Day: May 15, 2024

The CLO Investor Podcast, Episode 3

Shiloh:

Hi, I am Shiloh Bates and welcome to the CLO Investor podcast. CLO stands for collateralized loan obligations, which are securities backed by pools of leverage loans. In this podcast, we discuss current news in the CLO industry, and I interview key market players. Today I’ll be joined by David Williams, one of our industry’s prominent CLO bankers. A CLO banker, sometimes referred to as a CLO arranger, is the person responsible for bringing a CLO to life. That includes arranging all of the financing for the CLO and mediating the negotiations between the CLO’s many constituents. A CLO banker earns a fee when the CLO is created and that usually ends their involvement in the CLO. Some of the topics for today’s podcast include strong CLO issuance, refis and resets, CLO profitability and opportunities and challenges in the CLO market. Now let’s get started. David, welcome to the podcast.

David:

Really appreciate the opportunity to speak to you.

Shiloh:

I know we’ve known each other for over a decade now, but why don’t you take a few minutes and just give our listeners an overview of your background.

David:

I’ve been in the structured credit space for just under 20 years. I recently joined Scotia Bank, actually almost coming up on my one year anniversary, in May of last year. Before that I was at Natixis, and at Natixis, I was running the credit group and also global syndication for structured credit within Natixis. That included CLOs, both middle market and broadly syndicated and financing business.

Shiloh:

Okay, and what does a head of syndicate do in the CLO business?

David:

Well, before I was the head of syndicate, I was actually doing more of the day to day where I was basically the intermediary between sales and banking and I helped liaise between the manager and the banking team to help get CLOs basically up and down and priced and source interest up and down the capital structure for the deals to be able to get best execution for our managers so we can get repeat transactions.

AI:

Note in CLO jargon, CLO notes, CLO liabilities, and the CLO stack all refer to the same thing. These are the multiple securities that are issued by the CLO to finance itself.

Shiloh:

So is that a little bit like herding cats?

David:

There’s a lot of herding cats and you have to make both sides happy at all times. So investors and managers, it’s a delicate balance and not always the easiest, but I find that if you can be successful and you can find that medium there, hopefully that leads to a successful repeat business and you want to come out where everybody is happy, not too happy because that means you did something poorly on one side or the other. So you want everyone to be moderately happy I think.

Shiloh:

So now you’re at Scotia and there’s a lot of CLO bankers out there. So how do you guys differentiate your platform?

David:

I think that we were able to be quite successful at my former shop. That being said, Scotia is really giving us a lot of tools here to build out the franchise the way that we collectively see how to build a successful business. At the end of the day, I think you need a bank that has the appropriate risk tolerance and by risk tolerance we are par lenders to par lenders. So I don’t think we’re doing anything abnormal, but you certainly need to have a balance sheet. You need to have the capital from a personnel perspective, from a distribution perspective, and you also need a bank that is going to be supportive in good and bad times and very relationship oriented. And since I’ve gotten here a year ago, Scotia has not only been supportive from a balance sheet perspective and helping us giving the tools and risk and really developing the credit franchise, but also from a personnel and to make sure that we mitigate all execution risks and that we are bringing the right deals to market and giving our new risk group not new risk group to Scotia, but the risk group with regards to structured credit comfort there.

We do things a little bit differently at Scotia and some other banks are certainly I think following suit or taking this business model. But back to your core question, I think that there are a lot of CLO arrangers out there. I think that we’re going to differentiate ourselves with being involved both in the private debt middle market side of the landscape and also on the broadly syndicated side and basically come with creative solutions from a financing perspective to our clients. And I think that’s hugely important.

Shiloh:

So what I’ve seen, especially on the middle market side, is that the banks that have the most success are really also the banks that like to lend against the loans. So before the CLO is formed, often a CLO warehouse is put in place to acquire loans. If a bank actually wants to provide the leverage in a warehouse, that’s very useful for the CLO formation. And if the bank doesn’t like that risk for whatever reason, then it’s hard to be at the top of the middle market league tables.

David:

I think that’s a great point. Fortunately I think Scotia has a great DNA with regards to lending and lending to the right partners, and I think picking those partners are hugely important. You really need to eat your own cooking in the sense that you are living with these loans prior to a full CLO coming to fruition and you need a bank that is going to be supportive with lower diversity with regards to funding those assets prior to having enough diversity to go into a CLO. So there needs to be a real comfort with the underlying assets but also the platforms across the board and you have to make sure that you are banking the right partners and you’re aligned in all of your interests.

Shiloh:

So the CLO industry is really off to a really strong start this year. So in terms of new issues, we’ve seen about 60 billion already as we’re talking here, at the end of April, and 50 billion of refi and reset, reset being just an extension of the life of the CLO, what do you think the key drivers of all the CLO business is today?

David:

I think that the CLOs have been around for I guess upwards of 20 years now and really taken a life of its own I would say since the mid-teens. And as CLO creation happens, there are different markets and liabilities are issued at different times, assets are aggregated at different times. We’re seeing a massive wave of refinancings right now and a lot of that is from legacy transactions that either have come out of reinvestment period and that are amortizing that are paying down. And sometimes that is because they have very attractive costs of debt and liabilities right now, but at some point in time the manager and the equity wants to extend that and doesn’t want to lose the assets. And then on the other side you have deals that were done at called the last 12, 18, 24 months where the liabilities in the CLO debt was at much wider levels and you’re seeing an opportunity to really decrease your cost of funds and decreasing your cost of funds will ultimately lead to, and these are actively managed portfolios as long as you avoid significant defaults of the portfolio, that should all be accretive to your equity investors.

So we’re seeing a huge wave of refinancings from both legacy deals that were coming out of reinvesting period, and then also more recent deals with higher liability costs on top of the new issue wave.

Shiloh:

So we’ve seen the cost of the AAA come down substantially over the last year. What do you think’s driving that? Is it just the banks were on strike for the last two years and now with economic conditions improving, their appetite for the top of the CLO stack has come back or you’re talking to these banks, so why don’t you give us some insight there?

David:

I think it’s a mix. I think most recently we’ve certainly seen a handful of the US banks who are the largest and Japan is the close second, and if you actually mix the two, the Japanese and the US banks are the largest buyers of AAA CLOs. But we’re also seeing new investors come into this space from different regions. And it’s not just geographic locations, it’s different types of investors. It’s asset managers and insurance companies and pension funds that historically may not have been comfortable with the three letter acronym because it’s been also associated with the CDO world. I think that that’s worn off after 14 years now finally, and we’re also seeing a lot of a ABS investors I think just realize on a relative value basis, CLOs has historically priced substantially wide to that of the ABS market and these are certainly floating rate products.

Floating area products in high rate environments should be attractive to more investors and you’re not locked into the same rate risk securitization can be used in many different ways, but at the end of the day, CLOs are pools of corporate credit both on the private credit middle market side to the broadly syndicated world, so small, medium, large, mega types of corporates on the underlying. And these CLOs have proved to be resilient over the years and it’s now a 20 plus year market where you can actually look at data all the way from equity to AAAs. And I think that the performance as an asset class has been quite strong and investors globally, whether it’s banks, hedge funds, asset managers, pension funds are recognizing this. And while some have been in this product since day one, there’s a handful of investors that were a little bit slow to get comfortable with the CLO world.

That certainly changed. It doesn’t hurt that it is a floating rate product. Floating rate products and higher interest rate environments are certainly attractive. That being said, higher interest rate environments historically have also led to higher default environments. This doesn’t seem to be the case as of now. We’ll see how that plays out. But at the end of the day, these structures have just proved quite resilient and given the floating rate nature, it is an extremely attractive return versus some of the other asset classes that we’ve seen on a relative value basis. A lot of crossover from traditional flow EBS investors that are now looking at the CLO world because of that performance history.

Shiloh:

And as you talk to the investors in the top part of the stacks, banks and insurance companies, obviously the CLOs cost of debt has been declining, but is that a trend that you would expect to continue throughout the year or is there some type of spread over SOFR where beyond that it’s hard to push?

David:

It’s hard to say that there’s a concrete level. We are probably, or I shouldn’t say probably, but we’re roughly 25 bps. If you look at the LIBOR, so far adjusted spreads about 25 bps wide of the absolute tights of where we got. So there likely is room to run versus historical spreads, but they always look at this asset class as a relative value where they’re seeing elsewhere and I think that they’re every handle. So right now, let’s say AAAs for top tiers at one 50, when I say handle, they say that’s a five to get to the four. There is some psychological barriers to investors. So if you’re able to break that, usually more deals follow and it’s the next shoe to drop so to say. And I think it’s always hard to push to get to those absolute tights and I don’t know if we should be in those absolute tights because there are macroeconomic considerations that we all need to take into account now, and there always were, but more so now we are in a higher rate environment and historically higher rate environments have led to more stress portfolio. So there are concerns, but the performance has been pretty decent and at the end of the day, CLOs have continued to be wide of other fixed income products. So we will and we continue to see demand at these tighter levels.

Shiloh:

Well, from the perspective of a CLO equity investor, I’m definitely going to cheer you on in looking for lower handles on the triple-A cost in terms of stories of higher for longer on rates, it seems like every month or so we have to reset our expectations and fed cuts continue to get pushed out. How does that affect either the AAA rate or your business in general? Just the trend for higher for longer here…

David:

It really goes to how we pick our credit managers and who we’re working with. At the end of the day, these are actively managed goals. If we had a crystal ball, we said that everything was going to be where it was today and not have any significant stress on the portfolios at these rate environments, I think everybody would’ve called us crazy. We understand that there are problems within every portfolio At the same time it goes to a question on how rapid these increases will potentially get or are we going to see substantial decreases From a lending perspective, it seems to be for us a pretty attractive entry point, but there’s always portfolio considerations I think with higher rate environments that you have to be thoughtful and maybe not go all in at once, so to speak.

Shiloh:

So one of the trends we’ve seen in the market over the last two years is that for newly issued CLOs, a lot of times the equity is being bought by the manager themselves and an internal fund rather than going out to a third party equity investor like us. And the reason is that new issue, the initial profitability expectation of CLOs, we call that the ARB has been really poor over the last two years, but in spite of the poor ARB, I guess managers take the deals anyways and I guess we’ll see how those returns work out for them. Is the arbitrage improving here in April of 24 with the cost of CLOs financing coming in?

David:

ARB is hard. There are situations where the ARB might not necessarily look attractive to all CLO investors, but there’s opportunities that present itself that may still make the equity attractive where you can maybe aggregate a portfolio. It might still be lower spread on the asset side, but lower dollar price, so it can be a pull to par trade.

AI:

A pull to par CLO investment is one in which the initial loans are bought at discounts to par. The CLO equity investor expects to benefit from both the cash flows of the CLO as well as price appreciation on the underlying loans.

David:

Some equity investors do take a strong view that they are able to potentially reset these transactions at post and on-call period after one or two years. I think liabilities certainly tightening help. The arb, I think that dealers, not to speak our own book, but we are getting compressed on fees substantially. That doesn’t hurt the ARB at all when you have lower costs. Maybe lawyers have had to compress their fees as well. I think the costs for the overall structure have ultimately gotten more efficient. So all these factors with the cost of CLO creation with tighter liabilities to enhance the overall. Over the past few months, we’ve definitely seen more loan creation, but the competitiveness on the asset side seems to be quite fierce and spreads have compressed to a good amount. So we’ll see what that ultimately does for the yard. But I think you need to be ready from an arranger and from an equity perspective to act when there’s any hiccup in the market and be decisive because even a 25 or a 50 basis point sell off in loans creates opportunity with a levered vehicle. And if you’re able to lock in, attract AAAs or have a structure that is ready to go in short order, those tend to create the best arbitrage opportunities on the CLO side.

Shiloh:

What we’ve found interesting over the last two years really was I think the initial before middle market deals in the primary was attractive. So we were active there and then we also saw pretty interesting opportunities in secondary CLO LO equity, which had sold off quite a bit for broadly syndicated CLOs in the primary. I thought that was a little bit of a tougher trade. The initial returns there would’ve probably projected to be maybe double digits. To your point, you could invest in A CLO like that and if you’re able to do the CLO refinancing or extension in a year or two, then all of a sudden the profitability expectation would increase substantially, but it’s just hard to put all your eggs in that basket. So we weren’t particularly active in those.

David:

I think that what’s really interesting you touched on in the beginning is on the middle market side, I think these portfolios, since they’re originated assets, they take a long time to aggregate the assets. So it could take anywhere from nine months to two years. So right now if you have a portfolio that has call protection and you were able to source that over the trailing called 12 to 18 months and you can go securitize those assets into a CLO at the current middle market spreads, the ARB should work out quite well. Whereas on the broadly syndicated side, you’re aggregating these assets at a much faster pace, mostly in secondary. We have seen the new issue pipeline pick up historically you’ve been able to build portfolios over a longer period of time. I think we’ve also seen a little bit of migration away from the banks with the size of the overall private debt managers out there eating the dinner of some of the banks to an extent and playing in what were previously broadly syndicated CLOs. 

So I think that all takes into account how do you make that our work on the forward pipeline because even with market, a lot of these portfolios, once they get securitized and they’ve been originated for the past 12 to 18 months, there’s a lot of competition on that side too. And maybe those spreads have compressed 50 or a hundred plus basis points. So we’re going to need to see further tightening I think on the liability side on both broadly syndicated in the middle market to make sure that that ARB is still attractive. But I do think that historically the mid-teens on the broadly syndicated and the high teens is where you needed to be to source that third party equity bit.

Shiloh:

Are you seeing new demand for middle market equity or double Bs?

David:

Yeah, so middle market equity I think you know very well and you’ve been extremely successful with your fundraise and with the way that your platform has evolved over time, and I think you’ve seen value for a long period of time in that space. Being able to write a substantial minority ticket alongside the manager is going to allow you to source those opportunities in greater bulk. A lot of these managers, they are financing traits, so they don’t always sell the equity. There’s nothing more important in middle market than alignment of interest. So there are opportunities where you can get majority equity in the middle market, but you know better than everyone that you want that manager having a say in the underlying loans, controlling those loans across all their portfolios, making sure that there’s that a true alignment if anything goes wrong, they are originating these assets, making sure that they have the risk retention structures in place for European investors for US compliance, et cetera. So the barriers to entry and being able to source middle market equity and even double BS can be challenging and you have to be patient, but if you are patient and you have the right partners, it’s proven that you tell us how that straight has worked out.

Shiloh:

So it’s definitely worked out great. But I think I would add to the barriers of investing in middle market equity or double BS for newer guys is that the securities are really only available to onshore investors. So if you’re not dominant out here, it’s going to be pretty tricky to get involved in some of these transactions.

David:

It’s a hundred percent right. There is less than a handful of managers that have seasoning vehicles and it’s very cumbersome to set that up.

AI:

Note a seasoning facility buys middle market loans from the CLO manager and holds them for a brief period of time before they are purchased by the ccie. LOA seasoning facility enables offshore investors to participate in middle market CLO equity and double B rated notes.

David:

If you have onshore money like yourself, it gives you a massive competitive advantage to source these opportunities. And there’s not very many with the deeper pockets like yourself. And you don’t want 20 equity investors in a middle market CLO or frankly, probably even in the broadly syndicated CLO. You want to know who your partners are and the ability to have onshore money really sets you apart I think from the rest of the investor base and you’ll get first looks on transactions. That goes a long way.

Shiloh:

Yeah, I think we’re fortunate in that setup. So you’re a banker, you’re putting the deals together. Once the CLO closes, you guys get paid a fee and then from there on it’s really the CLO manager managing the structure and investors like us getting our cut of the economics, whatever we’ve signed up for. But I know you also sit at a ton of meetings where the CLO manager is talking to investors like us and describing what they think the credit quality of the loans is going in. I was wondering if you could just give us some insights there. Well,

David:

It’s a new business for Scotia and I think Scotia has hopefully we’ve gotten comfortable with the asset class, but also I think the managers need to do, and these are actively managed vehicles, they have to take a proactive view and sure, they don’t seem too fuss. You have to always be wary at that time, but they are evolving in the way that they think about it. I think from time to time, industries go in and out of favor and you need to be thoughtful in higher rate environments. Okay, what are those industries that potentially are going to be more stressed or what industries are going to outperform or perform well in higher rate environments? So I think we’ve seen managers pivot not necessarily on their strategy, but evolve in the way that they think about certain industries. I think for a long time, technology and software was definitely an area that people tried to shy away from and things can change.

Over the past handful of years we’ve seen that part of the market outperform others and not all technology and software companies are created equal, but a lot of them are quite substantial in size and you can even see it in the equities market if significantly outperformed. Some of the blue chips that we’ve been accustomed to thinking are the best and biggest companies out there. And same goes for CLO managers. I think that they’ve evolved and the way that they’ve thought about industries and as actively managed portfolio managers, they’ve had to give some thought on what these rate environments and different environments in general are going to have an impact with regards to their portfolios.

Shiloh:

I think the biggest evolution I’ve noticed from the managers is just that for oil and gas, which was 5% of these portfolios back in 20 15, 20 16, we’re just really not seeing a lot of these energy names in portfolios anymore. And the reason is that it’s just this one risk that’s unquantifiable as a result. I think secured lenders just do not have a lot of appetite for these companies. So you do see some double digit industry exposure in technology, for example, in healthcare, but when you delve into it, it’s literally dozens of different business models. So there’s not one risk that it’s all correlated to like there was in oil and gas years ago or so. I think one other thing I’d point out is that whenever we’re talking about the risk in the loans, what we’re doing really is unique from other loan investing in that every CLO investor I imagine that you talk to for equity for example, is running a 2% default rate through the portfolio.

We know we acknowledge upfront that not all of the 200 loans in the CLO are going to work out as expected, and so we’re budgeting to take losses and we’re still targeting what we think are mid-teen or higher returns net of those loan losses where in other vehicles people are investing, they may look at a yield from a loan fund or a bond fund and they mistake, in my opinion, in that yield for future return. And it’s roughly correct as long as no loans or bonds default, but unfortunately that isn’t the world of high yield credit.

David:

It’s a great point. I think you need to really take into account, you have to change your assumptions, you have to take into consideration what these higher rate environments are going to do for your default assumptions. Also, when the credit markets are quite hot, you have to look at prepayment rates as well, and that’s going to go into the overall economics to your investment. At the end of the day, if you have a portfolio that was originated in a very attractive timeframe and those portfolio companies and those assets are performing quite well, there’s a high likelihood posted on-call period that you’ll get refinanced as soon as they can out of those assets and you need to take into consideration all of these dynamics when you’re looking at any of these investments.

Shiloh:

So after being in the CLO space for 20 years, what’s the one thing you find most interesting about our industry?

David:

I think that it’s still somewhat of a clubby market. It’s evolving. I think I love that we’ve seen an evolution of, call it middle market private credit CLOs, the receptiveness of investors now willing to dive into that part of the market where they never were the stepchild of the market for a long period of time and just the way that the CLO market evolves. You can use CLO technology in a lot of different ways and you’re not going to your job every day and it’s the same thing in and out. You got to be on your toes and you got to really be thoughtful with regards to who you’re working with, who your partners are, and it’s a long game. It’s a long nine innings, and the market ebbs and flows in times of stress, sometimes creates the best opportunities and sometimes when the markets are seemingly great, it tends to be exceptionally slow. You never know what you’re necessarily going to get. But I think working with good people, having new investors, new managers, and even the evolution of the retail market with ETFs, I have my aunts and uncles asking me about various CLO ETFs and interval funds, and I think it’s exciting when the Flat Rocks of the world are able to issue and given different products to investors that historically have not been able to enter this part of the market. And it’s certainly creating for more interesting conversation and makes your job interesting.

Shiloh:

I think it definitely is maybe surprisingly a relationship business. When I started going to CLO conferences a little bit over 10 years ago, the middle market CLO panel was really, if there were 10 or 15 people in the audience, you’d be lucky, and a few of those would’ve been people that were just working on something from the last presentation and didn’t get the cue that it was time to get up and go. And then now the middle market panel is probably as busy as the CLO equity panel. I do think relationships are huge in the space, and one of the things that I like about it is that sometimes we’re buying bonds in the secondary, so the CLO LO already exists and you’re just trying to get a price and it’s a zero sum game, so we’re sometimes buying CLOs that way, but in the primary market is totally different. It feels more like this team process where everybody’s working. You other equity investors, everybody’s pushing for the best steel and it’s somewhat of a team effort to get it over the finish line. And so doing that with people that you, I can respect, I find that very rewarding.

David:

I can’t agree with you more. I can’t remember ever working with a single equity investor one time or a single manager one time. I think you’re all working to a common goal, whether it’s working with the investor side, the manager side, collectively, I think that we are all in this together. We see a long-term future in this product, and relationships are immensely important to getting everything done in the collective success of having a fluid market for the long-term. It’s important for managers to have a liquid illiquid to have both buckets, especially in times of stress, to be able to play in liquid markets that are less liquid. To have a view there to be able to go anywhere with assets just in general is helpful. Yes, there’s certain managers that have not done as well as others in terms of differentiating the platform, and I think that’s hugely important. But if you’re not well capitalized, I think going forward and just the CLO landscape both on BSL and middle market, you’re in for a tough ride. There’s no reason for 150 managers anymore.

Shiloh:

CLO management is a scale business and either you have the capital to do deals in favorable markets and not favorable markets, or you’re just not going to be relevant. And if you’re out of the market for a while and you come back, then your CLOs cost of debt’s going to be elevated and somebody’s got to bear that additional cost from the equity seat. That’s a manager problem. But I think you need to be able to do three or more deals a year with outside capital or not to be relevant in the space

David:

Three deals a year, but tying them appropriately. You don’t want to do a deal just to do a deal, but you couldn’t say better. If you’re not in the marketing a consistent basis, you’re not going to get the right liability pricing if you don’t get the right liability pricing, the equity doesn’t work. So whether it’s three new issues or if it’s two new issues in a reset, I think just having enough transactions to be relevant to your end investor base, that’s going to certainly just improve the cost of financing and the CLO execution going forward.

Shiloh:

Well, thanks again, David. This is really above and beyond the call of duty.

David:

Thank you for having me Shiloh. Really appreciate it.

AI:

The content here is for informational purposes only and should not be taken as legal business tax or investment advice or be used to evaluate any investment or security. This podcast is not directed at any investors or potential investors in any Flat Rock Global Fund definition section. The secured overnight financing rate software is a broad measure of the cost of borrowing cash overnight. Collateralized by treasury securities, 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. A collateralized debt obligation. CDO is a structured finance product that is backed by a pool of assets other than leveraged loans. Securitization divides cash flows amongst different investors in a pool of assets.

Global financial crisis or GFC refers to the banking downturn in 2008 and 2009. Asset backed securities are securitizations, usually backed by non-first lie and loan collateral. Par lender is a lender focused on buying loans that are not in stress. Risk retention is when the CLO manager acquires securities in its CLO to meet regulatory requirements. Junior capital is financing that has a lower priority claim in debt repayment to a secured term loan spread is the percentage difference in current yields of various classes of fixed income securities versus treasury bonds, or another benchmark bond measure yield is income returned on investment, such as the interest received from holding a security. The yield is usually expressed as an annual percentage rate based on the investments cost, current market value or face value. The Flat Rock Global CLO equity index and its legal disclaimers are available on the Flat Rock Global website.

Amortization is the process by which the CLO repays its financing after the reinvestment period ends ETFR, exchange traded funds. General disclaimer section references to interest rate moves are based on Bloomberg data. The credit quality of fixed income securities and a portfolio is assigned by a nationally recognized statistical rating. Organizations such as Standard and Pores, Moody’s or Fitch as an indication of an issuer’s credit worthiness ratings range from triple A highest to D lowest bonds rated Triple B or above are considered investment grade credit ratings. Double B and below are lower rated securities, also known as junk bonds. Any mentions of specific companies are for reference purposes only and are not meant to describe the investment merits of or potential or actual portfolio changes related to securities of those companies unless otherwise noted. All discussions are based on US markets and US monetary and fiscal policies.

Market forecasts and projections are based on current market conditions and are subject to change without notice, projections should not be considered a guarantee. The views and opinions expressed by the Flat Rock Global speaker are those of the speaker as of the date of the broadcast and do not necessarily represent the views of the firm as a whole. Any such views are subject to change at any time based upon market or other conditions, and Flat Rock Global Disclaims, any responsibility to update such views. This material is not intended to be relied upon as a forecast, research, or investment advice. It is not a recommendation offer or solicitation to buy or sell any securities or to adopt any investment strategy. Neither Flat Rock Global nor the Flat Rock Global Speaker can be responsible for any direct or incidental loss incurred by applying any of the information offered.

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