Month: January 2024

22 Jan 2024
Insights Shiloh Bates 0 comment

Key Questions about Private Credit, CLOs

Is private credit a bubble?

Relevant for: Leveraged loans, CLO BBs, and CLO Equity

We do not believe private credit is a bubble. As a result of Federal Reserve interest rate hikes, middle market loans yields are now in the low double-digits. In the typical corporate capital structure, the more risk you take, the higher the required return. However, middle market loans could offer returns well in excess of where many economists project long-term equity returns to be. Middle market loans are senior and secured and therefore typically offer more downside protection than high yield bonds or equities. Standard and Poor’s estimates that private equity firms have raised $2.5 trillion that has yet to be deployed.1 We believe much of that capital will be used to buy middle market businesses in transactions where the loan will make up less than 50% of the purchase price. A substantial equity contribution from a private equity sponsor provides downside protection for the middle market loan investor. This favorable risk / return dynamic for middle market loans hasn’t existed for the last fifteen years, in our opinion.

Middle market loans are owned in long-term non-mark-to-market funds. The market should not see any forced selling of middle market loans due to margin calls. The result is more stable loan pricing over time.

Middle market lending has never been a zero-loss investment opportunity. Unforeseen events can push some business into default. When we model CLOs, we include a 60bps loss rate on the loans, consistent with the historical loss rate in those portfolios. Prior to the increase in interest rates, we believe most middle market loans were paying a fixed spread of approximately 5.0% over a LIBOR floor of 1.0%. Now, middle market loans pay the spread over the Secured Overnight Funding Rate (SOFR), which finished the year at 5.3%. The additional yield of 4.3% could provide an attractive offset for any increase in loan losses that could result from a slowing economy.

Outside of traditional middle market lending, we see risk in broadly syndicated loans where the loan documentation did not adequately protect creditors’ rights. We also see risk in second lien loans and unsecured debt, where if the loans were to default, recoveries would be much lower than first lien loans.

Can borrowers afford higher interest rates?

Relevant for: Leveraged loans, CLO BBs, and CLO Equity
We believe that most companies that issue leveraged loans will be able to pay the higher rates that have resulted from Federal Reserve interest rate increases. By our estimation, interest coverage ratios of middle market borrowers have declined from ~3.7x at year-end 2021 to ~2.0x at year-end 2023.2 Rate increases were long expected, but the Federal Reserve certainly did not expect that it would have to raise interest rates to current levels to tame inflation. The interest rate markets now expect SOFR rates to normalize in the 3.0% area in 2025.3

Higher interest rates have resulted in less cash flow for middle market businesses, but that has been partially offset by the borrowers growing revenue and profitability. At the end of the day, corporate borrowers either make their contractual interest and principal payments, or the lenders take over the business and work for the best loan recovery possible. Given the average initial loan-to-value for senior secured loans is around 50%, there is significant equity and junior capital financing each borrower. We believe that the private equity firms would rather support their existing portfolio companies for what is expected to be another year or two of higher rates, rather than take a total loss on their equity investment. Higher interest rates have resulted in a favorable shift in economics away from private equity for the benefit of senior secured lenders.

Where we’ve seen borrowers struggle, the cause is usually some input cost pressures that can’t be passed along to customers or the loss of key customers to competitors. If the business is tracking to plan, the higher rates are manageable, in our opinion.

The SOFR forward curve predicts that SOFR will decline by 2.5% over the next two years,3 increasing borrower cash flow and liquidity. Of course, higher for longer has been a smart wager.

When / if refis and CLO extensions will be possible?

Relevant for: CLO Equity
The potential for significant upside could exist in CLO Equity if the CLO can refinance its debt at lower rates, or if the reinvestment period can be extended on favorable terms. Since the beginning of 2022, CLO financing costs have been elevated, and these transactions have been rare. Last year the CLO AAA spread over SOFR declined from 2.1% to 1.6%.4 We believe there can be a significant number of refinancings and reinvestment period extensions this year if AAA CLO spreads decline 0.20% from current levels.

In addition, many CLOs issued in 2022 and 2023 have elevated debt costs, relative to current levels. Many of these CLOs are good candidates to extend their reinvestment periods, even if CLO AAA spreads do not decline further.

CLOs issued in 2021 or before, may go their full lives without refinancing their debt or extending their reinvestment periods. In such cases, the CLO equity could benefit from below market financing costs for the CLO’s 8-10 year expected life.

A CLO reinvestment period extension has the potential to add 2% to our base-case projected returns, assuming no change in the CLO’s cost of debt. The value of refinancing portions of the CLO’s debt at lower rates depends on the magnitude of the cost reduction. A general rule is that 10bps of reduction in the CLO’s cost of debt results in 80bps of incremental cash flow to the CLO equity for a middle market CLO levered 8.0x.

What are the causes and effects of lower loan issuance?

Relevant for: Leveraged loans, CLO BBs, and CLO Equity
Leveraged loans are often created in a Leveraged Buyout (LBO). LBO activity has declined since 2021 due to the inability of private equity sponsors and business owners to agree on a purchase price for the business. Higher interest rates in general have resulted in a compression of acquisition multiples that private equity sponsors will pay and many business owners have been unwilling to sell at these lower multiples. As interest rates decline, we would expect LBO activity to rebound to more normalized levels.

Much of primary activity in the loan market this past year resulted from refinancings, repricings and maturity extensions, rather than new LBOs. While new loan creation was down, the quality of new loans that did come to market was high, in our opinion, both in terms of the projected returns of new loans as well as lender-favorable documentation terms.

The decline in new loan activity resulted in stronger bids for higher quality credits in the secondary market. During 2023, the Morningstar Loan Index (“the Loan Index”) increased from 92 to 96. Higher loan prices were a tailwind for CLO equity and CLO BB returns during the year.

Has there been CLO self-healing over the last two years?

Relevant for: CLO BBs and CLO Equity
CLOs typically start their lives with a 4- to 5-year reinvestment period, during which the CLO can reinvest proceeds from loan repayments into new investments. During periods of market turbulence, loans tend to trade down in price. That enables the CLO manager to purchase discounted loans in the secondary market. These discounted purchases can provide a material offset to increased defaults during economic downturns. Discounted loan purchases can enhance the CLO’s credit profile for CLO Note investors and potentially increase returns for CLO Equity investors. We call this the “self-healing” mechanism of CLOs.

The Loan Index ended 2021 at 99, but during the last two years, the Loan Index had an average price of 95.5 This has provided an opportunity for CLOs to buy discounted loans. However, the loans that CLOs invest in tend to be more conservative than the overall Loan Index. We believe that our CLO managers have been able to invest loan repayments at dollar prices between 97-98 throughout the year. This is accretive to CLO equity returns given our usual CLO modeling assumption of a purchase price of 99.

Is there a trend towards lower loan recoveries in the event of default?

Relevant for: Leveraged loans, CLO BBs, and CLO Equity
Our usual base-case CLO modeling assumption is that 2% of the loans will default each year and the recovery rate will be 70%. This can be considered a loan loss reserve. One of our goals is to invest with CLO managers that outperform on these metrics.

For broadly syndicated loans, recovery rates for 2023 were poor, which was a headwind for CLO equity returns. Fortunately, loans default rarely, and the default rate of 2.0% at year-end 2023 was consistent with our modeling assumptions.6 But across the 52 defaults in 2023 tracked by JP Morgan in the syndicated loan market, the recovery rate was 36.4%.

There are two primary reasons why broadly syndicated loan recoveries have been coming in below our typical CLO modeling assumption of 70%:

1. Initial loan to value was marginally higher than in the past, i.e., less equity and unsecured bonds as a % of the initial financing

2. Loose loan documentation did not adequately protect creditors’ rights

While JP Morgan measures the recovery rate of a loan as the trading price 30 days after the loan defaults, that is not the ultimate recovery value. In a default, the lender often ends up with a restructured term loan and an equity investment. In some cases, the equity upside can be substantial, but it takes time for the recovery to play out.

We view low loan recoveries as unique to the broadly syndicated loan market. In the middle market, we believe loan documentation is still creditor friendly, and initial loan-to-values are below 50%.

We expect the impact of loan defaults to be less pronounced on CLO portfolios than on the loan market overall. CLO managers are actively managing their CLO’s underlying loan portfolios to improve average credit quality and ensure the CLO’s compliance with its many tests. Accordingly, CLOs own loans that are much more conservative than the overall Loan Index.

The other important variables that determine CLO equity returns have been tracking favorably: default rate, interest rate, new loan purchase price, and new loan spread. Additional CLO equity upside could exist in 2024 and beyond if we’re able to refinance our CLO’s debt at lower rates or extend their reinvestment periods.
SOURCES

1) S&P Global Market Intelligence, December 2023

2) Flat Rock Global Assumptions, for a borrower levered at 4.5x EBITDA paying a SOFR + 5% interest rate

3) Chicago Mercantile Exchange SOFR Futures

4) JP Morgan CLOIE Index

5) Bloomberg, LLC

6) JP Morgan Default Monitor December 2023

DISCLOSURES

Past performance is not indicative of future results.

This is not an invitation to make any investment or purchase shares in any fund and is intended for informational purposes only. Nothing contained herein constitutes investment, legal, tax or other advice, nor is it to be relied on in making an investment or other decision. Nothing herein should be construed as a solicitation, offer or recommendation to acquire or dispose of any investment, or to engage in any other transaction.

For further information feel free to email info@flatrockglobal.com

10 Jan 2024
Insights Robert Grunewald 0 comment

Recession Avoided, Private Credit Wins, and Other Predictions for 2024

As another volatile year concludes, it is with great humility and deep respect for the likelihood of the unexpected, the following are my top 10 Predictions for 2024:

1. While we will avoid a recession, GDP growth will slow significantly.

Real GDP growth for 2023 is expected to come in around 3%. I wouldn’t be surprised to see the effect of higher interest rates result in 2024 GDP growth of around 1%. Wall Street is mostly convinced that the Fed will reach its goal of a soft landing for the U.S. economy in 2024. This means there will be slower economic growth, but no recession, leading to interest rate cuts in 2024. Consider how close that leaves us to dipping into negative growth/recession territory if the Fed doesn’t manage interest rates carefully. Hedge your bets.

2. The S&P 500 will be up mid to high single-digits—let’s call it 5%.

The average Wall Street analyst remains constructive on U.S. equities, forecasting a ~5% total return on the S&P 500 in 2024. These forecasts reflect positive EPS growth and valuation assumptions, despite headwinds from a sluggish economy and uncertainty around the 2024 Presidential election. We view private credit as the relatively more attractive asset class.

3. Private equity returns will not be worth the lack of liquidity and drawdown hassle.

Higher rates have led to a shift in economics away from private equity to the benefit of private credit. Even BlackRock predicts only 11.2% returns for private equity over the next 10 years. Enough said.

4. Real estate investments warrant caution, as more pain is yet to come.

Commercial real estate incurred over half a trillion dollars in losses in 2023 and is projected to have similar losses again in 2024. Read the recent Muddy Waters Research report on Blackstone Mortgage Trust (BXMT) and the hair will stand up on the back of your neck. Of course, out of chaos can eventually come opportunity.

5. Private credit default rates will continue to trend in line with historical averages.

JP Morgan’s most recent forecast is for private credit default rates to average 3.25% in 2024. This represents a 75bp reduction in forecasted default levels from their previous prediction. The 25-year average default rates are 3.00%. I expect default rates to remain close to these historical averages. Interestingly, the loans in Flat Rock Opportunity Fund’s CLOs have defaulted at a 1.7% rate in 2023. Carefully curating your private credit exposure can make a significant difference in risk and return.

6. Grouping private credit risk into a monolithic bucket will be fraught with risk.

Private credit, now estimated to be in excess of a $1.5 trillion market, is as diverse in potential risk as bonds. First lien risk is radically different than second lien risk and certainly mezz debt or distressed debt. Loan-to-value is critical—the more equity that finances the business, the greater the margin of safety for the lender. According to JP Morgan Research, first lien loans have a recovery rate of 64.3% while second lien loans have a 23.9% recovery rate. That means even a small amount of second lien exposure has the potential to materially increase risk. Why expose yourself to anything except high quality, first lien, senior secured loans when they are currently generating equity-type returns?

7. Private credit will outperform the S&P 500, private equity, and real estate.

At the current interest rate levels, high quality, first lien loans are generating equity-type returns. Even if rates decline a bit, as economic growth slows, there is safety at the top of the capital stack.

8. Unique investment opportunities will be found in capacity-constrained strategies.

Consider CLO BB Notes, CLO Equity, lower middle market private credit, and one-off real estate transactions underwritten by quality firms. These market segments are too small for the behemoth asset managers.

9. Boys in the Boat will win the Oscar for Best Picture.

I read this book a few years ago and consider it one of the best books I’ve read. It’s the story of a Washington University crew team overcoming numerous obstacles to achieve an unbelievable level of success. The main message for me was the power of hard work combined with the power of teamwork can allow you to accomplish goals you never thought possible. I am immensely grateful for the hard work of the entire Flat Rock Global team and the power of teamwork they show every day.

10. The Eagles will win the Super Bowl.

Or it could be the 49ers, or the Chiefs; I like the Bills as a long shot, damn who knows, but our colleague Yuri is such a diehard Eagles fan I have to cheer for them. Go Birds!

SOURCES

1. Bureau of Economic Analysis; Bureau of Labor Statistics; Congressional Budget Office. December 2023.

2. 2023 Stock Market Year in Review. Forbes Advisor. December 4, 2023.

GLOSSARY

Basis point (bp): Refers to a common unit of measure for interest rates and other percentages in finance. One basis point is equal to 1/100th of 1%, or 0.01%, or 0.0001, and is used to denote the percentage change in a financial instrument.

Collateralized Loan Obligations (CLOs): Collateralized loan obligations (CLO) are securities that are backed by a pool of loans. In other words, CLOs are repackaged loans that are sold to investors.

First Lien Risk: First lien loans are first in line for payment in a bankruptcy, with a lien on all the company’s assets.

Second Lien Risk: Second lien loans are second in line for payment in a bankruptcy, and thus carry more risk than first lien loans.

Mezzanine (Mezz) Debt: Mezzanine debt is when a hybrid debt issue is subordinate to another debt issue from the same issuer.

Distressed Debt: Distressed debt is debt that belongs to government entities or companies that are facing financial difficulties, such as default.

Loan-to-Value: The loan-to-value ratio looks at the amount of money being borrowed and compares it to the market price of the asset being purchased.

Margin of Safety: The margin of safety principle of investing applies when an investor only buys securities when the market price is below the estimated intrinsic value.

BB Notes: BB Notes refers to debt notes with a rating of BB by a National Recognized Statistical Rating Organization (NRSRO) such as Moody’s Investor Service (Moody’s), Standard & Poor’s (S&P), or Fitch Ratings.

DISCLOSURES

Past performance is not indicative of future results. This is not an invitation to make any investment or purchase shares in any fund and is intended for informational purposes only.

Nothing contained herein constitutes investment, legal, tax or other advice, nor is it to be relied on in making an investment or other decision.

Nothing herein should be construed as a solicitation, offer or recommendation to acquire or dispose of any investment, or to engage in any other transaction.

About Flat Rock Opportunity Fund (FROPX):

Flat Rock Opportunity Fund invests primarily in equity and in junior debt tranches of CLOs. CLOs provide exposure to senior secured loans on a leveraged basis. Flat Rock Opportunity Fund is structured as an SEC-registered closed-end management investment company operating as an interval fund, and shares of the Fund can be purchased using the ticker FROPX.

Consider the investment objectives, risks, charges and expenses of the Fund carefully before investing. Other information about the Fund may be obtained at flatrockglobal.com/flat-rock-opportunity-fund. This material must be preceded or accompanied by a prospectus.

ALPS Distributors, Inc. serves as our principal underwriter, within the meaning of the Investment Company Act of 1940, as amended, and will act as the distributor of our shares on a best efforts’ basis, subject to various conditions.

The following disclaimer relates The Flat Rock Opportunity Fund (FROPX). The Fund is suitable for investors who can bear the risks associated with the Fund’s limited liquidity and should be viewed as a longterm investment. There is no secondary market for the Fund’s shares, and it is not anticipated that a secondary market will develop. Thus, an investment in the Fund may not be suitable for investors who may need the money they invest in a specified timeframe. The shares of the Fund are not redeemable. Although the Fund will offer to repurchase at least 5% of outstanding shares on a quarterly basis in accordance with the Fund’s repurchase policy, the Fund will not be required to repurchase shares at a shareholder’s option nor will shares be exchangeable for units, interests or shares of any security. The Fund is not required to extend, and shareholders should not expect the Fund’s Board of Trustees to authorize, repurchase offers in excess of 5% of outstanding shares. Regardless of how the Fund performs, an investor may not be able to sell or otherwise liquidate his or her shares whenever such investor would prefer. The Fund’s distributions may be funded from unlimited amounts of offering proceeds or borrowings, which may constitute a return of capital and reduce the amount of capital available to the Fund for investment. Any capital returned to shareholders through distributions will be distributed after payment of fees and expenses. The amounts and timing of distributions that the Fund may pay, if any, is uncertain. A return of capital to shareholders is a return of a portion of their original investment in the Fund, thereby reducing the tax basis of their investment. As a result of such reduction in tax basis, shareholders maybe subject to tax in connection with the sale of Shares, even if such Shares are sold at a loss relative to the shareholder’s original investment. Shares are speculative and involve a high degree of risk, including the risk associated with belowinvestment grade securities and leverage.

For further information, please email info@flatrockglobal.com

ALPS Control Number FLT000397