the volatility of a triple A CLO. So you’re getting to
the point where it’s kind of like an equity type volatility. And so some people
are fine with that, particularly if you are very confident that we’re not going
into a recession or a very constructive on the overall economy and corporate
market. But that being said, you have to understand, if we go into a covid type
experience, that type of product could be down 10, 15, even 20%. Now you’re
getting an eight and a half percent yield to offset that. But we want investors
to understand what they’re signing up for because the only dissatisfied
investor should be a surprised investor and we don’t want people to be
surprised. So if that extra yield is worth it to you, by all means we think
it’s a great product. I own it myself, but if that’s too much risk for you,
then stick with JAAA.

Shiloh:

And so what’s the best way for an investor to find out more about
your funds?

John:

JanusHenderson.com or you can search on JAAA or JBBB. We have our
fact sheet on there. We have all sorts of information on either ETF, but that
is the best place.

Shiloh:

Great. Well, John, thanks so much for coming on the podcast.
Really enjoyed our chat.

John:

Yeah, same. My pleasure and great questions. Really, really
enjoyed the conversation.

Disclosure AI:

The content here is for informational purposes only and should not
be taken as legal business tax or investment advice or be used to evaluate any
investment or security. This podcast is not directed at any investment or
potential investors in any Flat Rock Global fund.

AUM refers to assets under management

LMT or liability management transactions are an out of court
modification of a company’s debt.

Layering refers to placing additional debt with a priority above
the first lien term loan.

The secured overnight financing
rate (SOFR) is a broad measure of the cost of borrowing cash overnight,
collateralized by treasury securities.

The global financial crisis (GFC)
was a period of extreme stress in global financial markets and banking systems
between mid 2007 and early 2009.

Credit ratings are opinions about credit risk for long-term issues
or instruments. The ratings lie on a spectrum ranging from the highest credit
quality on one end to default or junk on the other.

A AAA is the highest credit quality. A C or D, depending on the
agency issuing the rating, is the lowest or junk quality. Leveraged loans are
corporate loans to companies that are not rated investment grade broadly.

Syndicated loans are underwritten by banks, rated by nationally
recognized statistical ratings organizations and often traded by market
participants.

Middle market loans are usually underwritten by several lenders
with the intention of holding the investment through its maturity spread is the
percentage difference in current yields of various classes of fixed income
securities versus treasury bonds or another benchmark bond measure

ETFs are exchange traded funds.

Offset is a refinancing and extension of A CLO investment. 

The Bloomberg US Ag Index is a broad-based flagship benchmark that
measures the investment grade US dollar denominated fixed rate taxable bond
market.

JAAA and JBBB are the tickers for the Janus Henderson CLO Triple A
and CLO Triple B ETF.

For the risks of investing in these funds, please see
janushenderson.com.

RMBS stands for Residential mortgage-backed securities.

Non-Agency mortgages are mortgages not owned by a government
agency

CDO or asset-backed security is a securitization backed by
collateral that is not first lien corporate loans. 

General Disclaimer Section

References to interest rate moves are based on Bloomberg data. Any
mentions of specific companies are for reference purposes only and are not
meant to describe the investment merits of or potential or actual portfolio
changes related to securities of those companies unless otherwise noted. All
discussions are based on US markets and US monetary and fiscal policies. Market
forecasts and projections are based on current market conditions and are
subject to change without notice, projections should not be considered a
guarantee. The views and opinions expressed by the Flat Rock global speaker are
those of the speaker as of the date of the broadcast and do not necessarily
represent the views of the firm as a whole.

Any such views are subject to change at any time based upon market
or other conditions, and Flat Rock Global disclaims any responsibility to
update such views. This material is not intended to be relied upon as a
forecast, research, or investment advice. It is not a recommendation offer or
solicitation to buy or sell any securities or to adopt any investment strategy.
Neither Flat Rock Global nor the Flat Rock Global speaker can be responsible
for any direct or incidental loss incurred by applying any of the information
offered. None of the information provided should be regarded as a suggestion to
engage in or refrain

from any investment related course of action as neither Flat Rock Global nor its affiliates are undertaking To provide impartial investment advice, act as an impartial or give advice in a fiduciary capacity. This broadcast is copyright 2024 of Flat Rock Global LLC.

All rights reserved. This recording may not be reproduced in whole or in part or in any form without the permission of Flat Rock Global. Additional
information about this podcast along with an edited transcript may be obtained by visiting flatrockglobal.com.

Disclaimers regarding JAAA and JBBB:

This is not an offer for any of the funds mentioned in the interview.  The returns quoted for JAAA and JBBB are past performance and do not guarantee future results; current performance may be lower or higher. Investment returns and principal value will vary; there may be a gain or loss when shares are sold. For the most recent month-end performance call 800.668.0434 or visit
janushenderson.com/performance.  Janus Henderson Investors US LLC is the investment adviser and ALPS Distributors, Inc. is the distributor. ALPS is not affiliated with Janus Henderson or any of its subsidiaries.

JAAA Fact Card

JBBB Fact Card

The CLO Investor Podcast, Episode 7

Shiloh:

Hi, I’m Shiloh Bates and welcome to the CLO Investor podcast. CLO stands for collateralized loan obligations, which are securities backed by pools of leverage loans. In this podcast, we discuss current news in the CLO industry and I interview key market players. Today I’m speaking with Patrick Wolfe, the middle market CLO manager at BlackRock. I’ve been investing in Patrick’s CLOs for over a decade now, and BlackRock is the largest CLO equity manager across Flat Rock funds. In last week’s podcast, Paul Nikodem and I discussed some of the metrics that are used to pick CLO managers and Patrick’s CLOs and his platform check all my boxes. Other investors seem to agree as BlackRock is able to get some of the best CLO financing rates in the market. Our primary discussion was an update on middle market loans and how Patrick sees his platform as differentiated. We also discussed the risks he sees for CLO investors in today’s economy. Many of the questions I pose to Patrick are the same ones investors are asking me, including how borrowers are managing higher interest expense and if there are enough good middle market loans for everyone to get enough. So we’re going to hear the answers in this case directly from the horse’s mouth. And now my conversation with Patrick Wolfe. Well Patrick, thanks for coming on the podcast.

Patrick:

Yeah, thanks for the invitation. Happy to be here.

Shiloh:

So I understand you were recently at a CLO conference in Barcelona. What was that like?

Patrick:

The vibe of the conference was very positive. You’re seeing a lot of demand from a lot of new regions. Slowly different regions have come back online. So it was interesting, we had meetings from people from all over Europe, from Middle East and even as far away as Japan and Korea. So it was very well attended and a lot of people are exploring adding CLOs to their portfolios or turning it back on. We even met with a bank from Greece who was exploring adding middle market CLOs. So it was really an eclectic group of people there. And the weather and the food of course is always nice in Spain.

Shiloh:

I would think that would be a very compelling part of the conference. So why don’t we start off and if you could just walk us through your background and let our listeners know how you ended up managing CLOs.

Patrick:

Happy to. So I worked for Deutsche Bank around 2006 in structured products and luckily was a junior person at the time when we went into the global financial crisis and worked all the way through the global financial crisis. Saw a lot, got a lot of scars, had a lot more hair at the time, and worked on some really interesting bankruptcies in CLOs and gained a real good foundation of how to manage A CLO and at the time how to manage CLOs in difficult situations. And then post the global financial crisis around 2012, 2013, I got approached by 10 capital partners who was more of a multi-Strat credit firm. They asked me to join them as they looked to start issuing middle market CLOs and I joined the firm in 2013. We were acquired by BlackRock in 2018, so I’ve really been in this same role for almost 11 years now. We’ve become a large issuer, middle market CLOs. I think we’re on number 14 today and we’re approaching around a little over 6 billion of middle market CLOs. But the broader direct lending platform, which the middle market CLOs sit a part of is about 25 billion today. Or I also play a senior role as portfolio manager on the broader direct lending funds. But my history and my background was born in structured products.

Shiloh:

So then why don’t you give our listeners just a 1 0 1 on middle market loans and how they’re different from broadly syndicated loans, which are the bigger part of the CLO market.

Patrick:

So there’s quite the difference between middle market loans and broadly syndicated loans, or at least there has been for the last few decades. Middle market loans, I like the phrase is very much farm to table credit as we have to go out and originate and find the opportunities and we have to structure and underwrite and actually go visit the site and spend time with management and really manufacture an investment opportunity from scratch where a broadly syndicated loan, all your large investment banks, Morgan Stanley, Goldman Sachs, JP Morgan, all these large investment banks are out there syndicating away small pieces of loans and you typically get asked a question, do you want to buy this loan and at what price? So it’s much more of like going to a grocery store. You can go on Bloomberg and sort by industry sort by rating and within a day you can acquire a hundred broadly syndicated loans with a few phone calls to a few of the big banks.

We’re in middle market, like I said, we’re out originating the asset. We have much bigger teams required and we’re typically providing financing to help the middle market economy. Think of companies around 50 million of ebitda and in some cases they are selling their business to a private equity firm or they’re acquiring a competitor, but they just need some middle market financing to grow their business or transact. And that’s really the big difference is that middle market is very much a much bigger time commitment and amount of resources because like I said, we don’t just get to go on Bloomberg and pick from a pool of loans with a few phone calls.

Shiloh:

So the typical loan that you’re underwriting today, what do you think the average loan to value is and what’s the spread over SOFR?

Patrick:

So the average loan to value is going to be in the high thirties to low forties for first lien senior secured loan. And that’s really the only place we’ve been focused in the capital structure over the last couple of years is the first lien and that today is probably around SOR five 50 to SOR 600 today at that loan to value about nine months ago, I would say it was 600 to six 50 over SOFR. So we really have seen some spread compression over the last six to nine months, but relatively speaking, we’re probably a little bit wider than our historical levels. So it still has been a very compelling time to be at middle market lending. We still get covenants in our loans. That’s a big benefit of the middle market as we are negotiating and manufacturing and structuring these. So it’s hard to say it’s apples to apples to the broadly syndicated loans because those loans typically do not have covenants. So we have in a way a better structured downside protected credit agreement at a wider spread. So that’s where we’re seeing levels today.

Shiloh:

So one of the things I’ve been seeing is private credit, middle market lending has just become more and more popular each year. Are there enough middle market loans for everybody to get their share given how many competitors there are in the market and how much money’s been raised in the asset class?

Patrick:

That’s a very common statement that people do not expect there to be enough loans for everything to go around. I think people underestimate the size of the middle market economy and also where that economy is. Those companies are in their life cycle. A lot of these businesses are still owned by founders who could be from the baby boomer generation who are getting older and we’re starting to see a lot of companies transact. And there’s a quote that there’s over 50,000 companies in this 25 to 75 million ebitda and a very high percent of those need to go through a generational shift in the next 10 years. So there is by far more loans than there are capital for today. I do think direct lending on real market lending is very underfunded. When you look at the amount of private equity dry powder that’s been raised over the last few years, there’s estimates anywhere from around one to one and a half trillion dollars of private equity dry powder, and as I just mentioned on the loan to value, it’s close to one-to-one and direct lending is somewhere in the hundreds of billions from dry powder. You really need it to be closer to parity with that. If anything, direct lending is underfunded relative to private equity and there is a huge portion of our economy in this core segment. I do think there is room for more competitors and there’s plenty of deals. We are very selective. We only execute about 5% of the deals we review every year. So that’s maybe anywhere from 60 to a hundred deals a year on average. So yeah, I do think there’s plenty. And if anything, direct lending is underfunded relative to the broader private equity markets

Shiloh:

And with a lot of your loans being created in leveraged buyouts, do you think that is some activity that’s going to pick up later this year or is it that the higher base rate of SOFR has just really slowed down that market substantially and maybe there won’t be an increase until interest rates come down

Patrick:

The last two months. We’ve seen it up month over month, April, may. We’re very, very busy. We’re continuing to see it pick up. I think rates will only pour gasoline on it. When rates do come down, I think m and a activity will pick up a fair bit and it’s going to be really on the buyers and sellers agreeing to a price. We have seen a lot of businesses put up for sale and there’s just a really big bid ask and over the last few months that’s gotten closer and you’re starting to see businesses transact. But I think once rates go down, there’s a lot of private equity portfolio companies that need to be sold. Some of these private equity funds are getting really, really long in the tooth. They’ve been in existence for over a decade and the investors are the limited partners. They want their money back.

So I think as soon as people have a good feeling that rates are coming down and you’re going to get a slightly better valuation, you’re going to see a huge pickup in it. But right now we are seeing pretty substantial pickup in m and a, but I would say that these are actually more new businesses that have grown really well and fared very well in the high rate environment. You really haven’t seen a business that’s just bumped along as a lender. A business bumping along is very much okay, you just don’t want to see it go downhill. Sometimes when a company does too well, you get refinanced really quickly and all your hard work was only worth about a year of interest coupon. So a company that just slowly grows, bumps along, it’s great. And we haven’t really seen those companies transact. It’s the private equity sponsors either hope and rates come down, it helps them grow top line or create better margins. But the election’s still out there and rate cuts. Now with the news today, people are pricing in a cut post November. It’s not the multiple cuts people originally expected, I think early part of the year. So I think there’s still some uncertainty, but it’s coming. There is a wave of m and a that we’ll see in the next, I’d say six to 12 months.

Shiloh:

So you mentioned that you’re highly selective in the loans that you make. Are there some industries or particular red flags that screen out a lot of borrowers in terms of your credit box?

Patrick:

Yeah, commodities, cyclical businesses. You really want to be careful when you need a crystal ball to predict their ability to be refinanced in the future. If they have a hard time meeting their breakevens at where a barrel of oil is priced at, you really don’t want to make a bet where the barrel of oil will be in four to five years when you’re loan needs to be refinanced. So we tend to avoid businesses linked to commodity inputs. We also tend to not very cyclical businesses as well. As a lender, you really want stable growing businesses. So where we have probably done better than most is on technology software specifically. That’s an industry that we’ve liked for quite some time now and software just continues to be a bigger and bigger part of everyone’s day-to-day life. It helps people grow their business, run their business. And during covid we saw a lot of these software businesses do fairly well where a lot of people question their ability to maintain a tough macro environment and these businesses can be very asset light. It doesn’t take many people to keep the lights on at some of these software companies so you can quickly cut expenses. So we continue to like that very much technology growing growth businesses, we are very much less into the manufacturing, high cost, fixed cost type business structures. We do like insurance services. I like to say I like car wash roll-ups more than healthcare. So those are always fun to discuss.

Shiloh:

So in terms of the competition for middle market loans, there’s lots of other firms out there who want to originate these loans. Do you see yourself as competing based on price or the economics of the loan or are there some reasons that people would select your firm that aren’t just tied to the economics of the deal?

Patrick:

Economics today seem to be less and less as much of a deciding factor. It definitely matters where it is, but everyone’s coming out around the same area. So for the ballpark, for example, if we say we think a loan should be price at SOFR plus five 50 and someone else thinks it’s SOR plus 5 75, it’s really not that big of concession where you’re seeing the ability to win transactions is really off reputation size of firm. Are you going to be able to grow with the business? Is your firm something that could be much more of a long-term financing solution partner? That was something at our legacy firm that we felt we missed out on is that we were really only able to finance your business when you were 50 million of ebitda, 75 million of ebitda. But if you very much grew and maybe wanted to go to an IPO or maybe you were going to move to the high yield market, our firm was stopped being able to provide financing.

And we have seen a number of transactions where I think we won the transaction maybe be even a hair higher on pricing, but they viewed BlackRock as much more as a long-term financing partner is that we could grow with the business if they had ambitions for an IPO BlackRock, it would be one of the bigger IPO buyers just by what we participate from our ETF business. And that’s something that I think has proven to be really helpful in competitive situations. The other place that we’ve historically excelled at is that our team on the underwriting side and the management side is constructed by industry specialization. For example, our head of healthcare comes from private equity. He’s very much still has a private equity mindset so he can have much more of a peer-to-peer conversation with the sponsor of the private equity firm or even the CEO and CFO.

He really speaks their language that definitely has helped us win transactions and competitive environment. We’re not very much a generalist or a generic banker or just a cheap cost to capital provider. We could be much more of a partner, a financing partner that’s going to understand the issues that they go through, aren’t going to be scared of a typical delay that we are used to seeing in that industry or that subsegment where someone that’s very general isn’t used to manufacturing delays in pharmaceutical drugs and that’s something that happens from time to time. So that is another place where we’ve historically been our biggest competitive advantage is that our team has industry leads and they manage the investment from entry to exit. So they continue to work with the management team and the sponsor. So that’s some of the ways we’ve been able to compete that is beyond just pricing and economics, but there are some sponsors that that’s all they care about and we tend not to excel with those sponsors because we don’t want to race to the bottom. So we tend to look for much more long-term partners.

Shiloh:

So for somebody sitting in my seat, whenever we model CLO equity, we put in a 2% default rate into all of our projections, we put a 70% recovery rate in. How do you think those projections will fare for the next coming years here?

Patrick:

So in middle market I think that’s still a very valid assumption, 2% constant default rate at that recovery. I think broadly syndicated equity is having a tougher time. I’ve seen recoveries for a few of the rating agency research reports on in court restructurings being sub 20 and you’re seeing out of court restructurings being in I think the mid fifties. So everything that people have been nervous about in the broadly syndicated loans with the weaker credit documents and not having covenants is leading to lower recoveries in bankruptcies. The benefit of middle market is we still have that feel of what the leverage loan market was 15 years ago with a high percentage of our loans or mostly all of them with covenants of the ability to get to the negotiating table before too much principle loss creeps into the story. So I do think core middle market is just even direct lending. That is still a very much a fair assumption. I do think on average we probably outperform the default rate and I think the recovery is plus or minus five to 10 points from there and probably averages out to 70. Ours is in the nineties when it comes to our CLOs that have had defaults over the last 12 years. But I do think in this credit environment there’s going to be a tougher time and I think two and 70 in our market is a very much a fair assumption when modeling out that investments.

Shiloh:

So in the broadly syndicated market, there has been some weaker credit documentation that has resulted in some low recoveries. Do you feel like in the middle market you’re still getting the documentation that you want and that there isn’t a risk of a looser documentation in your particular market?

Patrick:

There’s definitely a risk in our market and we are seeing the segmentation of middle market loans or direct lending playing a big part in that. So we view the market in three segments. Let’s say lower middle market is zero to 25 million of EBITDA is the lower segment core being 25 million to a hundred million of ebitda and then upper it being a hundred million plus that upper middle market has gotten very competitive and we’re seeing reports of less than 10% of those loans having covenants where on average the core middle market is closer to 70% of the loans having covenants. So you have seen some of the broadly syndicated credit documents start to creep into our market. We’re doing everything we can to hold the line on it. One thing you can get comfortable with is maybe not the financial maintenance covenant, but where you’ve got to be careful is some of the negative covenants like your ability to up tier or execute liability management transactions or lts. You have seen that creep in not anywhere to the same degree in the probably syndicated market. And one thing people forget, there’s very smart lawyers out there and even though J Crew Serta chewy are some of the more famous bankruptcies and we all focus on making sure the weaknesses that were exploited in those bankruptcies are tied up. There’s no saying that someone’s not going to create the new weakness.

Shiloh:

It’s a bit of a whack-a-mole I’ve heard.

Patrick:

Yes, it is exactly a whack-a-mole. There’s lawyers out there trying to figure out every which way to weaken the document and find a loophole to exploit some of these things. If you go back five years or even seven years in our credit documents, the Serta protections might not be there because no one believed they needed them. So the document is always evolving and one thing I like to highlight is there’s almost like a red yellow green from a strength protection, some of it. So right now what we thought was a strong credit protection to protect you from Serta, today’s age might be only lightly or moderate. So when you do have an amendment, do you want to rewrite that protection the document to be even stronger because even though you might’ve thought you had the protection, the lawyers find it the loophole to get it. So the document is always evolving, it’s always going to be whack-a-mole and private equity sponsors will try to find loopholes to protect their investment, their fiduciary to their investors. So if they could exploit some part of the credit document to increase the recovery or create a recovery, they’re likely going to do so that’s one thing that we’ve always been focused on is the sponsors are great until they’re not.

Shiloh:

So then one of the things I’ve also liked about middle market is just that when a company does get into stress that you only have one or a handful of lenders that are making the call and broadly syndicated, you might have a term loan that’s a billion in size and you might have 40 or 50 different people with opinions in the restructuring process. You might have a high yield bond, a second lien lawyers taking all kinds of fees for their time. All that’s going to eat into the first lien recovery.

Patrick:

That is a big benefit that we have. We’re typically the only debt and we’re mostly the first lien. It’s typically only first lien senior to secure loans. So it does make for a lot cleaner restructuring. A lot of times it’s done out of court. We don’t have to go through a formal bankruptcy system that can be very costly and just decreases your recovery as a lot of people get paid in restructurings and it could be 15 20 million in fees going out the door. So the direct lending, you have a much more of a sitting down across a table workout of a restructuring in some cases only one lender or a couple lenders. And for the most part everyone’s in agreement and there isn’t typically one lender trying to create a priming facility. It’s very much everyone’s arm in arm trying to get to the best outcome for the restructuring.

Shiloh:

So one of the questions I think I’m asked the most is just that as the Fed has hiked rates, loan yields are in, call it the 10 to 12% the area, are the borrowers able to make those interest payments over an extended period of time or do they really need the fed to start cutting in the future?

Patrick:

No, a very high percentage at least of our portfolio are still well above one and a half times from an interest coverage standpoint, meaning they’re able to still service the debt. I think for the private equity returns to pencil out to what they were initially underwritten at, they’re going to need to see the Fed to start to cut rates. We’re not seeing interest rates alone push a company into distress or de-stress. It’s typically interest rates plus a loss of the customer interest rates plus a supply chain issue. So for the most part, the companies have been able to manage the higher rate environment. They just had a lot less room for error. It kind of magnifies a mistake right now. I think if the interest rates start getting cut, it gives them a little bit more room to lose a customer to have a supply chain delay and still have liquidity to manage through. It just really has made it much more difficult for them to make a mistake. It’s hard to recover with their interest rates where they are.

Shiloh:

So do you see the higher rates is basically just transfer in economics from private equity firms to middle market lenders?

Patrick:

That’s exactly correct. We’re going from mid single digits to teen type returns on the assets and that is coming out of the equity ownership of the business. So they’ve benefited from low rates and very high returns for quite some time. And the term that gets thrown around a lot is the golden age private credit and it’s really the first lie loan is making almost equity like returns from a yield standpoint.

Shiloh:

So that’s why I think it’s so many headlines and so much interest in the asset class. It’s just that double digit returns from a security where you’re in the top of the capital structure. So one of the key trends in CLOs this year has been declining CLO financing costs triple eight down to double B. How does that affect your business in terms of issuance? Does that make it more likely that you’ll come to the market deals in the future or will you look to refi reset the deals that are already outstanding?

Patrick:

From a new issue standpoint, it doesn’t really change what we had planned for the year. From a new issue standpoint, it definitely makes things more appealing. Where it does change our plan is on the reset refinance side of the equation. So at the AAA levels we are today, a lot of the deals that we’ve priced over the last couple of years are all of a sudden it looks compelling from an equity return standpoint to go out and reset the deal for another four years and possibly lower the borrowing costs slightly. So that’s where I think you are seeing a lot more activity as people are starting to refinance and reset new deals. Middle market is less tied to a few basis points. Even when spreads were 75 basis points wider than they are today. People were still out there constantly issuing middle market CLOs because we just have a lot more spread in our assets and if a quarter basis, 25 basis points doesn’t necessarily make or break our returns like it does in broadly syndicated equity where they’re trying to get to a couple basis points of a model from an arbitrage standpoint because they’re going to magnify it 10 to 12 times and probably syndicated.

So every basis point really matters at that magnification middle market. CLOs can be anywhere from three to six times levered, so it’s less of a magnifier when we’re talking a few basis points. But I think reset activity does definitely pick up the back half of this year.

Shiloh:

So BlackRock has both broadly syndicated and middle market CLOs. Are the investors in those two different securities, are they different folks or do people play in both your middle market and your broadly syndicated issuances?

Patrick:

So we definitely do have a middle market US probably syndicated and European CLO business as well, which is syndicated loans there. We do have crossover on the debt side for sure. People are familiar with the platform, how robust our risk management functions are our Aladdin systems and they definitely get the benefits of underwritten one of the teams. There’s going to be a big portion of their underwriting completed, so they do get a synergy of that. So we definitely do see overlap on the debt investor side. On the equity side, I do not believe the middle market overlaps with the probably syndicated, but I can’t say it for a hundred percent certainty.

Shiloh:

Is there anything interesting happening in the market that we should touch on?

Patrick:

I think one thing that doesn’t get the attention in middle market loans are valuations. This has become really important recently for the AAA investors as because if a loan isn’t being marked a fair value, there’s no benefit or protection to the or other debt holders. From a triple C haircut standpoint, we’ve seen the S and p triple Cs creep up from a historical average where by nearly the s and p averages, most people are going to be having almost some form of a triple C haircut. Well, that haircut only protects you if the loans are being marked a fair value. If they have all the loans marked at par or near par, it doesn’t give you the protection,

Shiloh:

Then there’s no haircut on that.

Patrick:

There’s no haircut at that. So I was on a panel recently where another manager was saying they self mark their loans and they didn’t see the need to value their loans. And there’s just so many reasons why valuations should be done If you have a B, D, C, it has to be done, but the frequency and the way you do it is not standardized. And then when people are looking maybe to make direct lending fund investments, like if you’re just going to invest in someone’s fund, one manager might be marketing their book to represent fair value and their returns might look lower than a manager who doesn’t mark their book. So I think valuations is something that helps level set the different managers and also gives you a good third party view of the credit quality of the portfolio. One thing that I think you’re good at and the they’re good investors at is they look at the market values of our loans that are done by third party valuation agents and it could quickly tell you what loan is maybe underperforming or having issues.

It quickly highlights where outperformers and underperformers are, and you don’t necessarily need to be familiar with all the underlying borrowers, but this third party has gone in and reviewed the financials, has spent time with the budget as a really good understanding on how the company is performing. So if there was more of a standardization of valuations where everyone was doing it every quarter and they were doing it to market, there’d be a much more clear playing field where it’s really hard to light up managers side by side from a return standpoint because one manager might have unrealized losses because they’re marking their book to reflect the credit quality where one manager hasn’t marked his book and has everything at par, even though they might have problems underlying. Now you see the BDC analysts talk about it where one manager has a loan marked at 75 and two managers have it marked at par. So it’s one place I’d hope there would be more standardization and more people getting to quarterly valuations of the portfolio.

Shiloh:

I definitely see that when we pull up CLOs and Intex, sometimes all the loans are marked and that other times just some percent, it could be the CCCs are marked defaulted loans. There’s always going to be a mark for those, I think. But for my seat, yeah, if you can get a hundred percent loans marked, that would enable investors like me to compare returns apple to apples. And then it would also increase just the liquidity of a CLO manager’s shelf because at the secondary market, people would freely trade bonds if all the loans are priced and it becomes more challenging if there’s just some blank fields by the loan prices. So one thing I do see in our middle market CLOs is that sometimes there’s some broadly syndicated loans that make it into the portfolio. A lot of times these are, I call them maybe lightly syndicated loans where maybe they’re underwritten by a Jefferies or a UBS or something like that. Do you guys ever see value there for your middle market CLOs?

Patrick:

We have in the past. I’d say that market has gotten smaller over the last couple of years. We’re seeing less and less through that lightly syndicated. There’s still to us important to be middle market borrowers, so there’s still sub a hundred million of ebitda. Those do have some benefit is that you can in some situations actually drive change to the documentation. It’s not as much of a yes or no at what price transaction. It’s very much more of here’s the business. You could spend time with management if you like. You could do the same level of diligence that you typically like and in some markets they’re open to doc changes, improvements. We’re willing to come into this deal, but we need these two sections of the credit agreement tightened. Maybe we need a little bit more pricing. And in some markets we found some really compelling opportunities that almost felt private in the end where we went out and met management team and there are some that come in three days and it’s how much do you want to buy and at what price?

And those are less likely for us to participate. But they have been a way to add additional assets in some industries and even some businesses we know that was probably five, seven years ago was a common exit for us is we did a private deal and then the next step was to the lightly syndicated bank deal. We see that less and less now where a company just stays primarily in the private credit space where it goes from our market to another one of our peers that does bigger deals. With some cases we participate in enroll and sometimes the pricing is going to be so low or the documentation is not what we expect, so we just go home. But that is now, I would say the more traditional graduation from our segment to the larger segment of the market.

Shiloh:

Well, I think that’s all the questions I had. So Patrick, thanks so much for coming on the podcast. Really enjoyed our conversation.

Patrick:

Thanks. Always great to chat.

Disclosure AI:

The content here is for informational purposes only and should not be taken as legal business tax or investment advice or be used to evaluate any investment or security. This podcast is not directed at any investment or potential investors in any Flat Rock Global fund 

Definition Section: 

AUM refers to assets under management

EBITDA, or earnings before interest, taxes, and depreciation, is a proxy for a business annual cashflow 

Roll-up strategies are when a private equity sponsor is actively looking to grow a business through acquisitions. 

Loan to value is the value of the first lie in debt divided by the enterprise value of the company. 

LMT or liability management transactions are an out of court modification of a company’s debt 

Up tiering refers to placing additional debt with a priority above the first lien term loan. 

The secured overnight financing rate (SOFR) is a broad measure of the cost of borrowing cash overnight, collateralized by treasury securities.

The global financial crisis, GFC was a period of extreme stress in global financial markets and banking systems between mid 2007 and early 2009. 

Credit ratings are opinions about credit risk for long-term issues or instruments. The ratings lie on a spectrum ranging from the highest credit quality on one end to default or junk on the other. AAA is the highest credit quality. A C or D, depending on the agency issuing the rating is the lowest or junk quality. 

Leveraged loans are corporate loans to companies that are not rated investment grade broadly. 

Syndicated loans are underwritten by banks, rated by nationally recognized statistical ratings organizations and often traded by market participants. 

Middle market loans are usually underwritten by several lenders with the intention of holding the investment through its maturity. 

Junior capital is financing that has a lower priority claim in debt repayment to a secured term loan. 

Spread is the percentage difference in current yields of various classes of fixed income securities versus treasury bonds or another benchmark bond measure. 

ETFs are exchange traded funds.

High yield bonds are corporate debt rated below investment grade and sometimes referred to as junk bonds. 

Reset is a refinancing and extension of a CLO.

 Investment interest coverage ratio compares a company’s annual cashflow to its interest expense. 

Intex is software that CLO practitioners use. 

General Disclaimer Section: 

References to interest rate moves are based on Bloomberg data. Any mentions of specific companies are for reference purposes only and are not meant to describe the investment merits of or potential or actual portfolio changes related to securities of those companies unless otherwise noted. All discussions are based on US markets and US monetary and fiscal policies. Market forecasts and projections are based on current market conditions and are subject to change without notice, projections should not be considered a guarantee. The views and opinions expressed by the Flat Rock global speaker are those of the speaker as of the date of the broadcast and do not necessarily represent the views of the firm as a whole.

Any such views are subject to change at any time based upon market or other conditions and Flat Rock Global disclaims any responsibility to update such views. This material is not intended to be relied upon as a forecast, research, or investment advice. It is not a recommendation offer or solicitation to buy or sell any securities or to adopt any investment strategy. Neither Flat Rock Global nor the Flat Rock Global Speaker can be responsible for any direct or incidental loss incurred by applying any of the information offered. None of the information provided should be regarded as a suggestion to engage in or refrain from any investment related course of action as neither Flat Rock Global nor its affiliates are undertaking. To provide impartial investment advice, act as an impartial advisor or give advice in a fiduciary capacity. This broadcast is copyright 2024 of Flat Rock Global LLC. All rights reserved. This recording may not be reproduced in whole or in part or in any form without the permission of Flat Rock Global. Additional information about this podcast along with an edited transcript may be obtained by visiting flatrockglobal.com.

The CLO Investor Podcast, Episode 6

Shiloh:

Hi, I am Shiloh Bates and welcome to the CLO Investor podcast. CLO stands for collateralized Loan obligations, which are securities backed by pools of leverage loans. In this podcast, we discuss current news in the CLO industry and I interview key market players. Today I’m speaking with Paul Nikodem, CLO researcher at Nomura Securities. Paul’s job is to provide CLO market commentary and analysis to CLO investors like myself. Our primary discussion revolved around evaluating CLO managers at Flat Rock. We do not manage CLOs, we just invest in CLO Securities. Each CLO has a manager. Their job is to pick the loans for the CLO and to keep the CLO passing its many tests. According to Creditflux, the five largest CLO managers are Elmwood, Credit Suisse Asset Management, Blackstone, Neuberger Berman, and Octagon. But CLO investors have over a hundred different managers they can choose from. Our conversation also tackled declining CLO financing costs. And now my conversation with Paul Nikodem. Paul, welcome to the podcast.

Paul:

Thanks, Shiloh. It’s good to be on. Appreciate you having me.

Shiloh:

Why don’t you tell our listeners a little bit about your background and how someone becomes a CLO researcher?

Paul:

Sure. To be honest, I didn’t start off as a CLO researcher. I’ve been covering securitized products as a research analyst since 2003, but I started my career covering mortgages and housing for the first decade. So it was a really interesting time to cover both of those markets. Obviously saw the large runup pre global financial crisis and then the whole mortgage market and the housing market imploded and then that was followed by the recovery trade aided by a lot of government support and just a slow rebuild of the mortgage market. So it was a really interesting time to think about scenarios and how to stress test bonds and just experience both the boom and the bust cycle. And then after 2010 or 2011, it was really the recovery trade where we saw government support come back to the housing market and private capital and GSEs really start to slowly expand the underwriting box.

And the mortgage market slowly came back until the housing market accelerated and then it was boom times for much the next decade. So as we covered RMBS and housing during that decade post GFC and we expanded our coverage, we started looking at other sectors as well within the securitized products research arena. One of the sectors that stood out to us was the CLO sector that was starting to gain its footing and starting to grow pretty rapidly at the time. And it was really interesting for us as research analysts to look at the performance during the GFC. Now, the mortgage market clearly did not do well and it was really housing led, but CLO market did quite well surprisingly well when we started looking at the data. And it was really interesting to see how these structures held up in this first stress scenario that we started to take a look at.

And basically around that time, our firm Nomura also decided to make a commitment to grow in the CLO business, starting with the secondary trading and followed by the primary business as well. And we started to cover the sector from a research perspective. So the idea was that we had really great technology that we built up from the residential mortgage research arena looking at loans and mortgage servicers and intext data. First thing we did is we took a look at those systems and applied them to the CLO market where we had managers and we had individual loan issuers. We tried applying similar technology to see what we can find. And it was a really interesting time to start to look at a very micro level at the CLO market to see differences in manager performance and loan performance and issuer performance. And that’s how we got started.

We were in the right place at the right time and we were able to transfer some of that technology from R and BS to really hit the ground running on the CLO side. And since then, the market has obviously grown dramatically. It’s one of the key sectors within the securitized markets and it’s very fascinating to look at the market both from a very macro perspective where we look at the buyer base and overseas investors and just supply demand dynamics and also at a very micro level looking at manager selection and loans and recoveries and drilling in very, very deep. So it’s been a very exciting time to be a CLO research analyst over this past decade.

Shiloh:

So for your research, is it that you put out a different piece each week that goes to a number of clients telling them whatever you think is interesting that’s happening in the market?

Paul:

Exactly. So we try to respond to what questions are on investors’ minds at every week, sometimes more frequently than once a week depending on what’s going on in the market. But we try to combine some of the micro interesting data analysis and manager analysis with some of the broader macro observations that we find in our research.

Shiloh:

I know Nomura has a CLO banking team and a CLO trading team. Why don’t you talk about the other things that Nomura is doing with CLOs?

Paul:

So starting in 2015-2016, we started off by having a very strong secondary trading effort. So our firm is the most active trading desks in most scenarios in Double Bs and equity and me in general, we speak with all the key investors that are active in the space and we have a very strong franchise there. A couple years later, we also made an investment in the primary business where we deal with many of the largest, most established managers in the space and we’ve really built a top 10 business in that space. So part of it is timing and getting the timing right. Part of it is investing in talent and investing in balance sheet as well as research. So our firm has really decided to make an investment in this business.

Shiloh:

So what is it about CLO equity and CLO double Bs that’s of particular interest to your firm?

Paul:

It’s a very data intensive, research intensive product where there’s a lot of differentiation and performance across managers and deals and vintages. With the right tools in place and the right investment in place, we have developed a way to find a niche and an edge in identifying opportunities. There’s a lot of dispersion in performance, so that’s one. These products trade very differently depending on the profile and requires a lot of analysis and insights into the market to figure out how to generate alpha for our clients as well as run a successful trading business. And part of it is connectivity to our primary business as well, where a lot of what’s going on in the market today has to do with optionality for issuers and equity holders to refi or reset or call these deals. So having an insight into what investors want to do both on the primary and the secondary side and what are the outs for these deals has a large impact on valuations, especially given that most of the market is trading at a premium now. So the timing of that refi reset is also crucial. We feel like we’ve developed an edge in that as well.

Shiloh:

Interesting. So one of the things I wanted to focus on today was just how to evaluate a CLO manager. So if we’re talking about broadly syndicated CLOs, which is around 90% of the market, I think there’s a hundred different active CLO managers. What do you think the first step is in identifying a CLO manager that’s going to outperform?

Paul:

From a research perspective, we’ve developed a large variety of metrics to evaluate manager performance over a long period of time. So in the past I’d say that bill was the most relevant metric that we used.

Disclosure AI:

Note par build refers to the CLO manager growing the par balance of the loans. This can sometimes be thought of as loan gains.

Paul:

To benchmark and compare manager performance over a long period of time. Although in recent months and quarters, it’s become a less useful metric by itself given that a lot of managers have been focused on risk reduction and defending against tails, whether it’s downgraded loans or lower price loans picking up. And the stats have been skewed based on the par build metric alone. So we’ve done a couple of things to try to identify who’s outperformed in recent years. Number one is we’ve tried to improve on the par build metric. And what I mean by that is we’ve created a new sub metric within par build to try to decompose the two effects that drive par build. One is original portfolio quality or credit selection, how has that original portfolio performed over time, absent any subsequent trading activity and also the value add of trading. So we have a metric, we like to call it active versus passive par build. So we decompose that performance by manager. That gives a lot of interesting insights. First being that original credit selection matters a lot more than trading activity and driving performance for many managers over the past two years. So that’s one observation that we rely on from this metric.

Shiloh:

So is what you’re saying here that the CLO begins its life with 400 million or 500 million of loans and it’s really that initial loan selection that’s going to be the key driver of returns over time? That’s your view?

Paul:

In the last two years, that was the primary driver of differences in performance, not necessarily true in previous episodes of distress, but over the past two years, definitely the case. Another thing is looking at how CLO managers manage tails. So on the surface you could take a look at what’s the triple C concentration by manager, and that’s one thing that the market does tier for. But looking under the hood, there’s some managers that don’t sell a lot of triple Cs and they might have a credit view that some of these loans might recover and the market prices are too low at the time and you have other managers that might be very aggressive in selling. And then you also have the other dimension of high downgrade rates to triple C and lower downgrade rates to triple C. So I think it’s also very important to decompose and think about what are downgrade rate differences across managers and how does that interact with trading as well?

So sources of triple C and how managers are handling that through the cycle also matters quite a bit. And finally, just thinking more broadly, consistency matters quite a bit. So in terms of thinking about who’s done well in the past, there’s obviously no guarantee that past performance will lead to future success. So we like to look over a long time period at consistency throughout different cycles and consistency and style. But for example, some metrics we like to take a look at are unlevered returns on the underlying portfolio over time. So how does it look every calendar year going back five or 10 years depending on the 10 of managers we’re taking a look at? So consistency is important. If you’re a debt investor, you do not want to see large drawdowns necessarily equity investors, you might have a little bit more tolerance for that if you see more upside in certain years, but it all depends on where you sit in the capital stack. So consistency in general matters quite a bit as we think about forward outlook.

Shiloh:

So one of the things from my C is that the metrics that you used, I could obviously see the attractiveness of using them, but each metric is a little bit incomplete in some way. So for example, you mentioned the par balance of the loans and is it growing? So the shortfall of that metric is just, well, are the loans price at par or 90 or some other number? And then if we’re looking at CCC balances, CCC loans are certainly at higher risk of default. But one of the first experiences I had with CLO managers, I went to a prominent one and he was telling me about his philosophy on triple CCCs and he just basically said, Hey, listen, I’m just buying good loans for the CLOs and if a rating agency has a loan at ccc, it’s important to know that for the functioning of the CLOs many tests.

But at the end of the day he’s like, I just want to buy good loans. He trusted his credit team a lot more than the rating agency assessment of the risk in the loan, and he told me he might buy a CCC loan because it has a high spread or because it has a low dollar price. So sometimes the rating agencies are a little bit lagged in terms of their downgrades or upgrades. So that’s the downside to using the CCC balance as a prominent metric. And at the end of the day, really the question with CCCs are just are they going to repay at par or not?

Paul:

Yep, exactly. I think that’s very consistent with a lot of our thoughts as well. I think that speaks to original credit selection mattering a bit, and obviously you want to have a manager that’s at least aware of some of the triggers and tests and the structural constraints of A CLO versus just managing a loan portfolio as it relates to certain stress scenarios or the ability to have good metrics so that they’re able to continue to raise capital in the future. But at the end of the day, I completely agree it’s loan selection and having a good credit team definitely matters quite a bit. Those with better selection ability over the last couple of years have definitely outperformed in our metrics versus those that might be optimizing par build for example.

Shiloh:

So I think the first cut for CLO manager analysis, what we would do is just pull up their deals in Intex

Disclosure AI:

Note Intex is software market participants use to model CLO securities

Shiloh:

And look for deals that are two to three years old and see what’s happening with the loan portfolio and really just ask yourself, are these CLOs where I would’ve wanted to participate from inception? I think that’s a good way to start the analysis. One of the things that I think is everybody’s looking for the loss rate on the loans. So one manager might have 40 basis points of annualized loan losses, another might have 60 and somebody say, okay, well the 40 is better than the 60, but what you really need to do is normalize for the income or spread of the loans. So if one CLO manager has a 20 basis points of incremental loan losses, but their loans provide 40 basis points of incremental loan income, then that’s the better manager in our view.

Paul:

For equity holders, that’s definitely a valid way to look at it. I think that for example, our unlevered return metric handles that maybe not directly, but it goes in that direction where if you have a higher spread on the portfolio that’ll contribute to the returns and be offset against the market value drawdowns. So we don’t explicitly count defaults separately from market value moves. It’s counted together. And that’s a very good point for equity that you have some more cushion if you have a higher spread portfolio. So yes, absolutely, I would definitely consider that as well.

Shiloh:

If you were just going to use one metric and one metric only to evaluate a CLO manager, would it be the unlevered return of the loans versus the Morningstar loan index? So that’s just the performance of the loans outside of the CLO structure

Paul:

Over the long term in terms of identifying upgrade candidates and just thinking big picture. Yes, absolutely.

Shiloh:

So I mentioned earlier that there’s downsides to each way of measuring performance, and if you’re looking at the performance of the loans only, you’re not capturing any of the skill that’s needed to manage CLOs and the CLOs. Many tests and then also some CLO managers are just going to have more conservative loan portfolios. So those might underperform the Morningstar loan index, but with the leverage provided by the CLO structure, the returns there could still be quite favorable.

Paul:

I mean, one thing I would say for that is we tend to look at a cluster a two by two scatterplot, if you will, of returns versus standard deviation of returns versus some other risk metric. We’ve played around with a few to risk adjust those returns to do some comparative analysis. So for the higher return, lower standard deviation managers look at a quartile, for example, on this two by two grid, which managers are outperforming their peers. I agree with you. On average there are some biases to looking at it that way and it might not fully capture the equity returns, but we’re thinking more in terms of upgrade candidates or which smaller managers are outperforming some of their bigger manager counterparts and are deserving of an upgrade for equity managers. I think that definitely would look at different metrics more so in terms of leverage and distributions and cushions, but that unleveled return versus appears is more for a holistic view on upgrade potential and small versus big managers and who’s trending in what direction.

Shiloh:

So maybe the takeaway is just that there’s a number of different ways to evaluate CLO managers and you probably need to use all of them to really get a complete picture. So the result of CLO manager analysis is a tiering of CLO managers into tier one through four with one being the best. So I think starting at tier four, would you put anybody in tier four? I’m not necessarily looking for names at this point, but are there a handful of managers that have really underperformed

Paul:

In terms of underperformance? Yeah, there’s probably isn’t a quarter of all the managers outstanding. It’s probably not the bottom quartile. Maybe it’s the bottom decile of, as you mentioned, managers that haven’t issued and some of them might be trying to rebrand themselves and have much cleaner portfolios and switch their style, but there’s definitely a few that clearly have underperformed in the past and clearly have par holes or underperformed during past stress periods that are just not treated well in secondary at all. There’s stats reflect that. The other tier is just new managers in general, which we give them the benefit of the doubt and wait two to three years to see a track record before really taking on a view. To your point earlier that everything looks clean on day one, but it seems like it takes at least two to three years of history before we could start to differentiate who are the better and the worse of the new managers. And basically who deserves an upgrade to tier one or tier one and a half faster than others. That’s how we’re thinking about it.

Shiloh:

Okay. So who do you think is in the top tier if you’re able to share a few names with us?

Paul:

Sure. So top tier, the way we think about it internally, there’s a couple of different metrics, whether you’re the top, you’re the bottom of the stack, part of it’s performance, part of it is AUM, part of it is number of deals and primary spread tiering, and it’s a little bit of a circular argument. We don’t really love it as research folks, but it makes sense that managers that have been around longer who have consistently traded tight primary have better liquidity. So there’s a better refi reset optionality to get out if spreads tighten without as much extension risk and they’re going to trade better in secondary if you see another Covid scenario and spreads blow out, for example. So there’s some self-fulfilling prophecy to that. Our first blush would just be to rank by primary spread tiering as well as just AUM in general. So you’d see a lot of the usual names there, but to put a couple names out there in terms of overlaying a research view on performance and who’s been cleaner and who’s navigated through credit cycles better than others, some names that stand out within that tight spread and high AUM top quartile would be, for example, Elmwood, CS, Oak Hill, I guess BlackRock, CISC, Allstate are some names that come to mind.

Shiloh:

So do you think that most people on the market would agree with the tier one distinction for the guys you mentioned, or is it that CLO investors like myself that we are just using totally different inputs into our CLO manager analysis that would result in a different tiering?

Paul:

So at the top of the stack, I think it’s pretty self-evident given the AUM and primary spread tiering, which tends to be very sticky. And part of it has to do with the fact that larger anchor buyers tend to just set up their list and they tend to switch less frequently, although we have seen a shift in the AAA buyer base. So there’s some impetus for change, although not as rapidly as at the bottom of the stack. So at the double B and at the equity part of the stack, I think there’s a lot more opinions, especially of if a manager has tails that are increasing or has cleaned up quite a bit, the market could tier very, very differently pretty quickly after seeing some of the performance differences. Or they might tier a manager differently for vintages two years ago versus four years ago based on differences in performance. So it feels like down the stack that tiering is a lot more responsive and there’s a lot more opinions about who’s improving, who’s trending, who’s getting worse, et cetera.

Shiloh:

So from my perspective, it looks like a tier one status at the top of the stack for the AAA for example, a lot of that seems to be just based on name recognition rather than the performance of the underlying loans. And once you have that tier one AAA investor base, I think it tends to be pretty sticky. So these guys just continue to do your deals year after year and maybe aren’t looking to put new entrants on their list. And in CLO equity is totally different. So you’re daring any loan losses, it’s an issue for you. So name recognition doesn’t really pay the bills. The other part of CLO manager tiering and manager selection is just that there could be managers out there that we really like, but at the end of the day, if they can’t get good debt execution, then there’s really nothing for us to talk about because that’s the key ingredient for good CLO equity returns. So Paul, let me ask you this. It seems like every year there’s five to 10 new CLO manager entrance to the market. Have you seen any of those be particularly successful? I think it’s a pretty tough business to break into.

Paul:

This may not be the newest of managers, but Elmwood was probably the first one that stuck out. Obviously the PM came from BlackRock and the performance was pretty similar early on and conservative, but they’ve performed very well and are clearly tier one and nobody would call them a new manager, but they’re probably the first one that we would think of in terms of that upgrade cycle. But more recently, I guess Birchgrove white box stand out to us as also going down that positive trajectory.

Shiloh:

So one of the changes we’ve seen in terms of CLO management style is that pre Covid managers were doing loans with LIBOR spreads from 330 basis points all the way up to 400 basis points. And during Covid, when loan losses were elevated, a lot of the loan losses were actually in the high spread names, which makes sense. So it was really the conservative loan pools that outperformed during covid. And it seems a lot of CLO managers are really now just sticking to the lower spread pools. Is that something you’re seeing in your research?

Paul:

I’m hearing more of the latter, but as a research analyst, another thing that I point out is that a few years ago, if you take a look at a scatter plot of WAS versus performance

Disclosure AI:

Note WAS stands for, the weighted average spread of the loan portfolio

Paul:

High WAS tends to outperform. In good scenarios, they tend to have large drawdowns and bad scenarios, unsurprisingly, but more recently, over the past two years that correlation has broke down and it’s not obvious that high was has underperformed in the cycle. In fact, we’ve seen some lower spread managers that have had a small number of loans that have gone bad and unfortunately the recoveries have been so low that they’ve taken pretty big par hits. So the correlation between high and low spread and performance has really broken down in recent years and it’s hard to really show that relationship. Recently just given the market environment, the defaults have been low and just the loan recovery has been just very idiosyncratic. So anecdotally, it does feel like we’ve seen a number of higher spread managers previously that are trying to go into lower spread, more conservative portfolios rather than the other way around. But it’s not clear that that has a difference, an impact on performance as of right now over the longer run, in theory it’s supposed to have a correlation, but in the last two years it has not.

Shiloh:

Well, one of the reasons that we favored the low spread loan pools was that with the low spread portfolio, you can still generate very healthy distributions to the equity, but you’re taking less risk on the underlying loans. And if the loan pool stays strong over time, then the option value of doing resets and refis in the future is greater. Whereas if you just have the higher spread portfolio, that to me implies more risk and the higher spread loans do create more income for the CLO equity that comes quarterly and of course that’s nice, but you don’t really need to reach for the higher spread loans to get very good CLO equity returns is our view.

Paul:

Yeah, I think that makes a lot of sense. I remember I think five or six years ago, this is where we saw a switch where before that the lower spread managers didn’t necessarily have great distributions and a lot of them were shunned by the market. But after that there started to be a transition where some of the lower spread managers had really tight funding costs and they avoided a lot of the hiccups in 2017, 2018, 2019, whether it’s retail or some of the idiosyncratic issues that showed up in the loan market and they really outperformed, at least some of them started to outperform. And I think that trend has continued. So I think that makes a lot of sense.

Shiloh:

So changing topics, one of the things we’ve seen this year is that the CLO financing costs have come in really dramatically. And curious if you think the trend’s going to continue or if there’s some floor level to SEAL Lewis spreads that we may hit at some point?

Paul:

That’s a great question that we often have received recently. I feel like spreads will continue to oscillate down, but the issue is that every time you tighten a few bps, you could see another wall of refi reset supplied pickup, and that could temporarily cause spreads to widen before they tighten again. But the general direction continues to be tighter. So across all the securitized products assets that I cover now, the conversation is really spreads are pretty close to post pandemic tights or near two year tights. And now take a look at where spreads were before the pandemic and look at that comparison. And CLOs are not in a vacuum by any means. I don’t think that there’s anything preventing CLOs to go into the low to mid one-thirties by year end with a couple of fits and starts where spreads might temporarily widen with refi reset supply.

But there’s a couple of important factors here. One, just from a broader macro environment, we think the macro environment will be relatively benign and fund flows will be positive and insurance and annuity flows will be positive and more importantly, bank demand for securities has gradually picked up and we think that trend will continue going into year-end positive for CLOs just given the duration profile and the floating rate nature. But I think all the major investor groups are either investing quite a bit or rising as a share of buyers in terms of the CLO market and broader securitized products. Also, net issuance is very, very limited for CLOs and even more limited for triple eight given that amortization speeds are elevated and most of the amortization happens at the AAA part of the stack. So to give some context, CLO AAA net issuance is barely above zero year to date, whereas overall CLO net issuance is about 15 billion year to date.

So the net amount of growth and the AAA part of the market is pretty close to flat and that’ll probably continue for the remainder of the year. Taking a look at some of the bank data, banks have been roughly flat down in terms of their holdings over the last quarter and they could pick up a little bit. ETFs obviously are growing and accelerating, especially at the top of the stack, and it doesn’t take much of ETF or bank flows to really push AAAs tighter given that they’re not really creating new AAAs. A lot of it is recycling from short to long and amortization. But in general, we think the technicals should be positive, think the macro environment should be positive. We think the Fed first rate cut, we’re calling for July with some risk that it gets pushed to September, but we’re calling for two cuts this year, possibly slightly less, but at least one cut this year. Even if some of the inflation prints are a little bit hotter in the near term, it does feel like a risk on environment and general spread tightening environment. So we are positive at the top of the stack continuing to tighten.

Shiloh:

Do you think that spread tightening is really a function of the fundamental performance of the underlying loans or is it more technical in nature?

Paul:

I think it’s very technically driven recently, so a year ago agency spreads at 180 bps was certainly an impediment to CLOs tightening given that you saw some crossover buyers look at both, that issue has gone away. Agencies have tightened in quite a bit and we think they are slightly below where fair value is right now. So that’s one. The technical environment of issuance is very, very limited and the buyer base has expanded tremendously. Used to be a couple of anchor buyers in Japan and a couple of domestic banks sponsoring the majority of deals. Now you have deals that are syndicated, you have money managers, you have insurance, you have ETFs, so you just have much more players, especially in retail sponsoring the sector. And on the fundamental side, we see no issues at the AAA part of the stack. It’s as positive as ever. So we think that all signs point to continue tightening

Shiloh:

Well. I think the higher base rate has certainly attracted a lot of people to our market, the science CLO equity. The other really important security to me is the CLO double B. So by our math, there’s been about 25 basis points of annual defaults there over the last 30 years. And s and p publishes a stat on that. I think there’s about 35 different names that have defaulted. So it’s a pretty small number. Given the size of the overall market. Do you think that the favorable risk adjust returns of BBs will continue here or is there any reason to think that the default rate will pick up from the 30 year history?

Paul:

We’re very positive on double Bs. We think it’s a very stable structure. We don’t think that default rates will materially pick up. Obviously there’s a manager bias where if you take a look at some of the deals that have taken write downs or have not paid principal in the past or have been downgraded to default in the past, they tend to be some of the smaller managers, maybe managers that have taken on more of the risk, but not necessarily in the large top tier managers that have had more of a defensive posture and an active trading posture in general. So overall on a model basis, it’s extremely hard to break double Bs. You need to annualize the fall rate of at least five, maybe seven or 8% per year for life depending on your other assumptions. And it’s like a GFC scenario extrapolated multiple times, but we know that averages don’t tell the full story. And for the deals that have taken losses in the past, they were unlucky with concentrated bets in the wrong sectors multiple years through multiple cycles. And we just don’t see that happening with many of the large managers with diversified portfolios and experience and dedication managing these structures. So in general, we’re very positive on double B credit and just the structure itself, especially with rising credit enhancements over time. So we see no reason for that to get worse compared to those historical stats.

Shiloh:

Yeah, well the stats that I quoted, by the way, those are for the last 30 years, but that doesn’t account for is that post financial crisis, there’s actually more equity in CLOs than there was prior. So the newer double Bs are actually the more conservative ones. And at Flat Rock we like to invest in middle market double Bs where you get 12% equity in the CLO instead of the 8% or so in broadly syndicated CLOs. So if we’re talking about a default rate requirement to break a deal to miss a dollar of interest or principal, we’d see that as a 15% annualized default rate. So as a result, we’re very bullish on middle market BBs.

Paul:

Absolutely.

Shiloh:

So one other question I wanted to ask you is just around what are investors reaching out to you on these days? What are the key topics? I assume refis and resets are the biggest, but is there any other topics that are worth mentioning?

Paul:

I think that’s a lot of it just refis and resets how to model optionality both for equity and for double Bs in light of high reset volumes. What are the characteristics driving refis and resets expectations for investor demand, whether it’s bank regulation, whether it’s overseas, whether it’s ETFs or insurance, some thoughts on that. Other than that, a lot of it’s macro and thinking about interest coverage ratios and when and how much will the Fed cut. You obviously have a large share of issuers with rate hedges on that are probably going to expire in early to mid 2025, or in other words you could say that the median issuer probably has a three-ish percent base rate right now net of hedges in terms of SOR for the loans. So depending on where SOFR and FED funds will be in mid-2025, if they don’t cut, that’s five and three eighths and that’s an issue. We think that the terminal fed funds rate can get down to something like three and an eighth. Within about two years. The Fed could cut quarterly potentially next year once they start cutting and they have confidence to cut. But where that fed funds and SOFR rate is in early to mid 2025 will have a large impact on credit and potential downgrades as these hedges are rolling off. So doing analysis on that and trying to monitor that situation in light of macro is another question we get pretty often

Shiloh:

For CLO equity. If a deal is coming off period in say six months and the capital stack is in the money, so meaning you could refinance it today, if you could at a lower rate, in your experience, would a secondary buyer, would they be willing to pay up for that optionality or is it more of a optionality where the owner of CLO equity has to execute on our refinancing or reset really to get any value?

Paul:

That’s a really interesting question. I feel like if you asked me that three or four months ago, the answer would be very different than now. But right now it feels like most of that optionality is pretty fully priced in for anything soon to roll off from no-call or past, no-call, but a few months ago the market was starting to lean into those assumptions but wasn’t really paying for it. So yeah, so a lot of the valuation in secondary equity is based on executing that refi reset and realizing those spread savings. Otherwise, the returns are definitely going to suffer

Shiloh:

For us looking for good candidates where there’s a refi or a reset coming, that’s certainly something we would focus on. But on the other hand, if it’s potentially six months off, I think you’re willing to pay something for the optionality, but you’re certainly not going to buy CLO equity under the assumption that when a on-call date rolls off, that magically the manager is going to be able to get a deal done on that date. Potentially there’s a deal ahead of you or spreads may move wider in the interim. You don’t know, so you really can’t bet on it. I agree people are starting to value the optionality more certainly in the current marks and where things trade, but for a long time I would just say there was really no value given to the optionality in these deals. So you were highly incentivized to look around in the market and find deals where you think something favorable could happen in a shorter period of time.

Paul:

I think that’s right.

Shiloh:

Well, Paul, is there anything else happening in CLOs that we haven’t covered today?

Paul:

Not really. I think we covered a lot of what we’ve done in our research and what’s interesting to investors minds in terms of our

Shiloh:

Great. Well, Paul, thanks so much for coming on the podcast.

Paul:

Great. Thanks for having me, Shiloh. I enjoyed it.

Disclosures:

The content here is for informational purposes only and should not be taken as legal, business, tax, or investment advice or be used to evaluate any investment or security. This podcast is not directed at any investment or potential investors in any Flat Rock Global fund

Definition Section

AUM refers to assets under management

The secured overnight financing rate, SOFR. is a broad measure of the cost of borrowing cash overnight, collateralized by Treasury securities.

A government-sponsored enterprise (GSE) is a type of financial services corporation created by the United States Congress.

The global financial crisis (GFC) was a period of extreme stress in global financial markets and banking systems between mid 2007 and early 20093.

Credit Ratings are opinions about credit risk. For long-term issues or instruments, the ratings lie on a spectrum ranging from the highest credit quality on one end to default or “junk” on the other. A triple-A (AAA) is the highest credit quality. A C or D (depending on the agency issuing the rating) is the lowest or junk quality.

Par build refers to building the par balance of the CLO loans where each that hasn’t defaulted is counted at its par value.

Leveraged loans are corporate loans to companies that are not rated investment grade.

Broadly-syndicated loans are underwritten by banks, rated by nationally recognized statistical ratings organizations and often traded by market participants.

Middle market loans are usually underwritten by several lenders with the intention of holding the investment through its maturity.

Global financial crisis or GFC refers to the banking downturn in 2008 and 2009.

Risk retention is when the CLO manager acquires securities in its CLO to meet regulatory requirements.

Junior capital is financing that has a lower priority claim in debt repayment to a secured term loan

Spread is the percentage difference in current yields of various classes of fixed income securities versus treasury bonds or another benchmark bond measure

Spread tiering refers to different CLO managers being able to finance their CLO at different rates.

RMBS are residential mortgage-backed securities.

Morningstar Loan Index serves as the market standard for the US leveraged loan asset class and tracks the performance of more than 1,400 USD denominated loans.

A LIBOR spread is the difference between the highest and lowest rate of the London Interbank Offered Rate

General Disclaimer Section

References to interest rate moves are based on Bloomberg data. The credit quality of fixed income securities and a portfolio is assigned by a nationally recognized statistical rating organizations such as Standard and Poor’s, Moody’s or Fitch as an indication of an issuer’s credit worthiness. Ratings range from triple A (highest) to D (lowest). Bonds rated Triple B or above are considered investment grade; credit ratings double B and below are lower rated securities, also known as junk bonds.

Any mentions of specific companies are for reference purposes only and are not meant to describe the investment merits of, or potential or actual portfolio changes related to, securities of those companies unless otherwise noted. All discussions are based on US markets and US monetary and fiscal policies. Market forecasts and projections are based on current market conditions and are subject to change without notice; projections should not be considered a guarantee. The views and opinions expressed by the Flat Rock Global speaker are those of the speaker as of the date of the broadcast and do not necessarily represent the views of the firm as a whole. Any such views are subject to change at any time based upon market or other conditions, and Flat Rock Global disclaims any responsibility to update such views. This material is not intended to be relied upon as a forecast, research, or investment advice.

It is not a recommendation offer or solicitation to buy or sell any securities or to adopt any investment strategy. Neither Flat Rock Global nor the Flat Rock Global speaker can be responsible for any direct or incidental loss incurred by applying any of the information offered. None of the information provided should be regarded as a suggestion to engage in or refrain from any investment related course of action as neither Flat Rock Global nor its affiliates are undertaking. To provide impartial investment advice, act as an impartial advisor or give advice in a fiduciary capacity. This broadcast is copyright 2024 of Flat Rock Global LLC. All rights reserved. This recording may not be reproduced in whole or in part or in any form without the permission of Flat Rock Global. Additional information about this podcast along with an edited transcript may be obtained by visiting flatrockglobal.com.

The CLO Investor Podcast, Episode 5

Shiloh:

Hi, I’m Shiloh Bates and welcome to the CLO Investor
Podcast. CLO stands for Collateralized Loan Obligations, which are securities backed by pools of leveraged loans. In this podcast, we discuss current news and the CLO industry, and I interview key market players. On May 15th, I attended
the Creditflux CLO Symposium in London. Creditflux is one of the papers of record for the CLO industry and their annual conference in London is always, for me, a must-attend event. It was great to see lots of familiar faces and the panel guests were really top notch. Some of the themes of the conference were the rise of middle market CLOs and declining CLO financing rates. Usually my podcast is me interviewing other market participants, but in this episode I’m posting a fireside chat I did at the conference with Credit Flux Managing
director Tom Davidson. Credit Flux also has a podcast that I’d highly recommend. It’s called The Last Tranche, and I was a guest there a while back.  Some of the topics we discussed were CLO education, current opportunities in the CLO market and CLO equity risk adjusted returns, which I emphasize are more important to me than total returns. And now my conversation with Tom Davidson.

Tom:

Welcome, Shiloh. Before we get going on the fireside chat,
maybe if you just want to introduce yourself with your main job.

Shiloh:

Hi everybody, I’m Shiloh Bates. I’m the CIO of Flat Rock
Global. We manage about a billion of AUM. We focus on CLO equity and CLO double Bs. And then within those two asset classes we have a preference for middle market CLOs, as you know.

Tom:

Great. Now for those of you who called the first fireside
chat, my colleague Lisa Lee and Jane Lee, Lisa upped the ante on us by announcing that Jane is an award-winning documentary film producer. Luckily enough, Shiloh also
has a side gig, which is as an author. I’ve got a copy of his book here. We also have a few more copies if anyone’s interested. This is CLO Investing with an Emphasis on CLO Equity and Double B notes. So maybe we should talk a bit about the book. Why did you decide to become an author?

Shiloh:

There’s a saying that it’s great to have written a book, but
it’s not great to be writing a book. The genesis though, really is in 2020 I had some free time on my hands and so I wrote a 60 page just kind of like manual, or the way I go about approaching investing in CLO equity. And we put
that on our website. I was really surprised at how many people read it and my competitors mentioned it to me, CLO managers and people that were just kind of interested in the space, they read it. And so that gave me the idea to just go ahead and do the bigger book. It’s about 220 pages, but a lot of what’s written in the book is stuff that I’m constantly as part of my job educating investors. And so some slides from our pitch decks are in the book.

I’m frequently answering their one-off questions for
investors. And so I came up with the outline for how I wanted to tell the story of CLOs. And at the end of the day, there’s really like maybe four concepts that make CLOs different from other asset classes. So I would agree it’s not
as, especially in equity, it’s not as straightforward as investing in a high yield bond or a leveraged loan directly or certainly a stock. If you want to learn about CLO equity and Double Bs, one option is a book obviously, but if you didn’t do that, you can spend a lot of time Googling and finding different articles and you can kind of put together the information you need. But the idea with the book was to put it all as kind of like a one-stop shop for your CLO needs.

Tom:

And it’s an amazing read if you haven’t had a chance to read
it. As I say, we have a few copies, it’s come out, so come and find us. I think one of the interesting things is obviously you wrote this a few years ago now, the market’s changed pretty dramatically in a lot of ways since then. What would you change now? What do you wish you’d written in the book?

Shiloh:

In the segment about double Bs in the book, I make the point that if the MVOC, so if the market value of all the loans in the portfolio plus the cash, that if that does not cover the full balance of the CLOs debt, AAA to
double B, that means you have an MVOC of less than a hundred percent. So it might be 98 or 99, something like that. And a point that I made in the book was that you can very comfortably buy bonds that are not covered and still expect a payout. And the reason really is twofold. So one is that if the loans don’t perform well, the CLO will not pay the equity and that profitability will be trapped in the CLO and ultimately that will benefit the double B. But then the
other part of it was just that the loan index was trading at discount of the levels.

And so at the end of the day, loans are either worth par or
they default and get some recovery, but there’s no in between. That’s kind of the binary thing. And our view was that most loans trading at discounts, it was really a function of heightened risks in the market, political risks, economic
risks, and that at the end of the day, there would definitely not be enough defaults to really impair a lot of the double Bs. That part has actually paid out, I think very few double Bs. Definitely very few have defaulted. I would expect very few to default in the future, but today a double B that’s not
covered by its fair market value given how much loans have traded up, is a much higher risk situation than it would’ve been last year at this time.

Tom:

Great. You are obviously very passionate about this investor
education piece. I know as well as the book, you have a new podcast as well. I have a podcast as well. Welcome to the space. It’s always great to see some competitors joining in. Tell me about the podcast.

Shiloh:

The new podcast is called the CLO Investor, and basically in
the first episode I just talk a little bit, I do a CLO 101 and just talk about the market to establish that foundation for people who need it. And then in the second podcast I interview a colleague, we talk about our strategy in
the market and what we find interesting. The third and fourth podcast, which we will drop soon, one is an interview with David Williams, who’s a CLO banker at Scotia who I know you know. And then Evo Turkejiev is a broadly syndicated CLO manager at New Mountain Capital. From the perspective of writing the book and the podcast, I try to approach it as from the angle of somebody who’s an investor
in the space, and I hope people will find it beneficial as once you figure out how to be a podcaster, when you have good guests on, they do all the work. You just have to think of the questions that they do all the talking, and then you talk for an hour and then hopefully it’s a quality product that people like.

Tom:

Absolutely. Let’s get into the equity investing side. And I
think one of the things which I find interesting is it’s actually quite hard to unpack for people looking at equity investing. How well is CLO equity performing as an asset and how much is added on by the alpha from managers? And
I think this is something you’ve done some work on.

Shiloh:

Well. Yeah, so one of the things that we put together
starting about four years ago was a CLO equity index. And it’s available on our website, it’s public. If you invest in any of the debt securities, double B to AAA, JP Morgan has great indices for that. Palmer Square does as well. And on any
day you can see, oh, how did double Bs do today or single A whatever you’re interested in. But with equity, you really can’t do that because there’s just not enough trades in the market. So what our idea was in putting together the
CLO equity index was to take information from what’s called public filers in the US. And so I’m a public filer myself, meaning that every quarter I tell our investors, these are all the CLO equity pieces I own. This is where I mark them
at 3-31 or 12-31.

I have a number of competitors who do the same. And so if
you know that somebody owned 10 million of a specific CLO security and they had it marked at this price a quarter ago and this price, now you just need to figure out what was the payment received on the equity in the interim, and you
can calculate a return in that way. And so our index construction basically matches a Cliff Water direct lending index. They do the same analogy or the same methodology where you’re looking at other public filers figuring out what
they owned, what the specific return was in quarter. And I feel really good about the results because all those marks are marks that are coming from managers who are registered investment advisors. So there’s a lot of regulation. It’s not just people really thought about the mark, it’s not
just something that just came at thin air.

That’s kind of the regulatory setup there. And so we’re able
to mark about 500 different CLO equity tranches using this methodology. And one of the things that’s not ideal about it is that I have to wait to put the index together. So for 3-31, so for March 31st, I don’t know yet what the CLO equity return was. I need to wait for everybody to file with the SEC, and that takes 60 days for a lot of folks. But if you look at the index, one thing, the returns really for the last few years have looked very good. So last year, CLO equity did 22%, which I think people were pretty excited about. And then if you look at a three-year annualized rate, it’s about 12. And if you go back five years, it’s like nine. So the more recent performance of CLO equity has been the better.

Tom:

I think it’s interesting you can compare and contrast that
with on the credit flux side, we track fund performance a lot of CLO equity funds. And as you say, last year, I mean I guess all of the returns were above 20%. And that makes sense now because almost anything you bought would’ve
delivered that. But equally, some investors are producing returns much higher than that, more than that 30%. I think some of them were hitting 40%. So clearly there is also a lot of alpha you can add as an equity investor as well.

Shiloh:

So the way I think about it and how we approach things at
Fire Rock is it’s not, your awards are a total return award. And how I think about it is we’re going for the best risk adjusted returns. So a lot of times at Flat Rock, we’re looking at CLO equity pieces or double Bs where we think the outcome will be very favorable and the return opportunities are quite high. But there’s also just an amount of risk that goes along with the securities that’s just kind of above and beyond what our investors would want to sign up for. Internall, we would look at some of these deals and say, oh, that’s something I would do in my PA if I could. But it’s not something we’re doing with shareholder money. And so what we try to do in equity is to provide a low double digit net return to investors with a high focus on reducing the downside risk. I’m guessing that for people who hit a 30% return for last year, they probably, the trade to get there would’ve been to buy single Bs at a discount or equity that was potentially a risk of missing payments. And both of those would’ve worked out to your point. But investors in those funds are signing up for a level of potential volatility that mine are not.

Tom:

So turning to your investor hat away from the education hat,
what’d you like at the moments out there? What are you buying?

Shiloh:

We have really, since the inception of Fire Rock CLO, middle
market equity is kind of the core of what we’ve been focused on at the beginning of the year. We saw some pretty interesting opportunities there, and in the last two months we’ve seen some middle market issuance, but there really
hasn’t been a ton of new loan creation in the middle market. And so that’s been a hindrance to CLO issuance. And then we’d also seen recently that sometimes the manager takes all the equity themselves and they even take the double B
sometimes, which is another security that we would want if they would sell it. And so a lot of the recent issues or issuances have been middle market CLO where the securities offered are triple A to single A or triple B. That’s not where I’m playing. The two things that really we’ve liked about middle market equity and continue to like are the natural arbitrage in the deals, it’s more favorable.

There’s more profit in the CLO, you get higher cash
distributions each quarter one. And then through this conference today, a lot of what panelists have been talking about are a liability management exercises and low loan recoveries. Well, these are not really an issue in the middle
market. So in the middle market, it’s private market. There’s no distressed hedge funds buying the loan. And the secondary, if the loan does get into issues, usually it’s just one to three lenders who need to figure out a way to
move forward. And so in the middle market, I would expect recoveries to be around the 70% area. That is what we put into all of our modeling projections. And then broadly syndicated, the consensus is for lower recoveries. Certainly
those are the two benefits for CLO equity. We’ve, I think, benefited from that historically. And the trend should continue as well.

Tom:

And obviously, I guess from your side, its liability spreads
do keep coming in is actually good from an equity investor perspective.

Shiloh:

On the last panel, I learned that the spread between the
broadly syndicated AAA and the middle market AAA, I’ve always thought about it as about 50 bps over 10 to 12 years. That’s kind of what it’s been, but now it is certainly moving tighter. And I am all for tighter middle market aaas. I
also invest in middle market double Bs where I don’t need those to trade any tighter. And then for the equity, anything that trades tighter creates more profitability for the CLO and better equity distributions.

Tom:

Yeah. And then I thought the other interesting part of that
panel was a talk about improvements in liquidity in the secondary, and we were talking about this, the guys there were very positive about some of the work which has been done on transparency in middle market CLOs. I’m not sure we necessarily agree that it was quite there yet.

Shiloh:

When we look at a middle market equity or double B piece, for example, the middle manager sends us a list of the 200 or so loans that are going to go into the CLO, and they’ll give us some metrics around the loan, what’s the leverage, the interest coverage, the loan to value. And usually we
find seven or eight loans where they’re of particular interest or they stand out for one reason or another. And so we get the CLO manager on the phone and we talk through those credits. And usually there’s a very satisfactory answer
for why these kind of few loans stood out, if you will. And then after that, I think middle market reporting is a little bit mixed. So if you pull up the deals in Intex, sometimes you’ll see a mark for all the loans that’s relatively recent. For other CLO managers, you might see only loans that are rated triple
CA mark.

If the loan’s defaulted, there has to be a mark. Also, the
best thing for a CLO manager to produce is a mark for every one of the 200 loans. I realize it may be a quarterly mark, it may be stale, but if the manager reports the information in that way, they’re going to find that their bonds are much more liquid in the secondary market, and that will lead to
better pricing for them in the primary as well. So that’s something that they should care about. I think there’s some challenges for the managers in that if you have a publicly traded BDC, you don’t want to put out loan marks for the
same loan that’s in A BDC in another fund kind of ahead of when the BDC might be reporting. There are some challenges there, I admit, but the more current marks and percentage of loans marked is better for all the investors in the deal.

Tom:

Great. We’re pretty much out of time now, shall I? So in
fact, we are exactly out of time. Thank you so much. Thank you for joining me.

Disclosure AI:

The content here is for informational purposes only and
should not be taken as legal business tax or investment advice or be used to evaluate any investment or security. This podcast is not directed at any investors or potential investors in any Flat Rock Global Fund.

AUM refers to assets under management. 

The secured overnight financing rate software (SOFR) is a broad measure of the cost of borrowing cash overnight, collateralized by Treasury securities. 

The London Interbank offer rate (LIBOR) was a broad measure of the cost of borrowing cash overnight for banks on an unsecured basis, leveraged loans or corporate loans to companies that are not rated investment grade broadly. 

Syndicated loans are underwritten by banks, rated by nationally recognized statistical ratings organizations and often traded by market participants. 

Middle market loans are usually underwritten by several lenders with the intention of holding the investment through its maturity.

A collateralized obligation (CLO) is a structured finance
product that is backed by a pool of assets other than leveraged loans. 

Global financial crisis or GFC refers to the banking downturn in 2008 and 2009. 

Risk retention is when the CLO manager acquires securities in its CLO to meet regulatory requirements. 

Junior capital is financing that has a lower priority claim in debt repayment to a secured term 

Loan spread is the percentage difference in current yields of various classes of fixed income securities versus treasury bonds. Or another benchmark bond measure yield is income returned on investments such as the interest received from holding a security. 

The yield is usually expressed as an annual percentage rate based on the investments cost.

Current market value or face value amortization is the process by which the CLO repays its financing after the reinvestment period ends. CLO equity missing
payments happens when there are too many triple C rated loans or defaulted loans in the CLO 

The Flat Rock Global CLO equity index can be found on the Flat Rock Global website.

Liability management exercises or LME are an out of court
restructuring of a company’s debt in which the lenders take a haircut on the principal balance of their loans. 

References to interest rate moves are based on Bloomberg data. The credit quality of fixed income securities and a portfolio is assigned by a nationally recognized statistical rating organization, such as Standard and Poor’s, Moody’s or Fitch as an indication of an issuer’s credit worthiness ratings range from triple A (highest) to D (lowest) bonds rated Triple B or above are considered investment grade credit ratings. Double B and below are lower rated securities, also known as junk bonds. Any mentions of specific companies are for reference purposes only and are not meant to describe the investment merits of or potential or
actual portfolio changes related to securities of those companies unless otherwise noted. All discussions are based on US markets and US monetary and fiscal policies.

Market forecasts and projections are based on current market conditions and are subject to change without notice, projections should not be considered a guarantee. 

The views and opinions expressed by the Flat Rock Global speaker are those of the speaker as of the date of the broadcast and do not necessarily represent the views of the firm as a whole. Any such views are subject to change at any time based upon market or other conditions, and Flat
Rock Global Disclaims any responsibility to update such views. This material is not intended to be relied upon as a forecast, research, or investment advice. It is not a recommendation offer or solicitation to buy or sell any securities or to adopt any investment strategy. Neither Flat Rock Global nor the Flat Rock Global speaker can be responsible for any direct or incidental loss incurred by
applying any of the information offered.

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