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 Lauren Basmadjian, Carlyle’s head of Liquid Credit, where she oversees $53 billion of assets under management. The Federal Reserve began its cutting cycle in September with a 50 basis point cut, and SOFR has come down almost twice that from its highs, so we discuss how that is expected to affect our industry. We also discuss her outlook for CLO spreads, loan defaults and recoveries, and how she thinks about investing in CLOs managed by other managers. If you’re enjoying the podcast, please remember to share, like, and follow. And now my conversation with Lauren Basmadjian. Lauren, thanks so much for coming on the podcast. 

Lauren: Happy to be here. 

Shiloh: Why don’t you tell our listeners a little bit about your background and how you became a CLO manager? 

Lauren: Sure. So I started in 2001 at a place called Octagon Credit Investors, which is a boutique below investment grade corporate credit firm, one of the oldest CLO managers. I spent 19 years there before I came to Carlyle to run the liquid credit platform. And today I run the liquid credit platform globally for Carlyle, which is about $53 billion dollars of assets under management, the vast majority of which are CLOs that are managed by Carlyle, or that we invest in other managers as well. And we are the oldest piece of Carlyle credit, so also established in 1999, and the largest liquid CLO manager. 

Shiloh: So how many CLOs do you guys usually print or create in a year? 

Lauren: So it definitely depends on the year. This year will be a record year for us, most likely between new issue resets and refinancings. We’ve already done 23 CLOs this year. Our record was 25 in 2021. 

Shiloh: Is that high number just because financing costs are attractive today, in your view, is that the key driver?

Lauren: That is certainly one of them. When you think about how wide liabilities got after Ukraine, it really made resetting deals impossible because you were going to increase your weighted average cost of debt for the most part. So in a way you have two years of a backlog of resets and that’s part of what’s led to such an active year for issuance this year. It’s not just new issue, but as liability spreads compressed pretty immediately in January of 2024, resets started to make sense again and we had a lot of deals in the backlog for that. 

Shiloh: Well, I’ve been in the backlog as well and it’s good to work through some of those deals for sure. So you’ve been in the market for a long time. What’s one or two things that you find interesting or unique about the CLO market? 

Lauren: In general, one of the most interesting things, and you could probably attest to this, is though it is a trillion dollar market, so large and liquid, it still does feel like it has a niche feel to it where not everyone invests in CLOs. And I think there’s probably some reasons for that. They’re associated with CDOs, for example, but CLOs did not blow up the economy during the financial crisis, but they’re also complex and there’s no standardized documents. So it takes more time to analyze the investments and you really have to invest in staff to do that. And so even though it’s a large liquid market, there are many investors that don’t have an allocation. 

Shiloh: Yeah, it’s funny. When I go to CLO conferences, I just see, even though the market’s grown so much, I really just see a lot of the same players. 

Lauren: Absolutely. 

Shiloh: Supposedly the market’s growing in investors as well as AUM, but I just see a lot of the same folks and that’s it. I think for me, one of the things that’s pretty interesting about the market is just, you can buy, for example, CLO equity in the primary or the secondary market, and at times these two markets just trade at totally different yields. So a lot of times primary is a lot tighter than secondary, and anybody would be able to get better risk adjusted returns by buying in the secondary for sure. But I think one of the things that accounts for the difference is just that the primary process is really the fun process. That’s the one where we’re all working together, we’ve got a manager, and there’s a warehouse and we’re trying to get the best debt execution and we’re commenting on docs. And for most people, especially newer to the CLO market, I think that’s the process that’s going to feel good to them. Whereas in the secondary, the CLO exists, some broker dealer is offering it to you, and really the only thing to negotiate is a price, and most people probably assume the dealer in between is taking a fair amount of economics for themselves. I think that just pushes a lot of people to the primary. 

Lauren: And I think we’ve also seen, with the slowdown in CLO issuance in 2022 into 23, there was a very specific profile in the secondary. It was either a really high weighted average cost of debt profile that you could buy and plan on a reset or repricing, or deals that were close to ending the reinvestment period or had a shorter reinvestment period left. So in order to diversify your maturity wall of investing, I think a number of investors came back to primary where they were going to get five-year reinvestments and diversify their book a little bit. I think that, especially with the cleaner pools, led to some of that new issue demand that we’re seeing this year. 

Shiloh: Are there any profiles of equity that you think have worked out particularly well? One that comes to mind would be, for me, any CLO that ramped during a period of stress where loans were bought cheaply. 

Lauren: A hundred percent. Could not agree with you more. I think that we’re trained to think of CLOs as an arbitrage product. 

Disclaimer: Note: By arbitrage, Lauren is referring to a CLO where the equity is owned by a third party looking for favorable risk-adjusted returns. 

Lauren: Most of the time they are, but they’re also an amazing way to buy discounted loans in long term, non-mark to market financing. And if you could close your eyes when the cost of debt’s really high and just say, we’re going to buy good assets cheap, and eventually we trust that the market’s going to come back and we’ll reprice our liabilities, I think those are the best deals. 

Shiloh: Agreed. And those deals are good both in the primary and then often are sold in the secondary too at compelling prices. So Carlyle is obviously one of the biggest managers, or biggest, I guess depending on how you do the cut or the stat. How do you think your platform is differentiated? 

Lauren: There’s a couple things. One is we are one of the oldest managers, so you could look at our performance through multiple cycles, even back to dotcom bust, financial crisis, energy, Ukraine, inflation. So you could see how we’ve performed. Two, because we’re big, we’ve invested behind it. So we have over 20 analysts in the US over 10 in Europe. We have a five person restructuring team, which I think is a key differentiator going forward. And we’re able to do it because we have the financial wherewithal to invest in the resources. I think that’s going to affect outcomes going forward, especially as we move out of the bankruptcy court and into this liability management paradigm that we’re living in. We also are very connected internally at Carlyle and we use the One Carlyle network in our diligence and our tracking. Coming from a boutique manager, it’s really different for me. It’s amazing the access you have to deal professionals, to strategic advisors. Just being able to get on the phone with people who know the industry, know management teams, or even our Washington resources. It just really is this One Carlyle network. It sounds like a buzzword, candidly. I thought that’s what it was when I read about it before I came over. But the connectivity is really strong and we’re all looking to help each other in our investment decisions. 

Shiloh: Is part of that that when you’re looking at a new loan opportunity, if it’s a leveraged buyout, that it’s very likely that Carlyle’s PE team has looked at the company and already formed a view? That’s part of your credit research and analysis? 

Lauren: It is. We may have looked at it or we may own a similar company. It’s all compliance-chaperoned.   

Shiloh: With you guys issuing so many CLOs, can there ever be too many or do you ever hit a point where there’s maybe just not enough demand for your CLO liabilities regardless of how well you guys are doing on the assets? 

Lauren: I would think of us relative to the market. So the market has stopped growing right now. I actually think it will grow again next year. But I would think of us relative to the market and as well, CLOs traditionally take two weeks to price. And I think part of that is this non-standardized documentation, which is not going to change. But I think as a market, we need to become more efficient with a quicker process in the primary, or multiple processes at the same time. If that doesn’t happen, then I think there is a cap to how many total transactions you could do, and we’re probably nearing that cap this year. 

Shiloh: Okay. And that’s because you just don’t want to be in the market with overlapping deals. You want to get one done, move on, and then the market opens back up to you again, that’s how you think about it? 

Lauren: Our equity investors generally don’t want us to do that unless we have a clear path for bespoke pricing. And we are finding those paths today where perhaps we’re syndicating AAAs in the US in one deal, but have a hundred percent buyer in Japan for another deal. So they’re not competing. And I think being able to identify separate paths is the way that you could bring more than one deal at a time to market. 

Shiloh: So the Fed cut by 50 bps in September. Does that matter to you at all in terms of CLO issuance or the performance of the underlying loans? 

Lauren: Yeah, rates coming down matters. What I’d say is that we’re already down about 80 basis points in SOFR and that’s going to flow through to our borrowers who mostly have floating rate debt. Some of it’s hedged. But you’re going to start to see that come through in the fourth quarter. And if you see further anticipation of cuts, SOFR likely comes down even before the cut. And that’s real cash benefit to our companies. I think that also leads to less downgrades, or dare I say, even upgrades, eventually, for the underlying loan borrowers. So those are the positives. There is an effect to CLO equity with rates coming down. CLO equity has benefited from a higher base rate, but we all use the forward curve in our modeling. And so right now we’re looking at terminal rates around three and a half percent in our models. To me it’s a question of is it higher or lower than what the curve is expecting versus how many more cuts because the curve is anticipating cuts, which is then flowing through into the CLO equity pricing. 

Shiloh: Yeah, I do a fair amount of education with our investors on this. And then the idea is that when you buy CLO equity, it’s a string of cash flows and to model that, you’re looking at a forward curve. So we’re already budgeting for the fact that rates are expected to come down. That’s already in the projection. It’s already been in the projection for some time, which is very different from owning loans directly. When rates come down, you just get less in income and that’s it. There’s no forward projection or anything like that. And I guess the other part of it, the other thing we’re reserving for in CLO equity is just that we assume that, I think most people assume 2% of the loans will default each year and the recovery will be around 70, maybe a little short of 70 depending, but is two and 70, are those numbers from the past or do you think those are numbers that you can still hit or how do you think about it? 

Lauren: I think it’s numbers from the past, but probably for maybe a different reason than what people are anticipating. There are very few in-court bankruptcies now and where a lot of street analysts expected us to jump to three, four, 5% after Ukraine, it didn’t happen, right? And today we’re around 80 basis points, but what’s happened in the last year and a half is distressed exchanges, discount capture, liability management, whatever you want to call it, where a borrower comes to you and says, “Hey, your credit agreement’s really loose. We’d like you to give us some discount. Us as equity, we’re not taking a loss before you are. You, debt holder, you’re going to take the loss and then you could close up the document and I won’t strip assets for you. I won’t dilute the value of your collateral.” And so that’s become commonplace. Before you had transactions that offended everyone and we all knew the names. It was J Crew or Chewy, and we all talk about them with brand names, but there’s been dozens of those now. And when I think about it, I think there’s more that’s going to be out of court. I think bankruptcies are going to be fewer, so we won’t be at an average 2-3% going forward. What I’d say if there’s any positive to that is that companies are generally asking for outside of court. It is very different and a much lower impairment rate than what we’ve seen historically for bankruptcies. So on average, the range that you’re usually seeing for the discount or the impairment out of court has generally been around two to 20 cents with the average a little over 10. So I think you almost have to think about a higher percent when you include the out of court stuff, but also a higher recovery because you’re not taking the same type of haircut off this. 

Shiloh: So if I’m modeling CLO equity and I use a 2% default rate and a 30% loss given default, so that’s like 60 bps and that’s really the key number, like, I hope it’s lower than 60, but whichever way of the two variables we get there is fine by me. Do you think 60 is optimistic over the next year or two, or how would you think about that? 

Lauren: I think it’s realistic, but here’s this other thing about the difference in how the market is changing is, before, if you owned a loan, you got the same recovery no matter what manager owned it, manager A owns a loan, manager B owns a loan, and they both get 60 cents back. And with more of these out-of-court processes, you are seeing groups that are put together to be a majority and be able to extract more value and better recoveries out of the process. Generally speaking, these are larger managers that are important to bankruptcy advisors, companies, sponsors, or they just have the right to be in there because they’re so big and they’re a top five holder. So I do think that the best thing to do is just avoid the bad credits, but that’s very difficult to do in totality. The second best thing to do is get in the right groups. And so you could see that 60 basis points, maybe even if they own the same loan, same exact loan by different managers, you could see some managers have a 20 point swing on recoveries based on what groups they get into. 

Shiloh: Do you think on these out of court restructurings that there’s a difference in private equity firm DNA and that some naturally are going to gravitate towards trying to get their first lien lenders to take a discount and others maybe are more old school and that’s just not how they’re thinking about the agreement between debt and equity? 

Lauren: I think that before there were a lot of sponsors that were worried about being viewed as a bad actor and what would that mean as they continue to do deals and their access to capital. I think unfortunately the advisors in general have done a really good job of convincing companies and sponsors that this is common practice and it’s not going to be viewed as egregious. If they did it with all of their companies, or half of their companies, sure, that’s a problem. They may be  cut out of the market, but to have one, two or three, it’s acceptable. And so I think sure, they’re probably a select group of sponsors that still view lenders as partners, but for the most part I think that’s done. 

Shiloh: I think I’ve heard one private equity firm say that actually they think it’s their fiduciary responsibility to try to put it to the lenders when they can. It’s like, oh, wow. 

Lauren: To preserve the equity. Right, they’re fighting for the equity. I have heard that as well.

Shiloh: It’s an interesting way to think about it. So I imagine around Carlyle you buy a lot of, or your firm buys a lot of CLO securities, many that are not managed directly by you, is that correct? 

Lauren: That’s correct. 

Shiloh: Are you involved in that process? 

Lauren: Yeah, I sit on the investment committee for that. 

Shiloh: Okay. And how do you think about what’s interesting to you and what managers you want to partner with in that? 

Lauren: So we have a team between structurer, traders, analysts that are looking at third party opportunities, so buying debt or equity and other managers’ CLOs. One of the things that we do is a deep dive on the portfolio because we do lend to a lot of companies and we have this huge research team. We try to incorporate their views. We even look at our view of WARF, meaning, well, we have our own rating system. 

Shiloh: WARF is the weighted average rating factor. 

Lauren: Right. The Moody’s equivalent, the numerical equivalent of the letter rating. And then we create a Carlyle one and say, well, our analyst team thinks this portfolio is riskier or safer than what the market is seeing, and we’re using our name-by-name analysis to do that. So that’s one thing. But I’d say in general we want to see consistency of performance. I mean, as you put together a portfolio of investments, we’re buying certain managers for their attributes. Maybe one is a lower spread manager, what we think is really stable, great historical default rates, and then we have another manager that we think is Alpha where they do take more risk, but we get compensated in the total return for that. What we get concerned about is when we see style drift from managers, and that’s what we try to identify early. 

Shiloh: What securities generally work for you guys at Carlyle? Are you putting equity and BBs into GPLP funds? 

Lauren: Yeah, we have a number of funds that invest across the capital stack. I’d say that it looks more like SMAs for investment grade, but we have retail products for lower tranches. So we have a fund called CTAC, which is a cross-platform credit product at Carlyle, but part of that fund is CLO equity and CLO double Bs. We have a public equity fund that is CLO equity. So we find different fund structures work better depending on the tranche, and we try to marry the liquidity needs, the investor needs by fund with the right end investment. 

Shiloh: You do a pretty heavy overlay I imagine, where you just look at somebody else’s CLO and just kind of determine, hey, what percentage of these loans are approved by you or sitting in your CLOs? I imagine that weighs pretty heavily. 

Lauren: We do. We have to be careful to just think that our view is always right and just buy the loans again that we like. But yes, absolutely. I think it’s actually more helpful on the bad loans, if that makes sense. So things that we passed on or think could have trouble, but the price doesn’t reflect that yet. And maybe we do own that loan and that could be the case too, but I think that it’s really identifying that tail risk that makes more of a difference in saying, yes, these 100 credits are totally fine. 

Shiloh: So a substantial majority of my investments are in middle market CLOs. Is that something that you’re involved in? 

Lauren: And that’s such an interesting space because it’s growing rapidly where the rest of the CLO space is a little stagnant right now. Traditionally, as you know, you’ve had most of CLO equity that’s for middle market or private credit CLOs be captive or financing trades, and you would place the debt through more traditional routes. Still today, a lot of middle market CLOs or private credit CLOs are financing trades, but you’re seeing third party equity interest because the cash flows are better because the arbitrage is much more robust than in liquid credit CLOs. So we are looking at that. We’ve issued a private credit CLO this year, but it’s been a financing trade. We’ve done another reset of an existing one, but we are taking a look at what a third party model looks like for private credit CLOs, meaning should we be issuing private credit CLOs with investors like you? 

Shiloh: You should be. That’s my opinion. Are you involved in that? So the selection of middle market loans for CLOs around your platform, is that something that you’re also involved in or is that a separate team? 

Lauren: So it is a separate team. We have a totally separate analyst team for direct lending and private credit. Our teams talk a ton and you’ve seen more movement of loans between the two, more idea generation between the two. But there’s a fully built out direct lending team. That said, I do sit on the investment committee for private credit as well. So I am approving the loans that we’re buying, but the team doesn’t report into me. It’s really a collaborative effort across the platform. And also it’s really beneficial for me to see, as a liquid investor, what’s happening in the private markets and it gives me an idea of what could be refinanced there, for example, or what kind of profile of loans they’re looking for. So I joined maybe two years ago and I think it’s been really additive to my thought process when investing in liquid credit.

Shiloh: Was it kind of a little bit of a shock or a surprise? If you go from liquid credit where, I don’t know, the EBITDA numbers for a borrower might be a hundred million plus, and then you find yourself somewhere where people are making loans at like 20 million of EBITDA, maybe with better covenants, maybe with a better LTV and better docs. 

Disclaimer: Note LTV means loan to value and Shiloh should know better than using three letter acronyms in his podcast. 

Shiloh: But still the difference in company size is substantial. Is that kind of an easy thing to get your head around or how did you think about that? 

Lauren: So no one’s ever asked me that question. It is so hard. It was hard for me to look at these companies and say, how do you lend to a company that’s like you said, twenty million dollars and buy and hold it? 

Shiloh: Yeah, no liquidity. 

Lauren: That’s right. Where in liquid markets, one, the average EBITDA of a company is a billion dollars at this point, and two, I could sell it if I changed my mind or all these things changed. So how do you underwrite to buy and hold? And that did take me a while. It took me at least a few months to get used to looking at the deals, thinking about them differently. I will say there’s a different level of information that you could get, diligence. Obviously the documents are way better and tighter than you see in liquid. There’s still a relationship with sponsors that I think we’ve lost in the BSL market. And so when we were going through Covid and then inflation, what was very clear is that we were seeing a lot more equity checks come in into direct lending from sponsors to support the companies than really I’ve ever seen in the liquid market. So I think I had to get used to looking at those smaller companies, but also with a lens of all the extra protections that we get by doing that. 

Shiloh: What do you think is a good premium to get paid if the loan has no liquidity at all and you’re going to hold it to maturity versus having kind of the broadly syndicated liquidity? What do you think that’s worth in basis points? 

Lauren: So today I’d say we’re at 350 for the liquid market and you’re seeing private credit go down to 500, 525 for good credits. 

Disclaimer: Note: Those numbers were spreads over SOFR in basis points.

Lauren: And that does feel a little tight. Now we’re both repricing, so the spread may change shortly again, but I think that you would generally want at least 200 basis points for that illiquidity premium. It’s illiquidity and size. Maybe I’m still stuck on that size thing that you asked about in the last question because I think that there are some of these hybrid private credit BSL issuers that they have a billion dollars of EBITDA and they’re really big companies, but they chose to access the private credit market. I think those probably should have less of a spread premium than the true middle market universe. 

Shiloh: Is there anything else happening in CLOs or your platform that you think would be interesting to discuss? 

Lauren: I think the most interesting thing is just the continued evolution of these liability management exercises. To me, we went from a covenanted market to cov-lite after the financial crisis, and this is the next sea change for me where we went from if you had a problem, you’re doing it in court to now seeing, even if you don’t have a huge problem doing it out of court, and seeing our documents used against us to advance more money if a company needs it or take a discount capture. I think that’s the big theme out there. Where I would say that’s positive is we lend to 600 companies in the US, over 200 in Europe. Our data is pretty good, I think probably better than index data. We see so many private companies and the resilience has been impressive. As we’ve said, the companies have been through so much in the last four years. Low investment grade corporate credit should be really hurt by higher interest rates because they have a lot of floating rate debt. And we’ve seen the percentage of our companies that produce cashflow is way higher today than it was a couple of years ago, like in 2021 for example, which seems counterintuitive because rates are so much higher and growth has slowed, but it’s because companies are focused on it. And it’s amazing that when management teams focus, they can start to produce cashflow. They’re figuring out how to become more efficient, maybe cut back on CapEx or hiring, but about 70% of our companies are producing free cashflow in this higher rate environment. We haven’t seen third quarter numbers yet, but for the second quarter, average sales growth of about 5% and average EBITDA growth of 10%. So I think there’s been pretty resilient market in the face of a lot of negativity of downgrades and distressed exchanges, but companies are figuring out a way for the most part to make it work. 

Shiloh: One last question. Do you expect that CLO liabilities will continue to contract here going into year end or they’re kind of in the middle of a lot of these conversations, I imagine? 

Lauren: I do. There’s so much supply, so I think it would be tightening much further if there wasn’t as much supply. But that said, AAAs have had negative issuance, net issuance, because the pay downs have been so intense for AAA buyers year to date from amortization of post reinvestment period deals and call deals and resets and refinancings. So I think as that market has shrunk and it’s performed really well, we’ll see continued demand to redeploy that money and I think that leads to continued tighter spreads especially. And then the rest of the stack, usually CLOs figure out a way to work, and loans are repricing.

About half of our portfolio has repriced year to date with an average reduction in spread of 44 basis points. That means we lost 22 basis points on average in spread. Liabilities have to reprice too to make the arbitrage work. 

Shiloh: That’s right. Great. Well, Lauren, thanks so much for coming on the podcast. It was great to talk to you. 

Lauren: It was a pleasure. I really appreciate you inviting me. 

Disclaimer: 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 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. 

LIBOR, the London Interbank Offer Rate, was replaced by SOFR on June 30th, 2024. 

Delever means reducing the amount of debt financing. 

High yield bonds are corporate borrowings rated below investment grade that are usually fixed rate and unsecured.

Default refers to missing a contractual interest or principle payment. 

Debt has contractual interest principle and interest payments, whereas equity represents ownership in a company. 

Senior secured corporate loans are borrowings from a company that are backed by collateral. 

Junior debt ranks behind senior secured debt in its payment priority. 

Collateral pool refers to the sum of collateral pledged to a lender to support its repayment. 

A non-call period refers to the time in which a debt instrument cannot be optionally repaid. 

A floating rate investment has an interest rate that varies with an underlying floating rate index. 

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. 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 Stephen Anderberg, the sector lead for US CLOs at Standard and Poor’s Global Ratings. We discuss how CLOs are rated, and trends in upgrades, downgrades and defaults. The Federal Reserve cut interest rates by 50 bps on September 18th, so we discuss how that is expected to move the CLO market. We also discuss how CLO ratings have performed relative to the more well-known corporate rating system. Many of the securities we discuss are rated speculative grade or “spec grade” by S & P, which means not investment grade, or more specifically, that’s when a borrower has the ability to repay but faces significant uncertainties, such as adverse business or financial circumstances that could affect credit risk. That’s according to the S & P website. If you enjoy the podcast, please remember to share, like, and follow. And now my conversation with Steve Anderberg. Steve, thanks so much for coming on the podcast. 

Steve: Shiloh. Thank you very much. Really appreciate the invite and I’m looking forward to the conversation. 

Shiloh: Likewise. Why don’t we start off by just going through your background and how you ended up as a CLO ratings analyst at S & P? 

Steve: So my current role at S & P is Sector Lead. I’ve been with S & P now for 25 years and before that worked with the city of New York in the Office of Management and Budget. Within S & P, I’ve always been with structured finance. I started in ABS surveillance back in August of ’99 looking after the ratings of collateralized bond obligations. And from there pretty quickly started working on CLOs, which at that point I think literally had six transactions outstanding, something like that. From that I’ve seen the CLO market evolve and grow through the 1.0 era, before the financial crisis, and the 2.0 era that followed. And obviously today it’s a trillion-dollar asset class and the core part of most investor portfolios, and structured finance investor portfolios. 

Shiloh: You were rating CLOs in 1999, is that right?

Steve: I was in the surveillance group, so doing the monitoring and rating changes on collateralized bond obligations, which actually did see a lot of rating changes. And then the CLOs, which really didn’t. 

Shiloh: I was just curious because I started on the buy side working for CLO managers in 2000. So like you, I’ve been around since the very beginning and seen this and experienced this huge growth. 

Steve: It’s been amazing to see it evolve from a bank loan market and then to grow into a trillion dollar market that we have today. It’s really astonishing. 

Shiloh: Agreed. So Steve, how are CLOs rated? 

Steve: The CLO ratings at S & P are built on a foundation of the corporate ratings, and by corporate ratings, I mean both the fundamental credit rating assigned to the company, a single B minus, double B minus, whatever it is, and then also a recovery rating that’s assigned to each loan in the collateral pool. And in BSL CLOs, something like 98% of the collateral carries a public rating and the company rating is used to infer a likelihood of default in the modeling. And the recovery rating obviously is used to infer the recovery assumptions in the cashflow modeling. So when we look at a CLO, when we rate a CLO, we put the portfolio into our credit model CDO evaluator, which simulates default rates for portfolios that are commensurate with our different rating levels. And then it provides something called a scenario default rate at each CLO tranche rating level. And you can think of these as the scenario default rates as our hurdle rate at each rating level. So for example, within a typical BSL CLO collateral pool, if you run that through the model, you might get a scenario default rate of say 68% at the AAA rating level, which just means that for a tranche from a CLO to be rated AAA, that’s collateralized by that pool of assets, the tranche is going to have to be able to withstand 68% of the collateral defaulting over the life of the CLO without the tranche missing any interest or principle. 

Shiloh: So each loan has its own probability of default and also the loans have some correlation with each other. So they’re in different industries or similar industries. So you’re running simulations through the loan pool and just trying to figure out what the AAA and AA survive, and then that ties back to the actual ratings that you give. Is that how to think about it? 

Steve: That’s exactly how to think about it. With the one caveat that we’re not looking at the debt rating, we’re looking at the company rating. And the reason for that is that the debt ratings get notched up and down based on the recovery prospects. So a senior secured loan is typically going to be one or two notches higher than the company rating, and we already capture recovery elsewhere. So we look at the company rating across our CLO analysis.

Shiloh: So when a CLO is coming to life and it’s not maybe getting the ratings that it is targeting, the solution to that is either to have more equity or to have a more diversified pool of loans, or a higher rated pool of loans. Are those the options? 

Steve: You could either rejigger the collateral pool and maybe put some higher rated assets in, or you could change the capital structure on the CLO to make it work under the methodology. One thing that’s nice as an asset class is that the models are available externally, including to the arrangers. So for the most part, when they’re submitting a transaction to us, they have an idea of what’s going to work and what’s not going to work, so we don’t have to go back and forth as much. 

Shiloh: And then one of the things I’ve noticed that maybe wasn’t intuitive to me right away was just when something’s rated AAA and sold as such through banks, a lot of times it seems like the rating agencies would actually be willing to provide more leverage at the AAA or AA in that it’s actually the cap on how deep the attachment point is, actually comes from end investors, not the rating agency. 

Steve: That is true up and down the capital stack that sometimes you end up with a tranche that could pass at a higher rating level that’s going out at a different rating level. And then it could be based on investor preference. There’s also you need a cushion in place. You’re not going to want a AAA that goes out and has a very tight rating cushion, both for just downgrade prospects of the tranche itself or tranche rating, but also because the manager does not want to get cut off from trading if they fail their CDO monitor test, which affects reinvestment. So they want some cushion in place there. 

Shiloh: So nobody wants to have ratings that are close to where they would be potentially downgraded if the CLO has some missteps. And then at Flat Rock, we’re an investor both in broadly syndicated CLOs and middle market CLOs. How does the rating approach differ between the two? 

Steve: It’s a really good question. Middle market CLOs are an area that’s seen tremendous growth over the past several years. In the aftermath of the GFC, it was typically, if you look at the overall issuance, it was in the maybe high single digits and then after 2016 it bumped up a little bit. Now it’s more like 20% of total CLO issuance. We use the same criteria for both BSL CLOs and middle market CLOs. There are a lot of structural and collateral differences between the two that get captured in the quantitative modeling. There are two key differences though from a rating approach, even under the same criteria, both having to do with the assets. So if you look at BSL CLOs, probably 98% of the assets carry a public rating. In middle market CLOs, that’s not the case. The majority of the assets are not rated and yet to run CDO evaluator, you’re going to need a rating on for each company in the portfolio. And so for those, we do credit estimates, which are basically, for the CLO manager’s purposes, just an estimate of what a rating would be if the company had a rating, and they could use that in their management of the CLO, and we could use it in our analysis. So credit estimates instead of ratings. And then the second difference is recovery assumptions. The spec grade public loans have a recovery rating tied to them that guides the recovery assumption, the CLO modeling, but the credit estimates don’t come with that. So there we have a standard table for recovery assumptions. So you have one set of assumptions, senior secured, non cov-light loans, and other set of assumptions for senior secured cov-light loans and so on down the stack. 

Shiloh: So for middle market loans and for broadly syndicated loans that are going into CLOs, either way they get rated, just the question is whether or not it’s a public rating available to all market participants or it’s a less formal process, the credit estimate that S & P also does. 

Steve: In order to do the analysis, you need a rating or estimated rating, implied rating on every company in the portfolio. It doesn’t work without that. 

Shiloh: So how has your ratings framework changed over time? 

Steve: The criteria does not change that often. It changes when our view of the fundamentals changes. So we did a really big update in September of 2009, which affected almost all the assumptions within the criteria, the assumed default rates, recovery rates, correlation, and a host of other things. If you look at the 1.0 CLOs, you could get to a AAA rating with maybe a 26% par subordination. But then coming out of the GFC, in part because of rating agency changes, in part because of market changes, it was more like mid- thirties now. So the criteria change of September of 2009 was part of that. Just required more par subordination to get to a AAA. And then after that there was a smaller update in June of 2019, which is to take into account the totality of data from the last of the 1.0 transactions, which were paying down at that point. 

Shiloh: So it sounds like, since the GFC, that to get the ratings that CLO investors want, there has to be more par subordination, or really equity, really at each level. So the AAA has more equity supporting it and the double A same all the way down the stack. So that’s beneficial. Obviously, you know we’re an investor in double Bs, so double Bs get more equity, that’s great for them, it means lower probability of default. But given how CLO securities performed through the GFC and beyond, why was it necessary to make your modeling assumptions or your framework more conservative from the perspective of the debt investors? 

Steve: Given what we were going through at that point and the data we’re looking at during the GFC, we were rethinking how correlated pools of credit might perform under different stressors. So we revisited the criteria based on that, and there was a lot that came out of it. The modeling assumptions became more punitive, especially at the higher rating levels, especially for AAA. Should point out, by the way, CLO AAA has performed really well in the history of the market. There’s never been a AAA default, but the criteria change did require more subordination for those. And there are other changes as well in terms of what we expect to see in the CLO transaction documents and other things. All just making sure the ratings produced and the criteria would be commensurate with the economic environments we thought they should be able to survive. 

Shiloh: The Fed has been in a hiking cycle. How has that affected CLO ratings? 

Steve: Given the 50 basis point rate cut on September 18th, this is obviously a timely topic. The key issues looking forward are going to be the path of interest rate cuts, but also what happens with earnings growth in the spec rate corporate space. The rate cuts this week provided a tailwind for leveraged loan issuers since they’ll be devoting less cash interest payments and able to use it for other things, including investing in future growth. And if we were to end up in a situation where EBITDA growth turned negative, the rate cuts will provide some cushion there. So definitely at least a modest credit positive for CLO collateral. In terms of CLO issuance outlook, I think the impact of the rate cuts is a little bit more opaque. I’d be interested in your perspective as well here, but resets and refis are just going to continue to dominate issuance this year and maybe next year just given the overhang of transactions that are out there, that are outside the non-call period with spreads that are wider than current market spreads. For CLO new issuance, we think that insurance demand for floating rate product is going to remain very strong and that will have a benefit for CLOs in general. And anecdotally, we’ve heard that insurance companies have raised a trillion dollars in annuities, and that’s a lot of dry powder to deploy into the CLO market. And Japanese banks, the ones we’ve spoken to, remain well positioned to continue to buy CLOs. So between those two things we think that would be supportive for CLO issuance next year. 

Shiloh: One of the things that has surprised me about interest rates and the market reaction is just that if you would’ve asked me in 2021, and broadly these syndicated CLOs were printing at, call it, there’s a LIBOR back then, but 115 basis points over was where some AAAs were getting done. And as the Fed started hiking, actually the spreads on AAAs went wider. And I would’ve thought people would be clamoring for AAAs because the higher base rate the return offered was higher. But actually the market reaction I think was twofold. It was banks sensing, potentially, the beginning of a recessionary period just were putting the brakes on buying new AAAs, one, but also because the base rate was higher, a lot of investors just didn’t want to take the extra risk and earn the AAA spread over LIBOR or SOFR for example. They were happy just earning the base rate. So now I think what’ll happen is, as the Fed lowers rates, I think what’s going to happen is people are going to be very interested more in the spread than they were in the past because the base rate isn’t going to be as high. And I think that’ll continue to put downward pressure on spreads, up and down the stack from AAA to double B. That’s how I think this is going to play out. 

Steve: I think you make an interesting point, Shiloh. So I fully agree that to some extent at least investors look at the all-in yield on a tranche so that as the base rate becomes less a driver of that, they’re going to focus more on the credit spread. So that could push for wider credit spreads going forward or at least put a damper on further credit tightening. Spread tightening. It is interesting, there are other factors that drive all this as well. And you look back at 2021, which was, so far, the all-time record for new issuance, 185 billion of CLO new issuance. And in that case the banks were just flush with deposits from COVID stimulus checks and needed a place to deploy. The cash rates were very tight. So CLOs just offered an attractive spread above the base rate, and that’s just where a lot of the money went, and that’s just drove issuance for that year. 

Shiloh: But I think I see it may be slightly different though. I think as the Fed cuts that actually spreads are going to continue to decline. And the reason is I think it’s maybe opposite of the theory. You’d be like, okay, well if the Fed’s cutting, I care about all in yield, so the spreads needs to be higher. But actually that’s definitely not what happened on the way up. On the way up, the Fed was hiking and investors were acquiring, at least for a while, more spread. So here I think what’s going to happen is AAA is going to be all the more interesting now because they’re going to need to earn it. They’re not going to be able to just take the base rate. So that’ll be more competition for AAAs and down the stack. 

Steve: I think that’s true if you look at 2022 and 2023, which showed very wide spreads on AAAs and other tranches of CLOs, economic growth or lack thereof and fear of a recession just drives a lot of this. So maybe that would be the dominant factor in driving credit spreads going forward. 

Shiloh: Prospects for recession definitely would be a big factor in there as well. So changing topics: The CLOs do have bond buckets, usually it’s 5%, the typical cap on bonds that can be put into a CLO, I think that’s the number. And a lot of times these are floating rate secured bonds, so they look a lot like loans anyways. But what are you seeing in terms of manager usage of bond buckets today? 

Steve: Interesting question. So we thought with the rate cut, it was a good time to take a look and to see where we were. So obviously the addition of bonds to CLO portfolios is a phenomenon we’ve seen over the past couple of years as higher interest rates took hold. And there was really a way for managers to pick up part the cost of giving up some spread. And there was also a pretty substantial weighted average rating factor, a WARF benefit, since a lot of the bonds came from slightly higher rated issuers, in some cases a lot higher rated issuers, than the typical leverage loan issuer. So I think we’re at like 2% of total collateral. So still modest in terms of actual usage of the bond buckets, but if you look, the median WARF or SP WARF of the bonds is 2165 against a median WARF of the CLO collateral overall of 2,700. So that’s a pretty significant difference. 

Shiloh: So the WARF is the weighted average rating factor, and that ties into probability of default for each underlying loan. 

Steve: That’s exactly right for each of the underlying issuers. So a lower WARF indicates, at least from a rating perspective, a higher quality collateral pool. And if you look at the bond holdings, I think we just did a quick snapshot yesterday, 82% of them are from spec grade issuers, so it’s as expected, but 14% were from triple B issuers and then 4% actually came from single A minus or higher, which you don’t usually see those higher rated obligors within C collateral pools. It was just a phenomenon for the bonds.COVID stimulus checks and needed a place to deploy. The cash rates were very tight. So CLOs just offered an attractive spread above the base rate, and that’s just where a lot of the money went, and that’s just drove issuance for that year. 

Shiloh: But I think I see it maybe slightly different though. I think as the Fed cuts that actually spreads are going to continue to decline. And the reason is I think it’s maybe opposite of the theory. You’d be like, okay, well if the Fed’s cutting, I care about all in yield, so the spreads needs to be higher. But actually that’s definitely not what happened on the way up. On the way up, the Fed was hiking and investors were acquiring, at least for a while, more spread. So here I think what’s going to happen is AAA is going to be all the more interesting now because they’re going to need to earn it. They’re not going to be able to just take the base rate. So that’ll be more competition for AAAs and down the stack. 

Steve: I think that’s true if you look at 2022 and 2023, which showed very wide spreads on AAAs and other tranches of CLOs, economic growth or lack thereof and fear of a recession just drives a lot of this. So maybe that would be the dominant factor in driving credit spreads going forward. 

Shiloh: Prospects for recession definitely would be a big factor in there as well. So changing topics: The CLOs do have bond buckets, usually it’s 5%, the typical cap on bonds that can be put into a CLO, I think that’s the number. And a lot of times these are floating rate secured bonds, so they look a lot like loans anyways. But what are you seeing in terms of manager usage of bond buckets today? 

Steve: Interesting question. So we thought with the rate cut, it was a good time to take a look and to see where we were. So obviously the addition of bonds to CLO portfolios is a phenomenon we’ve seen over the past couple of years as higher interest rates took hold. And there was really a way for managers to pick up part the cost of giving up some spread. And there was also a pretty substantial weighted average rating factor, a WARF benefit, since a lot of the bonds came from slightly higher rated issuers, in some cases a lot higher rated issuers, than the typical leverage loan issuer. So I think we’re at like 2% of total collateral. So still modest in terms of actual usage of the bond buckets, but if you look, the median WARF or SP WARF of the bonds is 2165 against a median WARF of the CLO collateral overall of 2,700. So that’s a pretty significant difference. 

Shiloh: So the WARF is the weighted average rating factor, and that ties into probability of default for each underlying loan. 

Steve: That’s exactly right for each of the underlying issuers. So a lower WARF indicates, at least from a rating perspective, a higher quality collateral pool. And if you look at the bond holdings, I think we just did a quick snapshot yesterday, 82% of them are from spec grade issuers, so it’s as expected, but 14% were from triple B issuers and then 4% actually came from single A minus or higher, which you don’t usually see those higher rated obligors within C collateral pools. It was just a phenomenon for the bonds.

Shiloh: So it sounds like some CLO managers have bought high quality bonds, probably low coupon, but bought them at a discount to par. And that helps with the CLOs over collateralization tests 

Steve: And just generally offset par losses that might’ve come from elsewhere. 

Shiloh: And then one of the trends we’ve seen in the market really over the last two years is the rise of the liability management exercise. So I did a podcast recently with Drew Sweeney of TCW on this, but the LME is the out of court restructuring where the private equity investor that owns the firm and the first lien debt agree to some restructuring, which probably entails a haircut, the first lien lenders taking a haircut on their debt. How has the rise of the LME affected your business and your ratings? 

Steve: So you’re right in pointing out that most of the LMEs have come from private equity owned or sponsored companies. There have been a couple with publicly owned companies as well, but one point I would make is that CLO portfolios are very diverse. The median portfolio has something like 300 obligors in it. So the impact of any one obligor in a collateral pool going through a liability management exercise is fairly muted. And we have noted, by the way, a difference in approach between the bigger scale managers, the higher AUM managers and the smaller managers, where the larger managers are more likely to leverage their scale and engage in the LME process and try to come through with a more positive outcome, something that’s more accretive to the recoveries. The smaller managers would be much more likely to sell and just get out of the situation because they may not have to scale to ensure they get our seat at the table. 

Shiloh: And then what’s the trends in loan upgrades and downgrades, for example, today? 

Steve: So the higher interest rates and slowing growth we’ve seen over the past couple of years have definitely put pressure on lower rated corporate borrowers, and, some of them at least, have been straining under the burden of higher debt service costs. And by late 2023, the downgrade rate for spec grade companies had risen considerably and peaked at three and a half downgrades for each corporate rating upgrade as of October of last year. And then it’s moderated a bit since, although it’s been choppy month over month. I think at this point most corporate loan issuers have adjusted to higher rates by cutting costs, deferring CapEx expenditures and doing other things. And then another benefit of the current market is that spec grade companies have been able to refinance or reprice their outstanding loans, in some cases cutting their interest expenses by 50 basis points or more. So they’ve got the benefit of two rate cuts just by refinancing their outstanding debt. So we’re definitely in better shape than we were, say, a year ago, 

Shiloh: The Fed beginning to cut: Should we infer from that, that maybe more upgrades than downgrades are on the come here?

Steve: So you are absolutely right that the decrease in rates is going to create a tailwind for highly leveraged borrowers. And it will free them up, at least to some extent, from the burden of interest payments and allow them to redeploy that money into other things, including CapEx, which could benefit growth going forward. In terms of the ratings, it’s already largely baked in, and when the analysts look at a company rating, they’re taking into account the forward rates and taking it into account when it’s not in the ratings. So the very fact of seeing the rate decrease, unless something is to change in the path going forward that makes us change our assumptions, I don’t think you would see a large number of upgrades based solely on that. 

Shiloh: So that was upgrades and downgrades for the underlying loans and CLOs, but what about upgrades and downgrades for CLO securities? 

Steve: So we haven’t downgraded a AAA CLO tranche rating probably since 2012. It’s been a long time. It really takes a considerable amount of economic stress before that happens. And I took a quick look at the past four years, going back to the beginning of 2020, at what the CLO tranche ratings were doing. And obviously 2020, given the pandemic, the shutdowns, the impact on spec rated corporate issuers was pretty significant. And there were a lot of downgrades in the CLO collateral pools and the liability ratings follow. So something like 13% of BSL CLO ratings from S & P got lowered in 2020 and a lot fewer middle market ones, 1% middle market ratings got lowered that year, but every year since from 2021 onward, there’ve actually been more CLO tranche upgrades rather than downgrades. So I think it’s a pretty good record, especially given the level of corporate downgrades in 2022 and 2023. The CLO managers were able to reposition the portfolios in most cases and go out against the downside and just the structural mechanics protected the transactions and they’ve done pretty well in the course of a stressed economic period. 

Shiloh: So transitioning from CLO upgrades and downgrades, the more important thing to me would just be defaults. So have we seen an uptick in CLO security defaults since the COVID period? 

Steve: The short answer is not really. We’re just about to update a piece and show that we’ve had 61 CLO tranche defaults through both the 1.0 and the 2.0 era. But the asset class is large enough now that every year you’re going to see a small handful of double B tranches that might default. Usually these are, right now, what we’re seeing is transactions that originated before the pandemic and then suffered again in 2022 and 2023 and just weren’t able to cover, at least on a projected basis, the debt outstanding at the double B level. But 61 tranche defaults out of 18,000 or so rated tranches over the past 30 years is a pretty good record. 

Shiloh: Agreed. So the default statistics that you just mentioned, how did those compare to the loan ratings? Does a double B CLO, is it comparable to a double B corporate, or how should we think about the ratings between the two?

Steve: The short answer is CLO ratings have done very well, and in every case, performed with fewer defaults against comparably-rated corporates. You have to be a little bit careful on how you do it, because fundamentally, if you’re looking at CLO ratings, they’re originated and then seven or eight years later, or maybe sooner if it gets reset or whatever, they’re not there anymore. With corporates, you have ratings outstanding for a long time, but Meredith Coffey from the LSTA published a piece back in July of 2022, actually using some S & P data and comparing the default rates for CLO tranches against the default rates for like-rated corporates. And if you take a look, for example, at double B, for CLO 1.0 transactions, the double B default rate for CLO tranches rated double B, it was something like 4%. For CLO 2.0, so far the double B tranche default rate has been well under 1%. And then if you look at corporate ratings over the same period, it’s more like 9%. So there’s a pretty significant difference between those two. 

Shiloh: But you’re quoting there the cumulative default rates. How I would think about it is like an annual default rate. So if the cumulative, you said it’s 4% for the 1.0s, so maybe if they were outstanding for seven or eight years, call it eight years, then it’s a 50 bps default rate per year. And then for say the 2.0s, you said 1% cumulative. Well, how many years do you think those double Bs were outstanding for maybe five, something like that? So it’s 20 bps per year would be the default rate there. 

Steve: Yeah, for an individual transaction, of course it’s going to be extraordinary, unlikely you’d see a default in year one. But if you want to look across the universe of tranches, you could look at it that way. Any way you stack it up, CLO tranche ratings come in pretty well below the comparable corporate ratings. 

Shiloh: So one of the questions I’m frequently asked, I tell them, Hey, the double B default rate has been quite low, and their response is, well, are we on the precipice of a massive default wave? Is the future going be very different from the past and maybe embedded in that is the question about higher base rates. But I think your answer on upgrades and downgrades answers that question. If the CLO securities are, as you said, for the most part, upgrades is the trend, not downgrades. 

Steve: That’s true. I mean, even during a stressed economic period, if you want to get a sense of how the CLO ratings might respond under different levels of economic stress, we actually publish a series annually, a series of stress tests, and the BSL iteration of that should be out this month or maybe early next month. We take all of the CLO tranche ratings and run them through basically four sets of stressors with successively more later defaults and successively bigger triple C baskets. And then we look at the impact for our rated universe of these stresses. So if you want to see what would happen to the double Bs, for example, under a scenario where 20% of loans default and the triple C baskets blow out to 40%, as unlikely as either of those things would be, you could do that. 

So Shiloh, if I could ask you a couple of questions and turn the tables, how do you use ratings into your investment process or processes at Flat Rock? 

Shiloh: We’re not really ratings constrained. So we own CLO equity. Obviously CLO equity is non-rated, so we’d like the CLO debt securities in the CLO to be rated well, but we don’t have a regulator, or a capital charge regime. Well, our regulator is FINRA and the SEC, but we’re not an insurance company or a bank where we need to maintain an overall rating or portfolio quality. So for equity, you’re not rating those securities, so we make our own judgements. And then for double B, your opinion on the credit quality of the note is certainly important, but we’re doing our own scenarios and work ourselves. So you said you’re for stress cases, we’ve got a bunch of stress cases as well, but at the end of the day, sometimes we would buy double Bs. That would be the weaker end of maybe where you guys would rate, and we would do that because they’re cheaper in the market and we think they offer good returns, and maybe they’re later in their life and they don’t need all the equity subordination that they might’ve had originally. If a double B is upgraded, which I don’t think we’ve seen too many of those, I don’t think it really matters that much in terms of trading level because… it’s funny. One difference in CLOs from other markets is that when a CLO security is issued as double B, I think the industry nomenclature just keeps it as double B. That’s where it was initially rated. That’s the part of the capital stack that it is. And if you guys upgrade it to triple B, I think people would continue to call it the double B. And if it was downgraded to single B, maybe somebody would still call it a double B, but acknowledge that there’s been some losses on the loan. Rating is a very important part of the market, but it’s really affecting, I think, especially the guys who are playing in the investment grade parts of the stack. So the AAA investor needs that rating for the bank, wants to make sure that rating is maintained through the life of the CLO. But some of the debt’s downgraded in one of our deals definitely means there’s been some par losses on the loans. But for us, that could just mean we bought the equity cheap in the past. It wouldn’t necessarily correlate to how we’re doing down the stack. 

Steve: Interesting. And how constructive are you on CLOs just as an asset class, say going into next year, how do you see the combined impacts of rate cuts and either economic growth or lack of economic growth impact in the asset class? 

Shiloh: So I think one of the things that will change now with the Fed beginning what we think is going to be this cutting cycle here is just that the relative attractiveness of double Bs has really been pronounced over the last two years. So the Fed hiked a lot, and you could get at least in, let’s talk about middle market CLOs for example, the yields on those securities, CLO middle market double Bs, have been in a 13% area. So a lot of people looked at that and said, Hey, that’s a great return. Why would I want to take first loss risk and be in the equity? So some of them made that rotation or that new allocation, and then now as the Fed cuts, the yields, the double Bs are going to be going down, one, and then two for CLO equity, the projected returns there are not going to look that different even though the Fed is cutting. And the reason is that I think most people who sit in my seat, they’re running an IRR calculation through the cash flows that the CLO equity is supposed to produce or is expected to produce. So there’s already baked into that a declining SOFR curve. So there’s already a budget there. If you’re buying equity today and you’re targeting mid to high teen returns, you’re budgeting for that decline in SOFR over time. Whereas for the double B, those payments are made quarterly and they reset quarterly and they’re going to be resetting lower, and that’s going to result in less cashflow to the double B. So my point in that is just I think you’re going to see a rotation out of double B; CLO equity is going to become relatively more interesting. And I think the two things that may benefit CLO equity here are that one, the lower interest expense burden for a lot of companies, it’s not going to matter. The loan’s money good, and maybe you’d rather have the higher base rate there, but some weaker borrowers in the market will actually benefit and have more cash, more liquidity, better interest coverage. And for CLO equity, that could mean a marginal difference in terms of default rate, more favorable to us. So I think that’s a potential benefit. And then the other part of that is, again, if you’re targeting mid to high teen returns for CLO equity, as the Fed cuts, other competing asset classes are going to offer lower comparative returns and CLO equity, the rates, we don’t see them coming down. So on a relative value basis, I think it’s going to make equity look more appealing than maybe it has over the last year and change. 

Steve: Interesting. 

Shiloh: Well, Steve, thanks so much for coming on the podcast. Really enjoyed the conversation. 

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 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. 

LIBOR, or London Interbank Offered Rate, was replaced by SOFR (Secured Overnight Financing Rate) on June 30, 2024

Delever means reducing the amount of debt financing High yield bonds are corporate borrowings rated below investment grade that are usually fixed rate and unsecured. 

Default refers to missing a contractual interest or principal payment Debt has contractual interest, principal, and interest payments, whereas equity represents ownership in a company. 

Senior secured corporate loans are borrowings from a company that are backed by collateral. 

Junior debt ranks behind senior secured debt in its payment priority. 

Collateral refers to the sum of collateral pledged to a lender to support its repayment. 

A non-call period refers to the time in which a debt instrument cannot be optionally repaid. 

A floating-rate investment has an interest rate that varies with an underlying floating rate index. 

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. 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 Ted Goldthorpe, the Head of BC Partners Credit Business. We discuss some of his lessons learned in what you’ll hear is a very impressive financial career. While most asset managers grow their business by launching new funds, Ted is also active in acquiring other asset managers. We talk about why that makes sense for his platform, and we also discuss the evolving landscape of private credit and business development companies. If you’re enjoying the podcast, please remember to share, like, and follow. And now my conversation with Ted Goldthorpe. Ted, thanks for coming on the podcast. 

Ted: Thanks for having me, Shiloh 

Shiloh: Why don’t you walk us through a little bit of your background and we will take it from there. 

Ted: So my background, I started my career in investment banking, and then during the Asian crisis I was in the FIG group. And then during the Asian crisis there became a lot of opportunities to invest in Asia, but particularly around financial institutions. So I got moved into private equity and then ultimately into distressed. So most of my background early on was on a distressed investing business. And then moved over to a group called the Special Situations Group where I ran a lot of their illiquid businesses, so things like a structured equity business, a turnaround business. I ran a Canadian business, a regional business as well. And then at the end of all that, I took over, ultimately the Global Bank Loan and distressed business on the investment side for Goldman Sachs. And then a lot of my career macro has an impact. So Dodd-Frank and Volker came out. It was much harder to do what we’re doing at Goldman 

Disclaimer: Note. Dodd-Frank and the Volker Rule were regulations put in place after the financial crisis of 2008. The goal was to strengthen the US banking system. 

Ted: So a number of us moved to the alternative asset management space. So I landed at Apollo where I ran their opportunistic businesses and then was there, ran their public company, did direct lending, ran their hedge fund, and then ultimately moved to start BC Partners Credit business. So BC Partners been around since 1986. It’s a very, very, very blue chip, white shoe firm that’s been around for a long time, but it had only really done private equity, so we diversified their business to credit. So today we manage about $10 billion. It’s split between sponsor finance, non-sponsored finance, and specialty finance. And we invested across a number of different, either long-term, locked up capital vehicles, or permanent capital vehicles. 

Shiloh: So one of the things I’ve noticed is a lot of the leaders from other alternative asset managers got their roots in the Goldman Sachs special situations desk or bank loan trading. What was in the DNA there that got so many people their head-start in the business? 

Ted: I think it was a couple different things. Number one is a really deep commitment to fundamental underwriting on both sides of the business. And then the thing that’s interesting about it is when you look at the people who grew up in the special situations group, a lot of those people have moved on to more locked up capital structures. So Fortress Sixth Street, one of the guys now has taken a very senior role at Blackstone. So that’s the path that those guys went on. Off the trading desk, originally it was David Tepper, but then post him it was Jonathan Kolatch and Ed Mule who started Silverpoint, and Anchorage, and all these amazing firms. That all came out. So it was more of like a hedge fund beginnings that’s now transitioned to institutional capital. But Goldman was very, very good about providing us capital and providing us capital at times where there was good times to invest. So the key I thought to us and our success was mandate flexibility. If we had a big investment in alternative energy in 2005, 2006, it became much less interesting. So we monetized a lot of assets and transitioned to other areas, and to this day, all of us continue to adapt to whatever the environment is. So a lot of things that I did 10 years ago, we just don’t do today. So you always got to evolve as a platform, but also as an investor you have to evolve as well. 

Shiloh: So from your time at Apollo, is there a handful of lessons that you took away from that experience? 

Ted: I think Goldman Sachs really taught me a lot about investing. So what makes a good investment, what makes a bad investment? And really the concept of risk-reward, and not selling tail risk. 

Disclaimer: Note selling tail risk means earning a profit in calm market conditions, but exposing yourself to massive losses in downside scenarios. 

Ted: And I worked with some phenomenally amazing investors there. Obviously Apollo is a best-in-class investment firm as well. The one thing I learned at Apollo is the asset management business. So Apollo is so strategic around a lot of these broad themes that you’re hearing about in the market, and they’re way ahead of people. So insurance, the rise of retail, all the big areas, origination, permanent capital, all these things that today seem obvious, weren’t obvious 10 years ago and 15 years ago. And Apollo is very, very early into a lot of these places. So I give a lot of credit to the management team over there who really sees things way down the road. And when you look at how our BC business is set up, we’re like a mini-Apollo. We have an insurance company, we have a retail business, we have a bunch of permanent capital, and we have institutional funds. I learned a lot from them around the importance of focusing not only on the asset side but also the liability side and your funding. 

Shiloh: So why was BC Partners a good platform to build out your credit business? 

Ted: Good question. So in a publicly traded context, incentive fees don’t really get a multiple. So management fees trade a big multiple. The reason why BC is interesting is the private company. So I think the partners here are indifferent to how we make the money. It’s just a matter of making the money. So it fits our investment style a lot better. I mean, typically my DNA is invested in higher returning type asset classes, and those asset classes oftentimes are much more incentive fee-based versus management fee-based. So because we’re private and because we’re a partnership, a lot less pressure on us to grow. And at the end of the day, even though Apollo’s all about making as much money as they can, again, incentive fees just don’t trade a great multiple, and in a partnership, that issue is not as relevant. I think Apollo is still in that business, but a lot of other big asset managers have exited that opportunistic business and that’s created a huge opportunity for us for this exact reason we just talked about. Opportunistic is hard. You need a lot of people, it’s risky, it’s headline risk. And at the end of the day, if you’re not going to get value for it in your stock price, why are you burning the calories to do it? 

Shiloh: I think people in the market look at it as the management fee is a perpetuity, and they’ll put, like you said, a very high multiple on it, and then for incentive fees, you could have earned nice incentive fees for 10 years or more, and a buyer will look at that and assume you’ll never make an incentive fee again. So that discrepancy is really quite stark in the market 

Ted: In Apollo, I always called it recurring non-recurring revenues. Apollo would always get incentive fees, and we couldn’t tell you exactly where they’re going to come from, but it’s not like we got zero incentive fees some year. We always got ’em from somewhere. But as a shareholder, it’s hard to underwrite that. It’s hard to model out incentive fees across a lot of different businesses over time. So people just give you zero credit for it. So there’s a little bit of a public-private arbitrage. 

Shiloh: So recently I listened to a podcast where you were on, CreditFlux, and they asked you a question about is private credit a bubble? Is it overheated? And just would love to hear your answer, your take, on that question. 

Ted: I got to remember what I said, but listen, I mean, to me, it’s every day for the last 15 years I’ve read on the front page of the paper, “Bubble in Private Credit?” and I think people look at the amount of money that’s been raised, and view it as a lot of money. If you track it versus private equity, it’s actually lagged. Most of private credit, it’s only 40% of our business, but a lot of private credit money is used to back private equity deals. So private equity has grown faster than private credit. That’s number one. Number two is when we started the business, we used to focus on companies with 10 to 50 EBITDA. And I remember a huge milestone in our space is when Blackstone did the first billion dollar unitranche. And that today happens every day. So that was only 10 years ago. And instead of doing these, it used to be called middle market lending. Now private credit is doing much bigger hold sizes and competing not only with each other but also with the banks and the syndicated markets. So the high yield market has shrunk, as has the loan market the last couple of years. And a lot of it is the private credit markets taking share. And again, 10 years ago, we did not compete against liquid markets. Secondly, we’re pushing into a whole bunch of new areas that we didn’t play in before, that used to be dominated by the regional banks. So GP, NAV financing, lender to lender finance, all these other areas, consumer finance, again, 10 years ago, 15 years ago, that was GE Capital. And I remember when I worked at Apollo, people were talking about the bubble in BDCs and all this stuff. GE capital’s middle market lending business was larger than the entire BDC sector combined. So if you took every BDC and add ’em all up, and you added up all the middle market credit managers, they were smaller than GE Capital. So GE Capital isn’t here. As much as people talk about new entrants, people don’t talk about the big people who’ve exited and the size of those numbers. So I think Silicon Valley Bank is 20% of venture lending, and they’re not making new loans right now. That’s a huge impact on supply-demand. Wells Fargo used to be our biggest competitor. We haven’t lost a deal to Wells Fargo in 15 years. As much money that has been raised, there’s also money that’s shifted out of the banking system, and being redeployed in other places. So it’s not apples to apples. It’s a very long-winded answer of saying, I find it very ironic when banks call our sector the shadow banking system. I always find it very interesting because everything I do is published and every investment I make is in my 10-K. And you go look at a bank, we have no idea what they own. You can’t itemize out every single loan they’ve made. So I find it ironic that they call us the shadow banking system when that system’s much more opaque than us. 

Shiloh: Well, sure. And there’s a lot more exposure to commercial real estate for banks as well. And then when we were maybe prepping for this call a while back, one of the things you teased me with is you mentioned that you occasionally teach at Harvard and Columbia. Would love to hear some of the advice you give to MBAs who are thinking about maybe entering our business. 

Ted: My advice would be: This is an awesome job. I have the coolest job in the world, and I think when I was in college, I didn’t really understand. I went to investment banking and I thought I knew what it was, but I didn’t really know what it was. And same with private equity. I went into Goldman Sachs’s private equity area and I thought I knew what it was and it wasn’t. So all I’d say is we have the coolest job. I wake up every morning, I get to learn about businesses, I get to meet CEOs of companies. I probably meet 20 management teams a week, and what we do is super interesting. And just think about this versus anything else I could have and would’ve done. We have an unbelievably interesting job. So I’d say that’s number one. And then number two is, I always say the same thing, which is you can’t really have a long-term plan. So it’s good to have a five-year plan and a 10 year plan, but when I was investment banking, I didn’t even know what distressed debt was. And then here I am a couple years later on a distressed debt business doing stuff that I didn’t even know what it was three years ago. So the advice I always give young people is, a lot of your career, you have to make micro decisions. People always say stuff like work for good people. And to me that’s like, of course. That’s like saying marry somebody you like. Of course you want to work with good people, but you have to take a step back sometimes and look at the macro. During the 2006 time period, it wasn’t like people thought housing was cheap. Everybody knew the subprime thing was crazy, but obviously people didn’t forecast severity. They didn’t think that it was going to unwind and Lehman would fail. So I think you have to take a bit of a macro approach, too, when you’re picking a career, in the sense of it’s probably not a good idea to go into the cigarette business today. But when you look at other businesses with tailwinds, if the industry is doing well, oftentimes there’s a lot of opportunity for young people to do well as well. I’ll say one more thing, and this is what I always say to people: People always say “take a risk in your career”. And I can’t disagree with that more. What I always say is take calculated risk. To go to some startup out of college and try to become the next Mark Zuckerberg and be the 10th guy there… For every one of him, there’s thousands of people who are not him, and then you don’t have a brand on your resume. So it’s always good, if you can, to start at Apple, or Amazon, or Goldman Sachs, or McKinsey, or somebody like that. And if you are going to go to startup, make sure it’s calculated risk versus just risk. 

Shiloh: Do you think the distressed debt business is a good one for investors today? 

Ted: I got to be careful on this one. I just don’t think distressed debt is a good asset class. If you back-test returns for a very long period of time, distressed returns are not that great. And what I would tell you is I think distressed is a really interesting asset class, every four years, but it’s not always interesting. So going back to my comment about mandate flexibility, having the ability to do distressed is really important, but if you’re only doing that, it’s a really tough business. So today, distressed debt’s not interesting. And it really hasn’t been interesting for a while. Even in 2020, just because it was a broad selloff, you could buy Charter bank debt, cable company, who knows what’s going to happen in the pandemic, who knows what was going to happen in the next couple of years? No one knew a vaccine was coming out. The one thing you do know is people are going to pay their cable bill and they’re going to do that every month, or more importantly, their high-speed data bill. So that bank did trade at like 78. Meantime, cruise line debt was trading at 70. So yes, cruise line debt was cheaper, but who knew that? Yes, we all thought people would get back on cruise ships, but we didn’t know when and how long and how much cash they’d burn through in the meantime. So just buy the easier thing. Even 2008, you could buy anything at 60 cents. I don’t view that as a great distress cycle. You can go buy great companies bank debt at 60, 70 cents. You didn’t have to go buy some piece of — company that has a terrible balance sheet. So I think the last real good distress cycle or good relative returns was in the early 2000s, post Enron, WorldCom, Adelphia, all these things all happened at the same time. It was an unbelievable time because the market hadn’t reached a level of sophistication that it’s today. Today, there’s such sophisticated people in our market, and when I say that I’m not just talking about Oak Tree, I’m talking about Eaton Vance and Fidelity. They’re very sophisticated in this area now. And unless you have a ton of capital, you don’t want to go into distressed because you get run over in these LME trades and creditor-on-creditor violence. If you’re a little guy, you’re going to get absolutely destroyed. And I just don’t think it’s a good idea to do that. 

Shiloh: Do you think part of the last attractive opportunity set is just a function of how much capital has been raised in these distressed funds? 

Ted: One thing that’s always talked about in newspapers has been a great thing is the rise of passivity. ETFs, no fees, outperforming active management. In 2020, we had six of our seven worst trading days of all time, in a row. And you and I could debate this, but it wasn’t worse than 2008. So why is it that we had our six worst trading days in 2020 and not in 2008? And the answer is, everybody we were buying debt from in March of 2020 was an ETF. So when an ETF gets inflows, they buy stuff, and when they get outflows, they sell stuff. So when we went to business school, we learned about the efficient market hypothesis. And obviously when so much of the market now is in passive hands, it becomes much more flow and technical driven than fundamental driven. And that’s, by definition, not efficient. So the key, I feel, is to buy assets during periods of dislocation, and then sit on the sidelines for the rest of the time. 

Shiloh: And then in terms of the, maybe tracking back to the MBA classes where you’re guest lecturing, besides what they should be doing as career advice, is part of what you’re lecturing there, just what are some differences you should expect from what you’re learning in the classroom versus what you’re going to experience in real life in the job? Is that a big part of what you’re teaching? 

Ted: Yep. There’s 10 key tenets to my business school education, most of which has been wrong. For example, you learn that classic formula: inflation plus currency equals… Currency should always adapt to the inflation rate over time. So if the markets were efficient, why is there a Japanese carry trade that’s persisted for 25 years? So like the markets had a massive spasm in July around the unwind of the carry trade. And again, if the markets were efficient, and that formula held, that carry trade existed for a long, long time. That’s just one example. Or I use the efficient markets hypothesis, which you know what that is. And then again, the world’s changed. The number of banks has declined by a lot. The number of public companies is down a lot, 75%. And more and more capital is flowed into alternatives. The world is a very different place today than it was 25 years ago. The idea of Apollo and me being super excited about insurance is we had that conversation 25 years ago, be like, what? How is that exciting? But now it’s exciting. 

Shiloh: I think some of the differences I’ve noticed would be in school you learn valuation is DCF, and if you start in my firm of yours and that’s your first inclination is to do that, that’s probably not going to get you very far because there’s just so many assumptions. It’s correct theoretically, but you have to put so many assumptions into a DCF that, at the end of the day, probably not super useful, but things trade at a multiple, they trade at a multiple of earnings, or they trade at a multiple of EBITDA a and that’s really how people think about it. And then the capital asset pricing model, beta times the return, less the risk free, or people using that. Maybe you’d find that if you hire a valuation expert, and they put together a 40 page valuation on something, maybe that would be in there somewhere. I think it’s good to know the theory, but it’s not what practitioners are doing. We think about risk, really, as it’s something that you have intuitively in your head after a ton of reps, as you’ve said in a previous podcast, but there’s no way to necessarily quantify… When you invest in a middle market business, there’s some chance it’s going to go bankrupt. That’s the risk you’re taking. But how you would really put a number on that to quantify it, I think that’d be really challenging. And the risk is low. It’s a low number. 

Ted: I agree with that a hundred percent. It’s good to learn this stuff because it’s the theoretical underpinnings of, again, six times EBITDA, and that’s cheap, ties into a DCF. You can actually tie it all back to theory, which I think makes sense. But your point about beta is a good one. Why is it that Bitcoin gold stocks are all trading at all time highs? Spreads are all time tights and Treasuries are rallying. That doesn’t make any sense. Every correlation’s gone to one and we think about portfolio diversification and allocation of capital. Again, these things are supposed to move in different ways. And when correlation goes to one, it comes back to we’re supposed to rethink some of these asset allocation models. 

Shiloh: So one of the things I think you’re doing at BC that it’s very interesting is that most of your competitors, I think they’re just growing by launching new funds. And at BC Partners, it looks like acquisitions is part of the strategy. So I’d love to hear how you think about that and what you’ve accomplished thus far. 

Ted: Credit’s very different than equities. You and I could start a hedge fund in equities with $30 million and make money, and you and I, 20 years ago, could have started a credit business with you, myself and A CFO. The barriers to entry are so high and the costs are so high, fees have gone down, compliance has gone up, legal has gone up. So you need a big business. When people talk about all these people entering private credit, it’s just not true. It’s the same people, they just have a different business card, but it’s not that easy to get into our business. So I think the reason there’s opportunities to buy is scale is becoming very important, and both to service our clients. So as their deals get bigger, we have to hold more and more debt from them. And on the GP side, for us, the economics of our business, we need to invest in distribution. So we need to hire IR people and build out our retail distribution, everything else, which is expensive. So you need scale to be able to do that and it becomes like a flywheel. So I’m not saying AUM is, we’re big into controlled growth, but for example, there’s a space called the business development company space, or BDCs, and there’s a number of sub-scale BDCs that just didn’t trade well, that couldn’t grow. The management team was stuck. We took five of them and rolled them all together and now we have a bigger BDC, and it trades better, and shareholders are really happy, and we’re more relevant to clients. Scale has just become more important, and sometimes buying is better than building. I think people look at it and say, well, why you spend all this money? For me, I’ll give you an example. We bought a retail business and it came with a team and a five-year track record and AUM. If I started that business from scratch, it would’ve taken us five years and I would’ve spent more money than what we did on the acquisition. So you obviously grinded it and did it organically, which is one way to do it. 

Shiloh: Yeah, for us it was just organic. 

Ted: And it was great. And you guys have had massive success, but for every one of you, there’s a lot of notyous. So you guys have done the best amongst a lot of people. We just made the decision to de-risk. Let’s buy it. It’s going to cost us the same to build it, and if we build it, it’s not without risk. You guys have had great performance, great AUM growth. That’s not a guarantee when you start a business. 

Shiloh: Do you find it’s a competitive space, acquiring other asset managers that are subscale, or maybe haven’t had the same performance you’ve had? 

Ted: I think there’s a big valuation arb between big platforms and not big platforms. Because Oak Tree is not going to pick up the phone for a hundred million dollar BDC. It’s a waste of their time. They raise more money in a day than the four month process for them to buy it. So when you look at the big BDCs that have sold, they’ve traded a big multiple premium to the small ones just because who’s going to waste their time on a small BDC? So this is my own view. I don’t think it’s that competitive. And the reason for that is because most of my peers are pure investors, so they’re really, really good at investing. To buy companies there’s a whole separate skillset. It’s M and A, it’s social, it’s pitching boards. It’s convincing shareholders that you’re doing the right thing, getting shareholder votes. There’s a whole other set of things you need to do. So I think everybody fantasizes about it and wants to do it, but they don’t really know how to do it. And it’s not rocket science. Anybody could do it. It just takes time and you have to go for a lot of beers and you have to grind out on these processes. Obviously it’s competitive, but I think we’ve shown that we’re pretty good at it. And then once you do your first one, it becomes much easier to win because people now see, okay, you got this done. They talked to the employees who came over who were super psyched to work here, and it becomes a little bit of a self-fulfilling prophecy. 

Shiloh: Are you surprised that there’s not more M and A activity in the BDC space? Because it seems like there’s a lot of BDCs trading pretty substantial discounts and not really a lot of shareholder activity pushing for change. How do you think about that? 

Ted: I think a lot of the BDCs that needed to get merged have merged. I don’t think you’re going to see a wholesale wave of BDC mergers. I think there’s some niche areas within BDC space that probably need to be consolidated, but by and large, I think a lot of that consolidation has been done. I think the one thing that people aren’t talking about is there’s lots and lots of money that have been raised to do BDCs, interval funds, et cetera, that are subscale in the non-traded space and there’s a lot of stranded assets and funds in that space. So it probably makes sense for some of those guys to come together or merge with a public company. So I think if I had my crystal ball and rolled forward three years, I think a lot of the M and A will be private companies either merging with public, or private companies merging together. And things like closed-end funds. There’s lots and lots of closed-end funds that don’t know what to do. They’re perfect candidates to merge with. So I think you’re going to see what I would call non-traditional M and A. 

Shiloh: One of the things we’ve seen over the last few years is that there’s a real trend towards just the private BDC, which stays private perpetually, rather than going public. Is that something that your LP investors are more interested in that structure than the traditional publicly traded BDC? Is that what you’re seeing? 

Ted: I think there’s different markets for both. So my shareholders in my BDC are pretty different than my LPs and my private BDC. And again, a lot of my LPs in my BDC want the steady distribution of cash. They don’t want the daily mark to market and the stock, and they want to be tied to NAV, not market. So I think it’s two different buyers. And if we could take our BDC public at two times book, I think our LPs would be pretty open-minded to it. But I think LPs have a bit of a fear that these things go public and trade at a discount. So you get dinged on your net asset value, or at least market trading price. 

Shiloh: Would you say BDC is an asset class that overall has performed well for investors and that people should have a decent allocation to in their portfolios? 

Ted: I think so. Take a huge step back. Everybody always stares at stock prices in BDCs, but they don’t look at stock price plus dividend yield. So my stock pays the 13% dividend yield. That’s a lot. So you can withstand a lot of mark to market because we’re paying out so much cash to our investors. BDCs over time, I think, have delivered for shareholders, and you get what you pay for. If you back a high quality manager, they’ve done very well. So something like an Ares has done incredibly well, fundamentally and stock price-wise and also been able to grow. So I think if you were a good credit underwriter, and you’re balanced about growth, I think they’re great investments. And again, it’s changed a lot. When I started in the space and took over, I was running, I think, the second biggest BDC at the time. It might’ve been the biggest. At that time, most BDC managers were entrepreneurs, and if you roll forward today, it’s institutionalized. So KKR, Carlisle, Blackstone, best in class firms, all have BDCs, and the entrepreneurs are largely gone. So if you roll back 15 years and look at a comp sheet, basically they weren’t attached to a large asset manager, and now the space is institutionalized. So what does that mean? I can’t say that they’re better investors or not better investors, but KKR is not going to miss-mark their portfolio. So some of the noise around some of these books that Einhorn wrote and everything else, 

Disclaimer: Note: “Fooling Some of the People All of the Time” by David Einhorn is an excellent book about investing in business development companies. 

Ted: The reality is these firms are too big and too important to screw around with shareholders. So the worries around bad behavior and stuff have just gone away. 

Shiloh: One of the things I saw during the COVID downturn though was a lot of the BDC share prices got cut in half. So if you got an exposure to a portfolio of secured loans, mostly first lien, some second, and then some other funky stuff, and down half is what you get in a downside case, I mean that really pretty unfavorably skews your risk return. That was my takeaway from COVID.

Ted: Fair, but I view it the other way around. Which is, just take 10% defaults. So in 2008, defaults in the broadly syndicated market didn’t hit 10%. And the broadly syndicated market typically has higher default rates than the middle market. So just use the number of 10%. And in the middle market, recovery’s been 80. So a really bad year for a BDC would be to lose 200 basis points of NAV, unlevered, and then they’re levered, so call it 4%. So if a BDC stock trade is down by 50% and they own first lien debt, you should buy the stock. I view it as a buying opportunity, and if you own it, buy more. And that’s always worked. Anytime you buy BDC at a big discount to book, these things always normalize and they revert to the mean. So anytime you can buy one of the best in class guys at 90% of book, they almost always go back to book. And when they go to 110 of book, they oftentimes will trade back down to 90. So in my experience, there’s been a big reversion of the mean trade and there’s some really smart BDC investors who’ve made a lot of money by doing that. 

Shiloh: Do you think that in general the fees in BDCs are too high and that’s what has some investors shying away from the asset class? 

Ted: Again, I think everything you have to look on a net return basis. So those platforms who’ve cut their fees are, generally speaking, not best in class. So if you correlate fundamental performance to fees, there’s no correlation. Meaning those who’ve cut their fees, typically, are guys who have not performed well, and those who have the high fee structures that perform well. So I tend to come at it, like, you get what you pay for. I know certain hedge fund allocators, they will only give money to managers at really low fees and they don’t understand why their performance is poor, and they have to understand you’re getting adversely selected. I just think you get what you pay for. So the thing I think that is a bigger issue is the differential in fees between what public shareholders pay, and in certain cases, what private investors pay. And maybe we have a debate about the differences, but the differences in some cases are too high, and that’ll normalize over time as well. 

Shiloh: And then transitioning to CLOs, I know you guys have a few that you’re managing, should we expect to see more issuance from your platform over the coming years or how are you viewing the CLO product as being useful to you? 

Ted: Well, I’d say a couple of different things. One is a CLO business to us is strategic because you have a library of every credit out there. So when there is a downturn, you can be aggressive and opportunistic in the whole business, and you’re more relevant to the street, and everything else. So that’s number one. Number two is one thing that you do, which I think is an awesome business that quite frankly, listen, you’re best in class and I’m not sure that we would be, but CLO is a great asset class. You just have to hold it in the right place. So if you look at 2008, no CLO has defaulted. In the height of structured products, carnage, CLO equity performed and CLO liabilities performed. So I always think CLO liabilities provide really off-market risk return, always, in any environment and in periods of stress, crazy risk/reward. 

So it comes back to size. It’s very hard to source that stuff in big size during downturns. It is a weird conversation because I feel like you’re the professor, I’m the student, and I’m lecturing you on it. But the reality is it’s very hard for me to say that CLOs and CLO liabilities and having that capability isn’t great risk reward in many different environments. So I think the problem, it gets tainted a by broad structured products and the subprime mortgage crisis has nothing to do with subprime mortgages. They’re totally different and the abuse that happened over there just doesn’t happen in CLO land. 

Shiloh: I think the difference though, by contrast, our CLO equity or double B investing versus just owning middle market loans directly, in like a GPLP fund or a BDC, it’s just that all the CLO securities, they’ve got a CUSIP, they’re trading around in the market, they’re modeled in Intex so anybody can see what’s going on. And if we’re trading, or somebody else is trading with a bank or a hedge fund, a lot of those trades are reported. So you’re going to see volatility in CLOs, CLO securities, that’s going to be quite different from just holding a middle market loan directly. In middle market loans, we see, a lot of times they’re underwritten at a price of 98 cents on the dollar, and if everything goes according to plan, the mark will be around that price for the five-year life of the loan, call it. And even if the loan underperforms, I think different managers would mark it differently. Some take a more optimistic look at it and say, “oh, well this has underperformed, but I still think I’m getting my money back and it’s near par”. I think other people would take an approach that would have the loan marked at a discount, but the end result is that the middle market loans do have a lower standard deviation than the CLO securities, less volatility, and some GPLPs just want that. But if you’re holding it for a long period of time, and you can bear a drawdown on your NAV, then my DNA is the CLO. That’s what I like. 

Ted: I think that’s very well said and that’s why I made the comment earlier about just make sure you own it in a place that has locked up capital or you can withstand mark to market. 

Shiloh: So is there anything that’s interesting to you that we haven’t talked about, or anything that’s going to keep you busy this fall? 

Ted: The thing that I’m spending my time on is, so if you think about the business of a GP, we can either scale assets very quickly, but they’re low margin and there’s other things we can do that are high margin but hard to scale. So the question is what scalable platforms are there that are high margin? So a place that we’re really active in is, and I mentioned it briefly before, is we’ve spent the last 15 years replacing banks in corporate lending. And now if you look at for the next 10 years, I think we’ll replace the regional banks for a lot of things that they do. So lender to lender finance, factory and equipment finance. It’s a strange world right now. Blackstone is able to provide us with financing. So five years ago we would’ve gone to Credit Suisse, now we go to Blackstone. We can go to other people too. Or if you think about, Apollo bought Atlas, which is Credit Suisse’s securitization business. If we had a security, something that was complicated and whatever, that’s an amazing business. So now if I have to securitize something, I’d go to Apollo. It’s interesting to see the evolution of all this stuff. When we had a problem, we used to go to the banks and the banks would help us solve it, and now oftentimes the banks come to us and they want us to solve their problems in terms of risk transfer, or reg cap relief, or leveraged finance businesses feel like they’re getting their clocks cleaned by private credit. So how do we monetize our origination efforts with your balance sheet? So there’s some really interesting dialogue and partnerships going on right now with large banks where we think about what a bank is, they have an amazing front end and amazing origination. What are we trying to build? We’re trying to build that and we have a balance sheet that is able to take on these assets. And to your point, we’re not dealing with ratings and risk charges and the Fed and we don’t have to deal with that stuff. We’re heavily regulated and we obviously have things that we’re regulated by, but it’s a very good marriage in a lot of different situations. So this whole private credit thing, I still think we’re in early days. We’ve replaced middle market lending. Now they we’re replacing large lending, now we’re going to replace the regional banks. Athene now is bigger than Swiss RE, I think. So our world is now taking over insurance and I’m actually really, really excited for the next 10 to 15 years, and I just think there’s so much growth ahead of us. 

Shiloh: Does the asset based lending and the securitization that banks are doing that’s maybe being moved to alternative lenders, does that really offer returns that are interesting to your investors? I thought of those asset classes as being quasi-investment grade or at least highly internally rated at the banks. 

Ted: So after Silicon Valley Bank, the average bank has a 25% mark to market hit to their equity. A lot of it’s driven by rates. Everyone thought there’d be a lot of M and A. Well, if there’s M and A, then you’re merging with somebody else. You still have a big hole in your balance sheet. What banks used to do in the US is they used to issue equity, but Silicon Valley Bank tried that and there was a run on the bank. So the only real solution is to ramp back on lending, and that gap over time is just going to close as things mature and duration shortens. So that’s what’s going on. Again, all this will normalize, but spreads are wide and do work for our investors at current pricing. And there’s other things we can do like back-lever it and do some other things that get to the returns that we need to get to if we want to do that. But you’re making a good point. We don’t really have a whole bunch of L350 or L400 products. We just can’t compete because if I raise money in that space, I can charge 30 bps, 40 bps, and I need an army of people to do that business. We just can’t make money doing it. What we can make money doing is if we can get a little bit higher yields, then you can charge a hundred basis points and then just do the math. We can actually afford to hire a team and build out a business. So the only counter to all that is if you can get stuff rated. So a lot of what we do is we originate illiquid stuff at wide spreads, we get it rated, and now they comp incredibly well to liquid credit and we sell that to insurance companies. That’s becoming a very large part of our business. 

Shiloh: So the SRTs, that’s the significant risk transfer, so that’s banks selling exposure to investment on their balance sheet and they’re doing that rather than issuing new equity to the market. Have you guys been involved in that? 

Ted: So we’ve been acting in that space for a long time. Deutsche Bank has a program called Craft. They have a new one called Loft, but now we’re actually seeing it at a much smaller level. We saw one from a HUD based lender, smaller bank that, again, would never have done one of these 10 years ago. So it’s becoming much more relevant for not just the big, big banks, but for a lot of banks. And it’s a win-win. If I’m taking a revolver from Bank of America as a company, you don’t want to see a distressed lender showing up at your door owning your revolver. You just don’t want that. So this is a way for them to maintain their client relationships, maintain a front end with these clients, but from a risk capital perspective, get off their balance sheets. It is a win-win, and these things price at a place where it’s very hard to lose money. You may not make lots of money, but in terms of risk return, it’s hard to lose money. All that being said, the caveat to everything I just said is the thing that SRT that always keeps me up at night is you’re selling first-loss risk. And it feels a little bit, and I dunno if you agree with this Shiloh, but it feels a little bit like we might be going into a more elevated default cycle. So if you’re doing first loss risk and defaults go up, those things aren’t good combos. So with the economy slowing down, and again, I’m not a macro economist, but it just feels like it’s slowing down, and that usually leads to defaults, and that usually leads to bad things for SRTs. So that’s the two sides of it obviously. 

Shiloh: Is one of the issues, and I haven’t looked at SRTs that much, but they’re obviously quite close to CLOs in structure. But in the SRT, it’s a pool where they may be a hundred designated assets at first and then the portfolio changes over time. Not sure how you’re in the first loss there. I guess you’re underwriting the bank’s underwriting, and getting comfortable that the loans that they continue to underwrite and put into this vehicle are ones that fit into your credit box. 

Ted: So I would say the way these are typically structured is one of two ways. So either do it against a static pool, which you can underwrite. More often than not, it’s a identified pool of loans and the bank has the opportunity to recycle some of that capital in what I call a credit box. So they obviously can’t start putting in derivatives and a bunch of random stuff in there. They have to fit a certain box, whether it’s regional, leverage levels, rating, so you can put restrictions on what the can and cannot do, and make it so it’s not purely a blind pool. And that puts limitation around the business. And then if you look at that static pool of loans with a three year reinvestment period, really you’re only taking exposure to 20% of the assets rolling off or something. So you can actually get comfortable with it from a bunch of different ways. 

Shiloh: Are you finding the SRTs that you’re interested in, or do they have assets that look similar to your private credit portfolios, or are they pretty heterogeneous in what’s in there? 

Ted: So the classic SRT that we see is the relationship lending book of big banks. So every time they do a leveraged finance deal, Deutsche Bank takes a piece of the revolver, and it sits on their balance sheet, and then they do a SRT to get that off their books. That’s the classic trade. So when we see these things, you would know all the obligors, it’s all liquid loans. We are beginning to get into more esoteric loan books, but those require a lot more work. So if you’re going to get into private credit assets, and you don’t know who these obligors are, that’s obviously a lot more work. So a lot of times the banks, when you look at who they own, they own GM, they own Pfizer, they own companies that you know. Verizon. Companies that are rated well and you know and can box credit risk. More and more and more the new ones we’re seeing, for the smaller banks, we typically don’t know any of the names, so we have to do a really deep credit underwrite. So those take a lot more time. 

Shiloh: Interesting. Well, Ted, thanks for coming on the podcast. Really appreciate it. 

Ted: Thank you so much. 

Disclaimer: 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 period

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

An add back would attempt to adjust EBITDA for non-recurring items. ETFs exchange traded funds 

CMBS are commercial mortgage-backed securities. A BDC is a business development company

Basel III is a regulatory framework for banks 

Efficient Market Hypothesis posits that it’s hard to consistently beat the market 

GP NAV lending refers to lending against the equity value of a private equity firm’s investments 

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. 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 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.
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